The end of fixed income with F/m's CEO
"Rotation" ETFs keep the money compounding
On Valentine’s Day 2025, I wrote an ode to the infamous heartbeat trade, which powers the tax efficiency of the ETF industry.
I was channeling Bloomberg’s 2019 piece in my hook, The ETF Tax Dodge is Wall Street’s Dirty Little Secret, one of the original articles on heartbeats.
Ben pointed out that it’s no secret (and many people agreed).
He’s right, of course. The heartbeat trade is perhaps technically complex, but well-known by now.
Matt Levine and Justina Lee at Bloomberg both wrote about it again recently.
For anyone technically curious, I recommend The Heartbeat of ETF Tax Efficiency by Elisabeth Kashner.
Anyway, since the heartbeat trade is so well known, we’re starting to see more creative uses of it.
For instance, I first reported how buffer ETFs achieve their pristine tax efficiency using heartbeats (side note/shameless plug: AQR recently cited my work in its critique of buffer ETFs).
It’s also common in other derivative applications, too, like box spread ETFs, and covered call ETFs.
However, rather than doubling down on complex options strategies, a new batch of ETFs simply hold other ETFs and heartbeat them in and out for various purposes, including alpha and cash efficiency, and end up creating some primo tax perks along the way.
What are rotation ETFs?
Rotation ETFs (I made up this term) hold other ETFs and heartbeat between alternative holdings to avoid distributions.
The simplest example is perhaps Roundhill’s XDIV, which I wrote about a handful of weeks ago. It “seeks to track the total return of the S&P 500® Index without paying distributions.”
To accomplish that goal, it simply heartbeats its one ETF holding out just before the ex-dividend date to side-step any dividend distributions, and replaces it with something else1.
There are two main reasons listed on their website: “to remain fully invested in the S&P 500® Index without the need to reinvest distributions” and tax efficiency.
Most dividend reinvestment programs in the US reinvest fractional equity shares very quickly, so the tax efficiency is what grabs my attention.
With a 1.30% S&P 500® dividend yield, cutting the dividend could mean 0.20% - 0.48% in annual tax savings. Should we call it tax alpha? It sorta is.2
Investors pay a layered fee of 8.49 basis points on top of a 2 basis point fee for SPLG.
So, in this case, the tax savings outweigh the extra cost, at least based on my rough estimates.
With the floodgates open, others are emerging with rotation ETFs in a thornier corner of the markets, fixed income.
Fixing income
Nearly anything can be rotated, so why not rotate through fixed-income ETFs to avoid income distributions?
That’s exactly what Alexander Morris at F/m Investments, an $18 billion investment manager, is doing with their new fund, F/m Compoundr U.S. Aggregate Bond ETF (CPAG), an ETF that avoids income distributions while approximately replicating AGG exposure.
F/m is a nerdy business name.
“We took the concept of a startup accelerator [the ‘a’], made it into a physics joke, and it stuck,” Morris told me last week.
If Force = mass x acceleration, then Force/mass = acceleration, and F/m was born.
F/m’s CPAG has a similar pitch to XDIV: staying invested and tax efficiency.
It replicates one of a novel index series called NASDAQ Compoundr (methodology, website), which “are designed to offer exposure that is commensurate with the total return of the underlying bond types without reinvesting dividend income.”3
With an approximate AGG yield of 3.36%, deferring income tax drag could mean saving 0.40% - 1.82% annually under some basic assumptions.4
Those savings are well above CPAG’s 0.45% total fees, though that may be more than some folks want to pay.
The tax will eventually come due when investors sell their CPAG shares. Though importantly, the growth will be price return taxable at (likely) long-term capital gains rates.
So, we have several benefits from this rotation ETF:
Income is indefinitely deferred
The tax character is capital, not ordinary (so, harvested losses can offset it)
The applicable rate upon sale will likely be long-term capital gains, not ordinary income.
“This whole product direction came from investors. They don’t want the income,” Morris said.
He thinks there may be interest from tax-exempt foundations and endowments for operational efficiency.
“Depending on the underlying asset, reinvestment following a dividend could take some time, and the reinvestment fills could be costly.”
He explained that investors are always dissecting why their experienced total return is different from the reported total return. F/m wants to close this gap.
Zooming out
“Taxable bonds should have a higher return as muni yields will be lower due to their tax-exempt status,” John West, a founder of Flatrock Wealth in Newport Beach, told me last week, but over some time periods, they don’t.
“My own theory is post [global financial crisis] liquidity dried up in munis… So since then, they have offered an illiquidity premium.”
In other words, if investors are considering products and tax efficiency, especially for high-bracket investors based in California, a muni fund like VCADX may be worth including in a side-by-side pre- and post-liquidation backtest.
In the rotation
Almost anything can be rotated. For instance, F/m Compoundr U.S. High Yield ETF (CPHY) is live today using an approach similar to CPAG.
Morris says F/m has essentially productized operational efficiency and plans to disrupt other areas of fixed income, too.
This could have a wide-ranging impact on portfolio design, including asset location. If more asset classes are taxed like equity, then investors might have some extra planning tools in the near future.
Oh, also… Dividends ≠ income
Have a nice weekend
Nerds may be interested in knowing that if the shares are trading below cost basis, the ETF may simply harvest a tax-loss and replace the holding with something else as an alternative to a heartbeat trade. TBD. We have to wait and see if their financial reports include accrued capital losses. They also need to be mindful of the wash sale rule. I digress…
Assumptions. S&P 500 dividend yield: 1.3%
High-tax investor: 20% LTCG + 3.8% NIIT + 13.3% state = 37.1% effective
Low-tax investor: 15% LTCG, no NIIT, no state = 15% effective
Annual drag = Dividend Yield × Tax Rate
High-tax investor: 0.013×0.371=0.004823⇒0.48% per year lost to taxes
Low-tax investor: 0.013×0.15=0.00195⇒0.20% per year lost to taxes
Consult an adviser. Check for errors. Rough math. Not specific to any individual
Interestingly, this was already picked up by FRED, which is a snappy marketing/backlink idea I’ll have to keep in mind for future use.
Assumptions. AGG yield: 3.36%
High-tax investor: 37% ordinary + 3.8% NIIT + 13.3% state = 54.1% effective
Low-tax investor: 12% ordinary, no NIIT, no state = 12% effective
Annual drag = Distribution Yield × Tax Rate
High-tax investor: 0.0336 × 0.541 = 0.0182 ⇒ 1.82% per year lost to taxes
Low-tax investor: 0.0336 × 0.12 = 0.0040 ⇒ 0.40% per year lost to taxes
You can sanity check these numbers using Morningstar’s Tax Cost Ratio, which does not include NIIT or state tax but is still a useful gut check.
Consult an adviser. Check for errors. Rough math. Not specific to any individual