Webinar Replay: The Cambria US EW ETF and 351 ETF Conversions (USEW) | Meb Faber

Key Concepts

• Diversifying highly appreciated securities: The core problem addressed, where investors hold significant gains in certain assets and face tax implications when selling.
• 351 Exchange: A tax code provision allowing the contribution of assets to a corporation without immediate taxation, utilized here for ETF formation.
• Market Cap Weighting: The dominant investment strategy where portfolio allocation is based on a company's total market value.
• MAG7 (Magnificent Seven): A group of large-cap technology stocks that have driven significant market gains.
• Schiller CAPE Ratio: A valuation metric that smooths out short-term earnings fluctuations by using a 10-year average of earnings.
• Shareholder Yield: A measure of the total cash returned to shareholders through dividends and buybacks.
• Endowment Effect: A cognitive bias where people value something more highly simply because they own it.
• Taxable vs. Tax-Exempt Investors: The distinction between investors who pay taxes on investment gains and those who do not.
• ETF Structure: The benefits of Exchange Traded Funds, including tax efficiency and liquidity.
• Asset Location: The strategic placement of different asset types in taxable and tax-advantaged accounts to minimize overall tax liability.

Current Market Environment and Challenges

The current market is characterized by an extended bull run, described as "as good as it gets" for US stock investors, with a "romping, stomping bull market for 15 plus years." This has led to historically high valuations.

• High Valuations: The Shiller CAPE ratio is at the second-highest level ever, only surpassed by the 1999 dot-com bubble peak. It is currently above 40, a significant contrast to the 12 seen in 2009.
• Low Dividend Yield: The US stock market dividend yield is at a historic low of 1.15%, down from 1.1% in 1999.
• Global Valuation Disparity: The US stock market is currently the most expensive in the world across multiple valuation metrics, with India and Denmark also showing high valuations.
• Concentration Risk: The market is heavily concentrated, with the top five companies in the S&P 500 (Nvidia, Microsoft, Apple, Alphabet, Amazon) comprising nearly a third of the index. Nvidia alone is approaching a $5 trillion market cap.
• Underperformance of Traditional Strategies: Small and mid-cap stocks, as well as value stocks, have underperformed. Foreign and emerging markets are significantly cheaper.
• Market Cap Weighting Drawbacks: While market cap weighting guarantees ownership of winners, it leads to over-allocation in highly appreciated stocks without a tether to fundamentals. Historically, excluding the single largest stock from a portfolio has improved returns by approximately 20 basis points annually. Research indicates that the largest stock in a market or sector typically underperforms the market by about 3% per year over the next decade.

The Problem of Highly Appreciated Securities and Taxable Investors

Investors who have benefited from the long bull market, particularly those in taxable accounts, face a significant challenge: holding highly appreciated securities.

• "Fat and Happy" but Facing a Dilemma: Investors are comfortable due to market gains, but selling these appreciated assets triggers substantial capital gains taxes.
• The "Ostrich Style" Approach: Many investors choose to ignore the problem, hoping it will resolve itself, which is a "horrific idea" for concentrated positions.
• The Endowment Effect and Bias: Investors develop an attachment to their winning positions, believing their personal success is repeatable and universally applicable, despite historical evidence of concentrated positions failing (e.g., Enron, CMGI, Lucent).
• Limited Traditional Options: Historically, taxable investors had two main choices: hold and hope, or sell and pay significant taxes.

The 351 Exchange: A New Solution

The video introduces Section 351 of the tax code as a mechanism to address the problem of highly appreciated securities for taxable investors.

• What is a 351 Exchange? It allows the contribution of assets to the formation of a corporation without triggering an immediate taxable event. Traditionally used for business formations (e.g., contributing a farm, barn, tractor), it has found a "magical marriage" with the ETF structure.
• How it Works for Investors: Investors can contribute appreciated stocks or ETFs to a newly formed registered investment corporation (which becomes an ETF) and receive ETF shares in return, deferring the capital gains tax.
• Regulatory Requirements for Diversification: To prevent tax avoidance, regulators require a diversified portfolio contribution.
  • Rule 1: The largest single position cannot exceed 25% of the contribution.
  • Rule 2: The top five positions cannot exceed 50% of the contribution.
  • Implication: This generally requires at least 12 stocks or the contribution of an already diversified ETF (like SPY) or a pass-through entity.
• Timing: The diversification rules apply at the time of ETF launch (the "seed" contribution). Once launched, the ETF trades like any other.
• Tax Safety and Precedent: Over a hundred such conversions have occurred, primarily from mutual funds or hedge funds to ETFs. Major institutions like Goldman Sachs have executed large conversions. The speaker believes this is "rock solid" and unlikely to be retroactively challenged, as it benefits retail investors and theoretically makes the market more efficient. It is not limited to accredited or qualified investors.
• Market Efficiency Argument: This mechanism can theoretically make the market more efficient by allowing active managers and investors to cycle out of expensive, concentrated positions into the broader market, potentially catalyzing small-cap, mid-cap, and value rotations. It can also benefit mutual funds stuck with appreciated positions and unwilling to distribute capital gains.

What Qualifies and What Doesn't for 351 Contributions

• Qualifying Assets: Liquid, exchange-traded assets.
• Non-Qualifying Assets: Futures, options, margin securities, micro-cap stocks, private assets, mutual funds, cryptocurrencies (though Bitcoin may be accepted in the future). Foreign stocks are only accepted if they align with the specific ETF's mandate.
• Cost Basis Preservation: The original cost basis of the contributed assets is preserved within the new ETF. This allows for granular management of individual positions within the ETF, offering flexibility for future sales, donations, or holding.

Cambria's 351 ETF Offerings and Track Record

Cambria Funds has successfully launched and managed several 351-based ETFs.

• Number of Funds: They are on their fourth launch.
• Previous Funds:
  • Fund 1 (Tax ETF): A US stock fund targeting value and quality companies with low to no dividends. Launched with $30 million.
  • Fund 2: Over $100 million.
  • Fund 3: Over $150 million.
  • Fund 4 (US EW): The newest fund, discussed in detail.
• Growth Projection: The speaker anticipates these funds will cross the billion-dollar mark per launch by 2026.
• ENDW (Endowment Style Strategy): An asset allocation fund using 140% leverage, targeting institutional investors.
• GUO (Global Stock Fund): Launched recently, performing well.
• US EW (US Equal Weight ETF): The upcoming fund, designed to break the market cap link.

Liquidity and Investor Concerns

• ETF Liquidity: The liquidity of an ETF is tied to the liquidity of its underlying holdings, not just its on-screen trading volume. For highly liquid underlying assets like large-cap US stocks, liquidity is generally not a concern, even for large trades.
• Holding Period: While investors can redeem ETF shares, doing so immediately after contribution would likely trigger taxes on any contributed assets with gains, as the original cost basis is preserved. Most investors are expected to hold for the long term.
• Blackout Windows: The fund can be mindful of blackout windows for companies with concentrated positions during launch.

The New Fund: US EW (US Equal Weight ETF)

• Objective: To provide diversified exposure to the top 500 US companies while avoiding market cap weighting.
• Strategy: Breaks the market cap link, aiming for a diversified portfolio of the top 500 US companies.
• Cost: A "rock bottom" 0.25% expense ratio.
• Timeline: Contributions are due by November 19th, with paperwork finalized by Thanksgiving. The fund launches in mid-December.
• Minimum Investment: Varies, but generally not recommended for very small investors who might benefit more from realizing gains.
• Advisor Involvement: Individuals must go through a financial advisor, who will charge a 0.05% fee. This is due to custodian requirements (Fidelity, Schwab) that prefer dealing with advisors for managing numerous individual accounts.
• Custodian Support: Schwab is noted as easy to work with, while Fidelity is less so. A list of approved custodians is available.

Expected Returns and Market Outlook

• Bogle's Formulas: Using traditional formulas (dividend yield, earnings growth, valuation changes), expected future returns for the US broad market cap-weighted index are projected to be in the low single digits, potentially near zero given the current 40 PE ratio.
• Unpredictability: The market could still experience irrational exuberance, with PE ratios rising further.
• Historical Precedent: Periods of high valuations (like the late 1990s) have historically favored equal-weight, value, and shareholder yield strategies over market cap weight.
• Equal Weight Advantage: Equal-weight strategies are believed to outperform market cap weight by 1-2% annually.
• Valuation Gap: There is a significant valuation spread between market cap-weighted indices and alternative weighting methodologies.

Other Investment Strategies and Alternatives

• Value, Momentum, and Trend: These strategies are favored by the speaker.
• Managed Futures: While currently struggling, managed futures are considered a viable alternative investment. Cambria has funds like MUTF (managed futures) and GMO (global macro, long-only, gold miners, Bitcoin, foreign stocks).
• Alternative Investments: The speaker discusses their podcast with Katie Kaminsky on managed futures and their "totally not crushing it" series profiling underperforming strategies like value/momentum and global deep value.
• Fixed Income Concerns: A significant concern is the lack of yield in the fixed income space. The TYLD fund, which invests in fixed income only when yield spreads are attractive relative to T-bills, has remained 100% in T-bills since inception due to low spreads. The speaker questions the rationale of investing in corporate and junk bonds with historically low spreads, especially given the potential for significant losses if volatility increases.
• Asset Location Revolution: The speaker predicts a shift towards more personalized asset location strategies, considering an investor's life stage (wealth building vs. income needs) and reinvestment behavior. This will lead to a focus on tax-efficient structures and low-yielding assets for wealth builders, and high-yield assets for income seekers.

Miscellaneous Questions and Answers

• Contribution of Single Stocks: Limited to 25% due to 351 rules.
• What Happens to Contributed Stocks: If they match the target portfolio, they are kept. If not, they are rebalanced out.
• Tax Deferral: The 351 exchange is a deferral, not an elimination of taxes.
• Fee on Contribution: No fee for contribution itself, only the ETF's management fee (0.25%).
• Difference from RSP: RSP is an equal-weight ETF that cannot be seeded via a 351 exchange.
• Leverage: The contributed portfolio cannot be a margined account, but leverage can be obtained elsewhere.
• ETF Expense Ratios: Management fees are tax-deductible, and short lending revenue can further reduce effective costs, potentially leading to negative expense ratios.
• Most Concerning Market Factor: Valuation of US stocks is widely discussed, but the lack of yield in fixed income is a less discussed but significant concern.
• Required Holding Period: No explicit holding period is mandated, but immediate redemption of appreciated assets would negate the tax deferral benefit.
• Webinar Replay: Likely available, with additional resources on Cambria's website.

Conclusion

The current market environment presents high valuations and concentration risks, particularly for taxable investors holding appreciated securities. The 351 exchange offers a novel solution by allowing investors to contribute these assets to a new ETF, deferring capital gains taxes while gaining diversified exposure. Cambria Funds is actively utilizing this mechanism with its new US EW ETF, aiming to break the market cap weighting paradigm and provide a more tax-efficient and potentially better-performing investment strategy. The speaker emphasizes the importance of considering individual investor circumstances and the evolving landscape of asset location strategies.