Animal Spirits Podcast: "Talk Your Book: Finding Tax Alpha in Fixed Income"

Episode Information

• Title: Talk Your Book: Finding Tax Alpha in Fixed Income
• Release Date: August 4, 2025
• Host: Michael Batnick and Ben Carlson
• Guest: Alex Morris from FM Investments

Introduction

In this episode of the Animal Spirits Podcast, hosts Michael Batnick and Ben Carlson delve into the innovative strategies employed by ETF providers to generate Tax Alpha in the fixed income market. The discussion centers around FM Investments' new Compounder Series of ETFs, which are designed to minimize taxable distributions, thereby enhancing after-tax returns for investors.

The Rise of Tax Alpha in ETFs

Ben Carlson opens the conversation by highlighting the growing emphasis on Tax Alpha among investors and ETF providers.

Ben Carlson [00:45]:
"Michael our inboxes are full of Tax Alpha these days and ETF providers are getting smart to the fact that they can now make changes that make it more tax advantageous because people really care about paying less in taxes."

Key Points:

• Tax Alpha Defined: Strategies that enhance after-tax returns by minimizing the tax impact of investments.
• ETF Innovation: FM Investments introduces the Compounder Series, which employs mechanisms to reduce taxable distributions.
• Market Demand: Increased investor focus on tax efficiency is driving ETF providers to innovate.

FM Investments' Compounder Series

Alex Morris explains the mechanics behind the Compounder Series and how it differentiates from traditional fixed income ETFs.

Alex Morris [02:16]:
"There is going to be more and more of this. So we've talked to Alex before. We talk about a bunch of different things... So here's our talk with Alex Morris from FM Investments."

Key Points:

• Launch Date: The Compounder Series is slated for release on August 12th, 2025.
• Structure: Utilizes ETF structures to avoid paying out income, thereby deferring taxes for investors.
• Strategy: Instead of distributing dividends, the ETF temporarily switches to a proxy asset around distribution dates to prevent taxable events.

Notable Quote: Alex Morris [06:28]:
"We're stepping out of the way. So for the div chasers, we're the div avoiders. We don't want the dividend, we just want to see continuous price appreciation in the fund."

Transforming Bond Returns into Total Returns

The discussion transitions to how the Compounder Series effectively converts bond returns into total returns by reinvesting income.

Alex Morris [06:18]:
"So you are transforming bond returns into total returns. So you're stripping out the income or you're putting the income back into the product. How does that happen?"

Key Points:

• Continuous Compounding: By avoiding distributions, the ETF allows returns to compound continuously.
• Investor Control: Investors can choose when to take distributions, optimizing their tax situations.
• Comparison to Traditional ETFs: Traditional bond ETFs distribute income regularly, creating taxable events for investors.

Notable Quote: Alex Morris [07:26]:
"The distribution power is to the investor then, not us. Because you know, in all fairness, us generating cash, giving it to you, you giving it back to us is pretty clunky."

Tax Efficiency Through ETF Structures

Ben Carlson probes into how the ETF vehicle facilitates these tax-efficient strategies.

Ben Carlson [07:37]:
"And the ETF structure is the thing that unlocks this and allows you to do this strategy easily. Right, because there's obviously some turnover involved. So explain how the ETF vehicle has sort of unlocked a lot of these strategies."

Key Points:

• Tax Efficiency: ETFs inherently offer tax advantages over mutual funds by limiting capital gains distributions.
• Dividend Avoidance as a Form of Tax Harvesting: The strategy mirrors tax-loss harvesting by avoiding taxable dividends.
• Operational Mechanism: The ETF switches out of dividend-paying securities before distributions and back after, ensuring minimal tax impact.

Notable Quote: Alex Morris [08:38]:
"Think of this as an ongoing tax harvest that's happening, but as opposed to taxes, it's an ongoing dividend avoidance strategy because we just don't want the dividend, we're in it for the capital appreciation."

Impact on Traditional Investments and Asset Location

The conversation explores how FM Investments' strategies compare to traditional investments like municipal bonds and the implications for asset allocation.

Ben Carlson [10:11]:
"How much of a competition is this to munis? Like are you on the muni fund block right now... Is this like, is this a problem for munis bonds in the future?"

Key Points:

• Municipal Bonds vs. Tax Alpha ETFs: While municipal bonds offer tax-free income, they come with different risks and liquidity profiles.
• Asset Allocation Flexibility: The Compounder Series allows investors to hold fixed income in taxable accounts without the tax drag from distributions.
• Complementary Strategies: The ETFs provide an alternative or complement to municipal bonds, catering to different investor needs.

Notable Quote: Alex Morris [11:23]:
"Taxes cause people to do some pretty wacky things. How do we just stop that? Like we shouldn't be allowing the tax tail to wag the dog at any point."

Addressing Potential Challenges and Risks

Alex Morris discusses the potential challenges in implementing such strategies and the importance of maintaining robust management to mitigate risks.

Ben Carlson [13:31]:
"This idea is so simple and I mean that in the best way possible. It is brilliant in its simplicity. So there's no like execution risk, is there?"

Key Points:

• Execution Risks: Managing ETF transactions to avoid distributing dividends without disrupting the market requires precise execution.
• Regulatory Considerations: Navigating SEC regulations and ensuring compliance is crucial.
• Market Dynamics: Potential reactions from the market, such as aligning dividend dates, could impact the strategy's effectiveness.

Notable Quote: Alex Morris [14:43]:
"Simple things done well over a long period of time often prove much more nuanced and difficult than I think folks at SEC at first."

Listener Questions and Deep Dives

The hosts address intricate questions from listeners, focusing on the performance of specific ETF strategies relative to inflation expectations.

Listener Question [17:42]:
"Since inception in February, the R bill is up 1.5% and the T bill is up 1.7%... It seems like something fishy is going on."

Alex Morris' Response [18:57]:
Explains the nuances of the Compounder Series, emphasizing that the ETF tracks a six-month bill rather than the pure T-bill market, which accounts for the observed performance discrepancies.

Key Points:

• Performance Metrics: The Compounder Series is designed to track shorter-duration bills, which aligns differently with inflation expectations compared to traditional T-bills.
• Market Efficiency: The ETF has beaten its underlying index net of fees, attributed to strategic trading and efficient management.
• Inflation Strategies: The ETF offers protection against inflation without the duration risk typically associated with TIPS.

Notable Quote: Alex Morris [21:41]:
"Our bill, if we look at it versus say a six-month bill, which is probably more in line with our average duration, you’re going to find they chase each other every day pretty closely."

Future Outlook and Expansion Plans

Looking ahead, Alex Morris outlines FM Investments' plans to expand the Compounder Series into various fixed income asset classes, enhancing tax efficiency across the board.

Alex Morris [24:04]:
"We've seen some action starting to come to our bill... We're starting to see some bites of action coming into high yield and we're starting to see a diversification of where folks are."

Key Points:

• Asset Class Expansion: Plans to introduce Compounder ETFs in higher income and alternative fixed income asset classes.
• Market Reception: Positive initial reception with substantial assets under management, indicating strong investor interest.
• Long-Term Strategy: Focus on providing continuous, tax-efficient fixed income solutions that cater to a diverse range of investor needs.

Notable Quote: Alex Morris [29:06]:
"We’re really encouraging folks to buy into that middle and hold onto it. We build bonds to go back to 100, right, or 1,000 or 10,000 and then reload."

Conclusion

The episode concludes with a reaffirmation of the value that FM Investments' Compounder Series brings to the fixed income landscape. By leveraging ETF structures to minimize taxable distributions, these funds offer investors enhanced after-tax returns and greater flexibility in managing their portfolios.

Final Remarks [31:43]:
Ben Carlson:
"Remind investors and advisors where they can go to learn more about your funds."

Alex Morris [31:47]:
"Fminvest.com has everything you'll need to know."

Takeaway:
For investors seeking to optimize their fixed income allocations with a focus on tax efficiency, FM Investments' Compounder Series presents a compelling solution. The strategies discussed in this episode underscore the evolving nature of ETF offerings and the increasing importance of tax planning in investment decisions.

Listen to the full episode for an in-depth exploration of Tax Alpha strategies and their impact on the fixed income market.