Leveraged ETFs Create Demand for Tax Analysis Software

Despite some of the warnings about “leveraged’ exchange traded funds, these high-octane instruments have become popular among retail investors and mutual funds.

“These things are popular so every asset manager is creating them,” said George Michael, CEO of G2 FinTech, a developer of tax analysis and risk mitigation software for securities transactions.

These more complicated ETFs allow investors to pump up their returns against the indexes they track – such as the S&P 500 – for a single day. It’s a way for someone who is not comfortable with short positions or margin accounts to behave that way. For example, reversed leveraged ETF allows an individual investor to bet against the stock market by buying a long security. Then if the market goes down, they make triple their money, explained Michaels. An inverse ETF would perform in the opposite direction. Leveraged ETFs are now popular and can be traded by an investor in a retail brokerage account.

To compete with hedge funds that are allowed to short stocks, mutual fund companies have created so-called 40 Act funds that hold leveraged ETFs. Large asset managers like Vanguard and BlackRock are big manufacturers of ETFs. Vanguard created the Vanguard 500 fund while Fidelity has the Spartan 500 fund. Hedge funds have also released “40 Act” funds to appeal to conservative institutional investors that use very little leverage, charge lower fees, and are overseen by strong boards of directors and custodians.

However, as leveraged ETFs proliferate, this can create compliance and tax headaches for fund administrators that provide accounting services to hedge funds and mutual funds. With reverse and inverse ETFs, fund administrators are now dealing with mutual funds that resemble hedge funds. Funds holding ETFs have all sorts of compliance rules that fund administrators never had to deal with before, said Michaels. In particular they are subject tax rules that don’t apply to long-only funds but apply to leveraged ETFs. “Now a lot of fund administrators are coming to us,” said Michaels, whose firm provides TaxGopher, a tax analysis product. Traditionally, a fund administrator had to go to their audit firm, which would bill them for the service. Mutual funds didn’t need to know these tax rules because they didn’t trade options, they didn’t go short and they didn’t use leverage, notes Michaels.

But the widespread adoption of ETFs is creating an opportunity for audit firms that can charge a premium for the tax analysis and tax preparation. “The public accounting firms in Nirvana because now all the fees go through the roof,” said Michaels. “We’re racing ahead and automating more and more of the features that traditionally you had to go to a public accounting firm for,” he said.

By contrast, if audit firms do the tax analysis, clients may need to write a blank check, he claims. "If an audit firm does a straddle analysis on your portfolio because you traded a reverse ETF, they’re going to be charging you.” A major accounting firm could charge a half a million dollars for that type of analysis, suggests Michaels. His firm offers software at a fraction of the price that a public accounting firm would charge. The software automates the analysis for firms that trade derivatives can use to pass an audit. “The thing is making sure you pay your taxes correctly, but paying to prepare your taxes is where we are trying to save them money,” said Michaels.

Fund managers tend to hire public accounting firms after the year is over and the damage is done. But if firms use software they can do your analysis say in November, when there is time to fix some of these tax issues, noted Michaels. However, if firms are using a public accounting firm, they refuse to look at things until February and only do it once, he said. If the software is used, the firm can run the analysis each month.

Fund administrators can actually do the analysis themselves if they had the software. “What makes the fund admin different is they are doing a very important job in making sure their customers are in compliance with the IRS tax code,” said Brian Roberti, managing director at G2 FinTech. The fund administrator has the opportunity to provide daily views for tax sensitive strategies, said Roberti. “Now all of a sudden they look different than their competition. It almost makes the small administrator leap ahead of the big guys,” he said.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio