The Challenge
When new ETFs launch through Section 351 exchanges, they inherit a mix of securities from separately managed accounts that may not match their investment goals. These “seed assets” need to be gradually replaced with securities that fit the fund’s strategy.
Timeline: 1-12 Months
Most ETFs take between 1 to 12 months to fully rebalance. During this period, investors may see tracking error as the fund’s performance differs from its benchmark due to holding mismatched assets.
Two Rebalancing Approaches
Fast Track: “Heartbeat Trades”
Some ETFs can swap out 40%+ of their holdings within days using sophisticated tax-efficient transactions called heartbeat trades. This involves coordinated creation and redemption trades with authorized participants to exchange unwanted securities for desired ones without triggering taxes.
Examples:
- Twin Oak Active Opportunities ETF (TSPX) replaced 40% of holdings (including Snowflake and Datadog stakes) with S&P 500 tracking funds shortly after launch
- Stance Sustainable Beta ETF quickly sold fossil fuel positions (Exxon, Chevron) to meet sustainability goals
- Castellan Targeted Equity ETF eliminated its largest holding (Palantir) within three days
Gradual Approach: Phased Transition
Many funds spread rebalancing over months to maintain “economic legitimacy” and avoid IRS scrutiny under the economic substance doctrine. Rapid selling could be viewed as tax avoidance rather than legitimate investing.
Examples:
- Avantis US Quality ETF slowly sold foreign securities over about a month
- Cambria Tax Aware ETF still held 12% in a Vanguard ETF and 5% in Nvidia two months post-launch
The Tax-Efficient Secret
ETFs use in-kind transfers to swap securities without triggering taxable events. This core ETF feature allows funds to remove appreciated assets from their portfolio while preserving tax efficiency for both the fund and its shareholders. The complexity of coordinating these transfers can extend rebalancing timelines but maintains the tax advantages that make ETFs attractive.
