Description

For those of you in the VIC community old enough to remember the movie classic “Animal House,” TOGA is for you: https://www.youtube.com/watch?v=Oe-_9K6SAiw

For those who don’t know the movie, TOGA represents a low cost, tax-efficient way to invest alongside an aligned, talented hedge fund team with a 23-year track record. TOGA is an ETF that invests globally in the consumer/tech/media/industrial sectors, managed by Tremblant Capital, a 17-person hedge fund founded in 2001 by Brett Barakett.

This ETF is best suited for those who are asset allocators looking for a low-cost way to gain sector exposure or who run a small fund and want exposure to certain sectors but don’t have the resources or analysts to dedicate to research these sectors. It just launched in early May and currently has very limited liquidity, but liquidity should improve over time as more investors become aware of the product.

For VIC members working at a fund, it may be worth exploring the tax efficiency of this ETF structure discussed below to see if it’s appropriate for your business. The IRS rarely offers a free lunch, but this may be the closest thing to one. 

Summary

1. Background

2. Tax Efficiency of the TOGA ETF Structure

3. Aligned, Talented Investment Team; Long Term Track Record of Success

4. Low Cost

5. Conclusion

Investment Considerations

1. Background

Some background on the ETF can be found on the TOGA fund website:

https://www.tremblantetf.com/

Here is a link to the fund prospectus from April 29, 2024:

https://www.sec.gov/Archives/edgar/data/1511699/000089418924000706/combined485atremblantetf.htm

The ETF is run by Tremblant Capital (https://www.tremblantcapital.com/), a global public equity investment firm founded in 2001 by Brett Barakett. Brett has a good pedigree and is supported by a talented team that has been together for a long time. 

TOGA generally holds 30-50 positions in developed markets, with an emphasis on large-mid cap companies. Their investment style is most likely in the growth at a reasonable price (GARP) box.

The ETF provides a daily update of its positions, which is great transparency compared to a typical hedge fund.

Tremblant specializes in certain sectors, namely retail, consumer, technology, entertainment, leisure, media, internet, telecommunications, and industrials and invests on a global basis. 

The ETF invests in the above mentioned sectors and typically has a 50% non-US geographic exposure. A breakdown of the portfolio can be seen here:

https://www.tremblantetf.com/?gad_source=1&gclid=EAIaIQobChMIhryRgvS6hgMV0FN_AB3TzTQ8EAAYASAAEgIuA_D_BwE#Portfolio

The ETF typically invests in a fairly liquid portfolio of securities in these sectors and can probably comfortably support a multi-billion dollar portfolio with the strategy. 

One of the reasons the TOGA ETF was established was to create an investment vehicle structure for the partners of the firm to invest their capital in a way that is more tax efficient in the long run than either owning the portfolio of securities personally in their own brokerage accounts or owning the shares through a partnership structure as general partners (GP) in their hedge fund (i.e., without paying the management and incentive fees that limited partners (LP) pay). This sounds strange but makes sense, as discussed below in the Tax Efficiency section.

2. Tax Efficiency of the TOGA ETF Structure

The TLDR of the TOGA ETF structure’s tax benefit is that its shareholders can effectively defer all capital gains until they sell their ETF shares. It’s like owning the shares in a tax-deferred vehicle like a 401k but even better because you don’t have to take any required distributions when you reach retirement age. For individual shareholders, if you hold your ETF shares until death, then you can benefit from stepped-up tax basis in your TOGA holdings and pass your shares to your heirs with a tax basis calculated at the fair market value of the shares on the date of your death. You can basically avoid all capital gains tax if you hold the ETF shares until you die (assuming no change in the tax code).

This is in contrast to a typical mutual fund, which realizes capital gains as it sells appreciated portfolio securities. The mutual fund is required to pass these capital gains through to fund shareholders who happen to own the mutual fund in the year of the securities sales, and those fund shareholders need to pay tax on the capital gains that are passed through to them. Investors who happen to buy into a mutual fund with large built-in capital gains can be stuck with something called a “tax overhang,” which is simply the built-in gain embedded in a mutual fund’s portfolio. Tax is imposed on investors who buy shares in mutual funds with tax overhang even though the embedded gain accrued well before their investment holding period. Here’s an article about this issue with mutual funds: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3413063

Even for hedge fund managers who intend to own a portfolio of securities in their own hedge fund as GPs, the ETF structure is also more tax efficient. For example, if the fund portfolio turns over let’s say 33% per year, the fund will realize capital gains (probably some mix of short-term and long-term) on the securities sales associated with the turnover. Those realized capital gains are passed through to the GPs annually, and the GPs are required to pay taxes associated with those gains at their applicable tax rate. 

However, if the fund managers instead own the same portfolio of securities through an ETF structure, the ETF’s annual portfolio turnover of 33% does not create realized capital gains that must be passed through annually to the ETF’s shareholders. There is no annual capital gains tax payment required of the fund managers who hold ETF shares, since no capital gains are passed through to the ETF shareholders. The capital gains tax is only triggered when the fund managers sell their ETF holdings. This capital gain tax is calculated based on the gain realized, i.e., the difference between the purchase price for the ETF shares and the sale price for the ETF shares. Thus, the fund managers can avoid paying capital gains tax annually along the way on any capital gains embedded in the securities turned over by the ETF in its portfolio. In effect, the amount of capital gains tax you don’t pay annually is reinvested in the existing portfolio and compounds over time.

Therefore, if the intent is to hold the portfolio of securities for the long term, the ETF structure is actually more tax efficient than holding the portfolio as a GP or holding the portfolio directly as an individual in a brokerage account. Imagine if your portfolio goes from $1mil to $10mil over time. If you hold the portfolio through an ETF and hold your ETF shares until you die, you can defer paying capital gains on the $9mil of gain until the date of your death, and then get stepped-up basis in the ETF holding that you pass on to your heirs. You’ve completely avoided paying tax of the $9mil of gain. The same tax treatment would apply, for example if you owned an ETF like SPY, but the benefit here is that you can control what securities are held in your ETF as the manager of the ETF.

This tax efficient structure has its roots in two specific legal provisions:

1. SEC rule 6C-11, which was finalized in 2019 and allows for a “custom basket” of securities for in-kind exchanges with authorized participants of ETFs. A “custom basket” is a basket of a non-representative selection of the ETF’s portfolio holdings (i.e., not a pro-rata slice of the portfolio).

2. Internal Revenue Code section 852(b)(6), which exempts from tax appreciated securities distributed in-kind to redeeming shareholders. This provision has been around a long time.

For those wanting to dig in further, more detailed information can be found here:

https://www.exegy.com/etf-tax-efficiency/ 

https://journals.library.columbia.edu/index.php/CBLR/announcement/view/497 

https://businesslawreview.uchicago.edu/print-archive/unplugging-heartbeat-trades-and-reforming-taxation-etfs

As can be seen in the UChicago article above, some tax policy commentators have argued that this special tax treatment for ETFs should be eliminated. In fact, Sen. Wyden, chair of the Senate Finance Committee, proposed eliminating IRC section 852(b)(6) in September 2021. Perhaps at some point if Congress needs to raise tax revenue, it will target this provision again. However, changing an arcane provision of the Internal Revenue Code and/or SEC rules may not be as simple as it seems. Many quirks in the tax code exist that never get amended because it’s quite challenging to get anything passed through Congress. The existing core tax provision has been around for a long time, and the SEC has deemed the custom baskets rule to be in the best interests of the mom-and-pop shareholders of the ETF. Moreover, the lobbying interest of the ETF industry (including mutual fund companies that have adopted ETF share classes for their mutual funds) is highly incentivized to make sure it doesn’t lose its tax advantage (cue Larry Fink calling the bat phone in Sen. Wyden’s office).

The below is an example of the potential tax benefit of investing in the ETF structure versus investing in a comparable hedge fund.

Assumptions:

1. $10mil invested each in TOGA vs. a comparable hedge fund

2. TOGA ETF: 0.69% fee

3. Hedge fund: 1.5% management fee / 18% incentive fee

4. Gross annual return 12%

5. Tax: Federal LT tax rate 24%; Federal ST tax rate 41%; State tax rate 7%; LT/ST splits 50%/50%; Annual portfolio turnover 100%

Investment for 20 Years in TOGA:

Pre-Tax Dollar Return   $75mil 

Final Tax Payment   ($23mil)

After-Tax Return   $52mil

Investment for 20 Years in a comparable hedge fund:

Pre-Tax Dollar Return   $57mil

Annual Taxes Paid   ($10mil)

Final Tax Payment   ($12mil)

After-Tax Return   $35mil

Investment for 30 Years in TOGA:

Pre-Tax Dollar Return   $239mil 

Final Tax Payment   ($74mil)

After-Tax Return   $165mil

Investment for 30 Years in a comparable hedge fund:

Pre-Tax Dollar Return   $152mil

Annual Taxes Paid   ($26mil)

Final Tax Payment   ($31mil)

After-Tax Return   $95mil

The Tremblant team, together with its lawyers and accountants, thoroughly analyzed the TOGA ETF structure to make sure it provides this tax treatment before investing their own internal partners’ capital and launching the ETF in May. 

3. Aligned, Talented Investment Team; Long Term Track Record of Success

TOGA currently has about $100mil AUM, of which ~$70mil was invested by the Tremblant investment team. Their investment in the ETF represents a substantial portion of their personal net worth. They are keenly aware of the long term tax benefits of the ETF structure and are highly aligned with the long term success of the ETF. They are paying the same 0.69% management fee as all of the other ETF shareholders in the public market. They are eating plenty of their own cooking. In part, the ETF was set up to invest the investment team’s personal capital more tax efficiently in the portfolio they manage (i.e., it’s more tax efficient than investing their capital as GPs in a hedge fund structure).

The investment team has a long term track record of success. Below is the track record of the Tremblant long only fund since inception in November 2011. This fund most closely tracks the strategy of the TOGA ETF going forward.

The investment team has decades of investment experience and notably has been working together for 17+ years. The firm does deep fundamental research. They have their own data science team that tracks and analyzes data from many proprietary sources to form a view that’s differentiated from what’s typically available from expert network sources.

• The founder of the fund, Brett Barakett, brings over 27 years of portfolio management experience and seven years of operational experience to his roles as CIO and CEO.

• Sector PMs have an average of 26 years of investment experience and have worked at Tremblant for at least 17 years.

• Research conducted by the investment team is complemented by proprietary data science analytics, led by firm partner Nick Onofrey (22 year tenure).

  • Proprietary work includes web data extraction and related data analytics, internet and telephone surveys, channel checks, and product testing.

    • An example for their work is analyzing the publicly available, but difficult-to-decipher, data on a company’s website to infer potential customer wins for the company.

More information about the investment strategy, process, and the team can be found on the firm’s website.

https://www.tremblantcapital.com/team

https://www.tremblantcapital.com/investment-philosophy

For those interested in hearing from the founder of the fund, Brett Barakett, there’s a recent podcast describing the firm and their research process.

https://www.capitalallocators.com/podcast/digging-for-the-puck-at-tremblant-capital/

4. Low Cost

The firm’s partners who own $70mil of TOGA are paying the same 0.69% fee as the rest of the ETF holders. This fee is lower than most other actively managed funds and far less than all hedge funds. A fee of 0.69% seems like a good value for an actively managed ETF run by a well-aligned and talented hedge fund team (composed of 10 investment professionals and 7 operations staff) doing deep fundamental research. Public ETF investors are getting a good deal on the ETF fee because the firm’s partners also have to pay the same fee on their own invested capital in the ETF and have an incentive to keep the fees reasonably low.

5. Conclusion

One way to think about an investment in TOGA is that you’re hiring a seasoned, well-aligned, and talented investment team to manage the consumer/tech/media/industrial sectors of your portfolio for a 0.69% fee. That seems like a good value. If you’re a small fund, family office, or institution looking for exposure to these sectors on a global basis without the operational overhead of managing your own team of sector analysts, TOGA is worthy of consideration.

For those investors concerned about an impending bear market or valuations in these sectors, it would make sense to dollar cost average into a position.

In any case, the tax efficient nature of this actively managed ETF fund structure outlined above may appeal to some investment professionals in the VIC community who want to HODL their fund portfolio without yearly tax leakage from portfolio turnover. For those interested, the operational breakeven AUM level of the ETF structure is approximately $50mil.

Risks

• Market risk

• Management risk

• Regulatory/legal risk

• Past performance does not guarantee future results

Legal Disclaimer: This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purposes only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author and/or his employer has a position in this stock and may trade this stock.

Catalysts

Investment returns over time

Catalyst

Investment returns over time