New ETFs cause major Israeli market upheaval
A hot topic in the Israeli investment world these days is Tikun 28 and its impact on investing. For managed portfolios, this change is having an immediate impact on how we manage money, especially for American clients who are being significantly impacted by the change. Since these changes are no longer only theoretical, as the legislation is going into effect over the next few months, I thought that maybe more of my readers would also appreciate a brief and simplified explanation of the changes in the teudot sal or Exchange Traded Notes (ETNs) in the Israeli marketplace.
ETNs are debt instruments that track the performance of market indexes. They can follow all sorts of indexes, including stocks indexes like the Tel Aviv 35 or the S&P 500 as well as bond indexes among others. At present, ETN managers (i.e. the issuer or investment house) raised money from investors (you) and was obligated to return (your) money with a profit or loss depending on the performance of the underlying index they were meant to be tracking. In Israel, many different ETNs were created to track local and international stock and bond indexes (and hybrid products) and despite Israel’s population being just under 3% of that of the USA, the Israeli market has approximately one third of the total number of comparable exchange traded products in the USA. (More choice – greater confusion for the average investor!)
It has been over a decade in the making but the investment reform which will make ETNs obsolete and replaced by ETFs (Exchange Traded Funds – which operate similarly to ETNs, but instead of being a debt instrument, the investor owns the underlying stocks or bonds) is now in place and will be completed over the next couple of months. All the fund conversions (from ETNs to ETFs) must be finished by the end of December 2018.
Beyond the standard performance-related investment risk, the ETN investor is exposed to company default risk: investors can only claim against company assets as a creditor in the case that an ETN issuer wouldn’t be able to fulfil his obligations to his investors, because their investment is structured as a loan or note. The Israel Securities Authority (ISA) saw this as a major threat to the stability of the Israeli market, and thus has been working for a long time to change the ETNs to ETFs where the underlying investments in the stocks or bonds held by the fund are owned by the investors (not the investment company) which drastically reduces their inherent risk.
So the Tikun 28 legislation is forcing all Israeli teudot sal (ETNs) to be converted into ETFs. The new product is being structured as a mutual fund. Some of these mutual funds are traded during the course of the day – like standard ETFs abroad – while others are tracking indexes (called kranot sal), similar to how index mutual funds are managed abroad.
In general, the change represents an improvement for investors. However, Tikun 28 will also complicate investors’ ability to invest in Israel due to other amendments included in the legislation. These include a unique management fee structure (fixed and variable fees) and performance not always mirroring exactly the movements of the index (‘best effort’). In addition, it will create a major PFIC (passive foreign investment company) issue for Americans. A PFIC is a foreign based corporation earning largely all income from passive income sources like interest, or dividends. While Americans are allowed to invest in mutual funds in Israel and throughout the world, it is often prohibitive from a tax planning perspective because of the higher tax rates and more onerous reporting requirements. Most accountants did not view ETNs as PFICs, however, the new ETFs are clearly mutual funds and therefore defined under US tax laws as PFICs.
Although it is not illegal for American Israelis to hold these funds, the new situation will certainly complicate tax implications for the investors. Most Israeli accountants recommend that Israeli Americans do not invest in PFICs. This means that small US investors have far fewer choices regarding how to invest their money here in Israel. What remains of possible options for American investors are as follows:
- Buying individual bonds and stocks (which is more complicated for the unsophisticated small investor who has to buy into many more securities to create a diversified portfolio) or
- Investing in US dollar-based ETFs that track Israeli stocks (which defeats part of the purpose for those who want shekel exposure).
Another difficulty is the fact that the new products will be viewed as brand new funds. Therefore, as things currently stand, there will be no history available. Investors generally use historical returns to choose their funds, but unless the ISA changes their current directives, there will be no historical data available to potential investors.
So how can investors choose with whom and how to invest?
- Carry out your own significant in-depth research using popular Israeli financial websites like funder.co.il.
- Rely on the investment manager at the bank to suggest specific funds. (If you are choosing this option make sure your bank advisor understands your situation and the tax implications and provides you with the information you require. Don’t assume they know more than you. When I raised the PFIC issue with the lead legislator who led the entire process of changing ETNs to ETFs he didn’t know what a PFIC was! Despite overseeing the legislative process he was unaware of the ramifications to the American Israeli investor.) NOTE: in general, investment managers in the bank often are less enthusiastic about working with small investors, so ensure that you stay on top of your situation and ‘nudge’ the investment advisor to help you if you need assistance.
- Work with an investment manager familiar with the issues and your tax situation, who can choose the best option for you and manage your portfolio.
An additional issue that arose during the legislative process was the halachic implications of the change. There was concern expressed in some religious communities about directly holding the underlying assets. Some halachic authorities view this situation as problematic because of interest issues and companies working on Shabbat. (This view is not held across the board. Please consult your local Rabbinic authority if this is a concern.)
However, as a result of this concern, the ISA developed a third product called keren sal kesheira which invests in ETFs, but is one step removed. The investor owns a portion of the underlying ETF which owns the underlying stock. This structure is intended to alleviate the halachic concerns, however the keren sal kesheira is still structured and viewed as a mutual fund, so it does not obviate the PFIC issue.
In summary, while this overhaul definitely represents significant improvements, there are still challenges ahead for the average Israeli investor, and even more challenges for the American-Israeli investor. These changes are happening now. Make sure you are apprised of your specific situation. If you can’t navigate the changes yourself, seek advice from a professional. Behatzlacha!