There are basically two schools of thought when it comes to legal systems. You can have a system where the rules are meticulously written down, and anything that isn’t written down is legal. Things that are illegal have clear punishments that are predetermined (within a range). This is mostly how it works in the US. Or, you can have a system where an authority figure - a village elder, or the Chinese government - has broad leeway to do what makes sense to them. Both systems have pros and cons!

In 2008, a Chinese baby formula company decided to save a few bucks by watering down the milk and then adding a chemical used in plastics, making hundreds of thousands of babies sick, with a few even dying. The top folks at the company went on trial, and the judge basically said “not on my watch” and gave them the death penalty, which was swiftly and effectively carried out. I’m good with that! I might be less good with it if I rolled a stop sign and the judge decided he didn’t like the cut of my jib, and believed my jib would be improved by some hard labor.

When you write down the rules, you (mostly) get pleasantly repeatable outcomes, which is a nice feature of a justice system. But it also creates a playground for gaming the system. Blockchain folks love to say “code is law” until someone finds a loophole in the code and steals all their money. My former employer Bridgewater had a famously unique culture. When the culture was just an essence that people carried around, it worked great. Once it got written down, eagle-eyed opportunists found loopholes and gamed it to great personal enrichment.

Which brings us to the most gamed set of rules in the world - the US tax code. There has been saber-rattling recently from various government officials about closing loopholes that allow wealthy individuals to pay less tax. As an asset manager that sponsored a 351 ETF and would like to sponsor more in the future, we’ve obviously been keen to follow the developments. Having dug into what is publicly available and what we could discern from out networks, here is how we see the state of play, though obviously it is still an evolving situation:

1. There seem to be two schools of thought as to why this is happening. One is that the Treasury is putting pressure on the IRS to increase revenues given the wide and growing deficit. Another is that this is being more directed by the IRS itself to CYA in anticipation of greater congressional oversight in Jan. Either way, we have an expectation of actual action.

2. This is broader than is being widely reported – for example, we know from sources that they are also going after people using Puerto Rico as a tax shield.

3. We expect that the crackdown will be primarily focused on the worst offenders. Any investment strategy designed to launder ordinary income into cap gains is at the top of that list. Our belief is those products will be the biggest focus and will be banned. At the other end of the spectrum, we think the equity long/short strategies run by AQR and others - where there is market risk taken with a genuine attempt at alpha - are likely safe.

4. As it relates to 351 ETFs, it’s worth noting that these exist on a very wide spectrum. We believe managers who carefully and conservatively followed the existing guidance at the time are pretty safe – including us. Managers who took a portfolio of stocks on day 1 and flipped it into a completely different portfolio on day 2 are at risk.

As always, we are happy to chat with anyone who wants to discuss this topic further.