Aug
01
2023
What Are Non-Transparent ETFs?

What Are Non-Transparent ETFs?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Are Non-Transparent ETFs?

Unlike ordinary exchange-traded funds (ETFs), which disclose their underlying assets daily, non-transparent ETFs are only required to reveal their holdings on a quarterly or monthly cadence. This ability to conceal their assets can help active non-transparent ETF managers to cloak their strategies for longer periods, with the aim of maximizing performance.

To understand some of the advantages these funds may offer investors, it helps to compare them with standard ETFs.

Why Would You Invest in Non-Transparent ETFs?

For nearly 30 years, exchange-traded funds (ETFs) have been a mainstay for big institutional investors as well as individuals, thanks to their transparency, tax efficiency, and low cost. Today, the ETF industry in the U.S. has billions, if not trillions, under management.

Traditionally, investors have found ETFs an attractive option because of their liquidity, which has made ETFs more transparent than mutual funds. Unlike mutual funds, you can trade ETF shares throughout the day on an exchange, similar to stocks. And the way shares are created and redeemed gives investors more visibility into the funds’ underlying assets, compared with mutual funds. This ‘transparency’ has been true of both actively managed ETFs as well as passive ETFs, which track an index such as the S&P 500.

But the fundamental transparency of the ETF “wrapper” or fund structure has been a thorn in the side of some active ETF managers, who may prefer less visibility around their holdings for strategic reasons. Hence the appeal of non-transparent ETFs to active managers.

Active non-transparent ETFs — also called ANT ETFs — aren’t required to reveal their assets daily, as noted above; rather they report a snapshot of what they hold on a monthly or quarterly basis, similar to a mutual fund. In some cases they report the assets they hold, but not how much they hold.

Recommended: ETFs vs. Index Funds: What’s the Difference?


💡 Quick Tip: How do you decide if a certain trading platform or app is right for you? Ideally, the investment platform you choose offers the features that you need for your investment goals or strategy, e.g., an easy-to-use interface, data analysis, educational tools.

How Passive vs. Active Strategies Can Impact Transparency

If you think about it, the evolution of active non-transparent ETFs makes sense in the larger context of the ETF universe, where passively managed ETFs comprise more than 90% of that market.

Passively managed ETFs offer some of the lowest ETF fees in today’s market, which is one reason they’re typically cheaper to own than mutual funds. The overall tax efficiency of index ETFs also helps to lower investing costs, and has contributed to their overall popularity with investors.

ETFs, of course, are also valued for their role in adding diversification to investors’ portfolios, with many ETFs invested in specific sectors (e.g. electric vehicles, pharmaceuticals) or securities (e.g. U.S. Treasuries, corporate bonds).

No matter whether an ETF is invested in a broader equity market or a niche sector, passive ETFs are designed to mirror or track the stocks in a certain index. Thus the transparency of these funds is part of how they work.

That’s not true of active ETFs, which rely on the oversight of a fund manager to choose the underlying assets (just like an active mutual fund). But because ordinary ETFs require a daily disclosure of the fund’s holdings, this can hamper an active manager’s ability to execute their investment strategies.

When a fund’s assets are disclosed on a daily basis, the market can bid up the price for their holdings. And while in the short term this might be good (the assets could go up), in the long term it could disrupt the fund manager’s strategies. And, if other investors try to anticipate the trades that active managers might make, sometimes called front running, that could cause asset prices to fluctuate and potentially impact the ETF’s performance.

The Use of Proxies in Non-Transparent ETFs

How might a non-transparent ETF solve this problem?

The way ETFs keep their price in line with their assets is that the sponsor of the ETF trades throughout the day with an “authorized participant.” These authorized participants will create and redeem “baskets” of securities, i.e. the stocks or bonds that the ETF holds, and then trade them to the ETF for shares of the fund, which allows the ETF to stay in line with the price of its underlying stocks.

This process obviously requires a great degree of transparency across the board. So, how does a non-transparent ETF obscure its holdings? The answer is, by the use of “proxies”: These are baskets of stock that are similar to but not identical to the underlying holdings of the ETF.

Thus, non-transparent ETFs are able to occupy a happy middle ground in the ETF world: they enable fund managers to conceal their strategies while keeping the liquidity of pricing that is core to trading ETFs overall.

The History of Non-Transparent ETFs

For years, the ETF industry was composed mostly of index ETFs, which helps to explain why the universe of ETFs is primarily passive. But over time, some investment companies began seeking regulatory approval for non-transparent ETFs, also sometimes called semi-transparent ETFs, in order to pursue more active strategies. The approval for these funds, and the technology underlying the non-transparent strategy, began rolling out in late 2019, and ANT ETFs have seen steady inflows since then.

Though non-transparent ETFs are still a relatively small part of the overall ETF market, this sector is gaining traction and is now approaching $2 billion AUM. This reflects a similar trend among active ETFs, which have also seen more inflows this year.


💡 Quick Tip: Distributing your money across a range of assets — also known as diversification — can be beneficial for long-term investors. When you put your eggs in many baskets, it may be beneficial if a single asset class goes down.

The Takeaway

Non-transparent ETFs may be a relative newcomer in the multi-trillion-dollar world of ETFs, but they offer an attractive new opportunity for investors who are interested in active investment styles — but still want the cost efficiency and liquidity of an ETF. Non-transparent ETFs also give active fund managers the ability to cloak their strategies, which may aid potential outcomes.

As with all ETFs, they may have a place in an investor’s portfolio. But it’s generally best that investors do some research or consult with a financial professional before investing.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

Photo credit: iStock/ANA BARAULIA

SoFi Invest®
SoFi Invest refers to the two investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected]. Please read the prospectus carefully prior to investing. Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

Claw Promotion: Customer must fund their Active Invest account with at least $10 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Aug
01
2023
financial charts on laptop and tablet

What Drove the SPAC Boom in 2020 and 2021?

By | Financial Topics, Growing Wealth, invest, Investing, Terminology | Comments Off on What Drove the SPAC Boom in 2020 and 2021?

Special Purpose Acquisition Companies (SPACs) were all the rage on Wall Street, particularly during 2020 and 2021. Nearly 250 SPACs went public in 2020 — four times as many as 2019. That momentum carried over into 2021 as well, but in 2022 and 2023, interest has dropped.

In 2022, the Securities and Exchange Commission (SEC) proposed new rules for SPACs that would require more transparency, and protections for investors.

As for what drove the SPAC boom in 2020 and 2021? It was a combination of factors, and SPACs are still very much a part of the financial ecosystem. That’s why it’s important for investors to understand what they are, and what drove their popularity.

SPACs 101

SPACs are shell companies that list on the stock market with the intention of finding an existing private business to buy. Also known as blank-check companies because they have no operating business of their own, SPACs typically have two years to purchase a target.

The current SPAC boom is unsurprising given the long-time dissatisfaction with the traditional IPO model. Private companies, especially tech startups in Silicon Valley, have grumbled for years that the IPO process is expensive, onerous, and time-consuming. Many have been staying private for longer, taking advantage of other avenues for raising capital such as venture capital firms.

Here’s how SPACs work:

1.    The first step tends to involve sponsors, generally former industry specialists or executives. They typically pay $25,000 in what’s known as the “promote” or “founder’s shares,” obtaining a 20% stake in the company in return.

2.    The SPAC goes public on a stock exchange, listing shares at $10 each and promising to use the proceeds to find a private company to merge with.

3.    Once an acquisition is found, shareholders of the SPAC vote on the company merger.

4.    SPACs can buy firms valued at five times the money raised in their IPO. Therefore, additional funding is often raised through institutional investors in something known as a “private investment in public equity” or PIPE.

For the private company getting bought, SPACs offer a cheaper, faster route to listing. Below are some potential benefits of SPACs:

•   In a regular IPO, investment bankers, who advise companies in going public, alone can eat up 4% to 7% of an IPO’s proceeds in fees.

•   The IPO process typically takes 12 to 18 months. In contrast, a SPAC merger generally takes between four to six months.

•   Regulators review SPAC mergers, but more forward-looking projections can be used to market the deal as opposed to IPO prospectuses, which require that only historical figures be shared. This can be particularly appealing to more futuristic ventures like those in electric vehicles or space travel.

•   The valuation of a SPAC target is typically determined by private negotiations behind closed doors, similar to how a deal in a merger would be struck. This can make SPAC IPO valuations less tied to the whims of public markets.


💡 Quick Tip: Access to IPO shares before they trade on public exchanges has usually been available only to large institutional investors. That’s changing now, and some brokerages offer pre-listing IPO investing to qualified investors.

SPAC Performance

Critics of SPACs argue that they are much too lucrative for the sponsors, and bypass measures in the traditional IPO process that are designed to protect investors. The flurry of SPAC activity in recent years also had many worried that a bubble was forming.

However, defenders of the structure argue that this most recent wave of SPACs is different. They say that more recent SPACs have had more credible sponsors, who then in turn target higher-quality companies.

An academic paper by professors at Stanford and New York University law schools looked at SPAC acquisitions between January 2019 and June 2020. The study found that companies that went public by SPAC fell by an average of 3% three months after debuting, 12% after six months, and 35% after a year.

Meanwhile, those with higher-quality sponsors returned 32% after three months and 16% after six months.
When it came to companies with higher-quality sponsors that had been public for at least a year, there were only seven and they fell on average by 6%. The professors concluded that, “It is true that a few SPACs sponsored by high-profile funds or individuals have performed well. But these are the exceptions, not the rule.”

Get in on the IPO action at IPO prices.

SoFi Active Investing members can participate in IPO(s) before they trade on an exchange.

How the SPAC Boom Came About

Here’s a table with the number of SPAC IPOs by year and the capital raised. It shows that the number of SPACs that have listed on the stock market have steadily increased in recent years.

Only 13 debuted in 2016, but the number of SPACs in the stock market spiked in 2020, quadrupling from 59 to 248, and more than 600 launched during 2021. The table also shows the money raised through these IPOs also climbed dramatically, but has since fallen again after a blowout year in 2021.

Year

 Number of SPAC IPOs

 Money Raised by SPACs
2023 (through June 1) 23 $1.8 billion
2022 107 $13.4 billion
2021 630 $162.5 billion
2020 248 $83 billion
2019 59 $13.6 billion
2018 46 $10.8 billion
2017 34 $10 billion
2016 13 $3.5 billion

Source: SPACInsider

Recommended: How Many Companies IPO Per Year?

What Drove the SPAC Boom?

There were several factors that drove the SPAC boom in 2020 and 2021.

1. IPO Dissatisfaction

IPOs have historically been an important step for maturing companies, signaling that a business is ready for public scrutiny, greater regulation, and increased liquidity of its equity.

However, in the past decade, tech IPOs haven’t always kept pace with the number of unicorn companies that have cropped up. Private companies have shunned the traditional listing process by either staying private for longer or seeking alternative routes such as direct listings or SPACs.

2. Booming Markets

Context is important, too: After the volatility in early 2020 caused by the COVID-19 pandemic, financial markets soared. The Federal Reserve’s stimulus measures played a role in keeping the markets buoyant.

In addition, there was an increase in investing during this time for several reasons. All told, it created an optimal window for private companies to enter public markets, giving them better odds of pricing SPAC deals at higher valuations.

3. Rule Changes

Both the New York Stock Exchange and the Nasdaq have tried to loosen their rules on SPACs in recent years in order to attract more such listings. Nasdaq had dominated the SPAC market until 2017, when NYSE had the first blank-check listing on its main market, after getting approved by regulators to ease some requirements. Separately, Nasdaq tried in 2017 to gain permission to lower a number for required shareholders.

4. Famous Sponsors

Well-known sponsors were also a defining feature during the SPAC frenzy. Well-known investors, former politicians, and former athletes have all jumped on the SPAC bandwagon, setting off a flurry of launches.


💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

SPAC Risks

Despite the combination of factors that helped spark the SPAC trend, the fact remains that most SPACS — like most IPOs — are highly risky endeavors.

In addition, despite the hype around both these paths for going public, the main beneficiaries of SPACs have been those closest to the company itself. Retail investors typically don’t have access to SPAC shares until they’re in the secondary market.

The Takeaway

SPAC activity reached a peak in 2020 and 2021, but some of the conditions that have turned SPACs into a popular IPO alternative had been in place for a while. For example, many private companies had been long unhappy with the traditional IPO model. Additionally, the mood in the stock market at the time had become increasingly ebullient, luring private companies into public listings.

SPACs have a checkered history when it comes to actual performance in the stock market. But some market observers have claimed that having more credible sponsors will lead to better mergers and consequently, better share prices.

Whether you’re curious about exploring IPOs, or interested in traditional stocks and exchange-traded funds (ETFs), you can get started by opening an account on the SoFi Invest® brokerage platform. On SoFi Invest, eligible SoFi members have the opportunity to trade IPO shares, and there are no account minimums for those with an Active Investing account. As with any investment, it's wise to consider your overall portfolio goals in order to assess whether IPO investing is right for you, given the risks of volatility and loss.

Invest with as little as $5 with a SoFi Active Investing account.

SoFi Invest®
SoFi Invest refers to the two investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.

New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Jul
31
2023

What Are Blue Chip Stocks?

By | Financial Independence, Growing Wealth, invest, Investing, Terminology | Comments Off on What Are Blue Chip Stocks?

Blue chip stocks are generally issued by large, well-established companies that have a history of steady growth. These companies are typically financially sound, they’re generally considered lower risk, and many blue chip stocks also pay dividends.

In other words, blue chip stocks are the big, stable ocean liners of the equity markets, not the smaller more volatile jet skis. When you’re constructing a portfolio, you may want to consider these large-cap stocks in the slow-but-steady corner of your equity allocation as part of your diversification strategy.

A Closer Look at Blue Chip Stocks

First, let’s answer the obvious questions: Why blue? Why chips? The origin of the term “blue chip stocks” is believed to originate with the game of poker, where traditionally the blue chips have the highest value.

While there is no fixed definition for blue chips, generally speaking, blue chip stocks are chiefly known for being stable and reliable. Blue chip companies can also share some other characteristics.

Common Traits of a Blue Chip Stocks

•   They’re well-known. Blue-chip stocks aren’t limited to a single industry, but can be found in grocery aisles and on entertainment channels. Companies like Disney, Coca-Cola, and IBM are all considered blue chip stocks.

•   They’re industry leaders. Often a stock has earned its blue-chip reputation by innovating over time, and becoming a market leader — often being among the top three companies in a given sector.

•   They’re worth billions. Many blue chip companies have a market cap of $10 billion or more, but many are larger. Market capitalization is a measure of a company’s value, and it’s calculated by multiplying the share price by the number of shares outstanding.

•   They’re well established. Most blue chip stocks are not newcomers. Rather they’ve demonstrated a history of financial stability, which can make them an important part of a defensive investment strategy.

•   They’ve weathered different market conditions. Owing to their longer histories, many blue chip stocks have overcome various market challenges, but that does not make them “safe” investments.

•   They’re on an index. You’ll often find blue chip stocks listed on the Dow Jones Industrial Average, S&P 500 Dividend Aristocrats, or the Bridgeway Blue Chip 35 Index.

•   They pay dividends. Blue chip stocks typically pay out dividends, or a share of the company’s profits, to shareholders.


💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

10 Historically Blue Chip Stocks

Here are 10 companies that have been historically considered blue chip. This list does not include all blue chips, but is a selection of some that are well known:

•   3M

•   Coca-Cola

•   UnitedHealth Group

•   IBM (International Business Machines)

•   Johnson & Johnson

•   JP Morgan Chase

•   Microsoft

•   Procter & Gamble

•   UPS (United Parcel Service)

•   Walmart

These companies have been around for decades, and because of their consistent performance history, they’re considered blue chip stocks today. You may want to consider them when you’re thinking about portfolio diversification.

In addition, a few newcomers (or relatively new companies) have joined the blue chip party, such as Amazon, Apple, and Alphabet.

Advantages and Disadvantages of Investing in Blue Chip Stocks

Like any investment strategy, blue chip stocks have their potential benefits and drawbacks. Before investing in blue chip stocks, you may want to weigh the positives and negatives of these types of stocks on your overall investment strategy.

Advantages

Blue chip stocks have their fair share of benefits:

•   They have a track record. Typically, blue chip stocks have been around for a while and are listed in some of the most well-known stock indexes. Some of these indexes can have stringent rules that only the most financially stable companies could meet.

•   They’re big. Many of these companies are global in reach, and have the potential to grow faster, secure bigger loans, and continue to compete in the market. Thus, blue chip stocks may be more stable than smaller companies in their sectors — but with the resources to innovate and maintain their status.

•   They can be lower risk. Blue chip stocks are often considered low risk because of their size and market history in the market. Many of them also pay dividends, which benefits investors.

•   They’re highly liquid. Because these companies trade frequently, but are typically not volatile, investors can generally be confident in these stocks’ value when selling.

•   They’re easy to follow. The companies behind many blue chip stocks tend to be well known, which means announcements and news around them is likely to make the front page of the financial section.

Disadvantages

There’s no such thing as a “sure thing,” especially in investing, and the drawbacks of blue chip stocks prove this point. Here are a few cons to keep in mind when considering blue chips for your portfolio.

•   They may fall harder. The old adage “the bigger they are, the harder they fall” may apply here. Just because a blue chip stock has a solid history does not ensure a profitable future.

•   Limited growth. Though these companies typically have longevity on their side, they are often past their prime growth years. This is why blue chip companies also have a reputation for being low risk.

•   They may be expensive. Blue chip stocks tend to be well-known brands and often a highly desirable part of people’s investment strategies. For that reason, you’re unlikely to get a deal on them.


💡 Quick Tip: How to manage potential risk factors when you invest? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

Investing in Individual Blue Chip Stocks

Like a well-balanced meal, investing in blue chip stocks can be one part of a healthy investment strategy. Those looking to make blue chip stocks a part of their balanced investment diet may first consider investing in individual stocks.

If the price per share is too steep for an investor’s budget, they might want to consider fractional share investing, which allows the purchase of a fraction of a stock instead of the whole share, starting at just $5. Restrictions do apply for fractional shares.

Choosing to invest in an individual stock might be a good way to get a feel for the market, or it might be a way to take a more active investment strategy. Either way, a brokerage can handle an investor’s single blue chip stock purchase.

Blue Chip Funds: An Alternative to Individual Stocks

If no individual stock strikes your fancy, but you still want to get into the blue chip game, you might consider investing in index funds or ETFs that focus on blue chip stocks.

Index funds and ETFs typically hold a diversified basket of stocks, often in line with a stock market index that tracks a segment of the market. Choosing an index fund or ETF that tracks large-cap stocks, the S&P 500, or the Dow Jones Industrial average can be one way to invest in a wide range of blue chip companies and add diversification. Investing in a blue chip fund or an ETF is investing in a portfolio of companies that a broker has selected.

The Takeaway

A company’s stock earns a blue chip designation when they have a strong performance history, consistent returns, excellent financials, and they’re considered industry leaders.

For investors who are ready to start investing, blue chip stocks can be a solid choice — but typically not one that’s likely to deliver a lot of growth or big returns. That said, blue chips are often viewed as being conservative. Being conservative can be an important part of an investment strategy, but it’s like a balanced diet. It may not be healthy to eat the same thing day after day, just as it’s not wise to invest only in bigger, more conservative options — but include other investments as well.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

Invest with as little as $5 with a SoFi Active Investing account.

There are limitations with fractional shares to consider before investing. During market hours fractional share orders are transmitted immediately in the order received. There may be system delays from receipt of your order until execution and market conditions may adversely impact execution prices. Outside of market hours orders are received on a not held basis and will be aggregated for each security then executed in the morning trade window of the next business day at market open. Share will be delivered at an average price received for executing the securities through a single batched order. Fractional shares may not be transferred to another firm. Fractional shares will be sold when a transfer or closure request is initiated. Please consider that selling securities is a taxable event.

SoFi Invest®
SoFi Invest refers to the two investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Jul
25
2023
Guide to Employee Stock Ownership Plans

Guide To Employee Stock Ownership Plans

By | Growing Wealth, invest, Investing, Preparing for Retirement, Terminology | Comments Off on Guide To Employee Stock Ownership Plans

You may have come across the term “ESOP” and wondered, what does ESOP stand for? An employee stock ownership plan (ESOP) is a type of defined contribution plan that allows workers to own shares of their company’s stock. While these plans are covered by many of the same rules and regulations that apply to 401(k) plans, an ESOP uses a different approach to help employees fund their retirement.

The National Center for Employee Ownership estimates that there are 6,500 ESOPs covering nearly 14 million workers in the U.S. But what is an employee stock ownership plan exactly? Is an ESOP a defined contribution plan? And how does it work?

If you have access to this type of retirement plan through your company, it’s important to understand the ESOP meaning and where it might fit into your retirement strategy.

What Is an Employee Stock Ownership Plan (ESOP)?

An ESOP as defined by the IRS is “an IRS section 401(a) qualified defined contribution plan that is a stock bonus plan or a stock bonus/money purchase plan.” So what is ESOP in simpler terms? It’s a type of retirement plan that allows you to own shares of your company’s stock.

Though both ESOPs and 401(k)s are qualified retirement plans, the two are different in terms of how they are funded and what you’re investing in. For example, while employee contributions to an ESOP are allowed, they’re not required. Plus, you can have an ESOP and have a 401(k) if your employer offers one. According to the ESOP Association, 93.6% of employers who offer an ESOP also offer a 401(k) plan for workers who are interested in investing for retirement.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

How Employee Stock Ownership Plans Work

In creating an ESOP, the company establishes a trust fund for the purpose of holding new shares of stock or cash to buy existing shares of stock in the company. The company may also borrow money with which to purchase shares. Unlike employee stock options, with an ESOP employees don’t purchase shares themselves.

Shares held in the trust are divided among employee accounts. The percentage of shares held by each employee may be based on their pay or another formula, as decided by the employer. Employees assume ownership of these shares according to a vesting schedule. Once an employee is fully vested, which must happen within three to six years, they own 100% of the shares in their account.

ESOP Distributions and Upfront Costs

When an employee changes jobs, retires, or leaves the company for any other reason, the company has to buy back the shares in their account at fair market value (if a private company) or at the current sales price (if a publicly-traded company). Depending on how the ESOP is structured, the payout may take the form of a lump sum or be spread over several years.

For employees, there are typically no upfront costs for an ESOP.

Get up to $1,000 in stock when you fund a new Active Invest account.**

Access stock trading, options, auto investing, IRAs, and more. Get started in just a few minutes.

**Customer must fund their Active Invest account with at least $10 within 30 days of opening the account.
Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

Employee Stock Ownership Plan Examples

A number of companies use employee stock ownership plans alongside or in place of 401(k) plans to help employees save for retirement, and there are a variety of employee stock ownership plan examples. Some of the top companies that are at least 50% employee-owned through an ESOP include:

•   Publix Super Markets

•   Penmac

•   Winco Foods

•   Amsted Industries

•   Brookshire Brothers

•   Houchens Industries

•   Parsons

•   Davey Tree Expert

•   W.L. Gore & Associates

•   HDR Inc.

Eight of the companies on this list are 100% employee-owned, meaning they offer no other retirement plan option. Publix offers stock purchase plans while Davey Tree Expert has a 401(k) option. Employee stock ownership plans are popular among supermarkets but they’re also used in other industries, including engineering, manufacturing, and construction.

Pros & Cons of ESOP Plans

ESOPs are attractive to employees as part of a benefits package, and can also yield some tax benefits for employers. Whether this type of retirement savings plan is right for you, however, can depend on your investment goals, your long-term career plans, and your needs in terms of how long your savings will last. Here are some of the employee stock ownership plans pros and cons.

Pros of ESOP Plans

With an ESOP, employees get the benefit of:

•   Shares of company stock purchased on their behalf, with no out-of-pocket investment

•   Fair market value for those shares when they leave the company

•   No taxes owed on contributions

•   Dividend reinvestment, if that’s offered by the company

An ESOP can be an attractive savings option for employees who may not be able to make a regular payroll deduction to a 401(k) or similar plan. You can still grow wealth for retirement as you’re employed by the company, without having to pay anything from your own pocket.

Cons of ESOP Plans

In terms of downsides, there are a few things that might make employees think twice about using an ESOP for retirement savings. Here are some of the potential drawbacks to consider:

•   Distributions can be complicated and may take time to process

•   You’ll owe income tax on distributions

•   If you change jobs means you’ll only be able to keep the portion of your ESOP that you’re vested in

•   ESOPs only hold shares of company stocks so there’s no room for diversification

Pros and Cons of ESOP Plan Side-by-Side Comparison

Pros Cons

•   Shares of company stock purchased on their behalf, with no out-of-pocket investment

•   Fair market value for those shares when they leave the company

•   No taxes owed on contributions

•   Dividend reinvestment, if that’s offered by the company

•   Distributions can be complicated and may take time to process

•   You’ll owe income tax on those distributions

•   Changing jobs means you’ll only be able to keep the portion of your ESOP that you’re vested in

•   ESOPs only hold shares of company stocks so there’s no room for diversification

By comparison, a 401(k) could offer more flexibility in terms of what you invest in and how you access those funds when changing jobs or retiring. But it’s important to remember that the amount you’re able to walk away with in a 401(k) largely hinges on what you contribute during your working years, whereas an ESOP can be funded without you contributing a single penny.

💡 Quick Tip: Did you know that you must choose the investments in your IRA? Once you open a new IRA and start saving, you get to decide which mutual funds, ETFs, or other investments you want — it’s totally up to you.

ESOP Contribution Limits

The IRS sets contribution limits on other retirement plans, and ESPOs are no different. In particular, there are two limits to pay attention to:

•   Limit for determining the lengthening of the five-year distribution period

•   Limit for determining the maximum account balance subject to the five-year distribution period

Like other retirement plan limits, the IRS raises ESOP limits regularly through cost of living adjustments. Here’s how the ESOP compares for 2022 and 2023.

ESOP Limits

 2022

 2023
Limit for determining the lengthening of the five-year distribution period $245,000 $265,000
Limit for determining the maximum account balance subject to the five-year distribution period $1,230,000 $1,330,000

Cashing Out of an ESOP

In most cases, you can cash out of an ESOP only if you retire, leave the company, lose your job, become disabled, or pass away.

Check the specific rules for your plan to find out how the cashing-out process works.

Can You Roll ESOPs Into Other Retirement Plans?

You can roll an ESOP into other retirement plans such as IRAs. However, there are possible tax implications, so you’ll want to plan your rollover carefully.

ESOPs are tax-deferred plans. As long as you roll them over into another tax-deferred plan such as a traditional IRA, within 60 days, you generally won’t have to pay taxes.

However, a Roth IRA is not tax-deferred. In that case, if you roll over some or all of your ESOP into a Roth IRA, you will owe taxes on the amount your shares are worth.

Because rolling over an ESOP can be a complicated process and could involve tax implications, you may want to consult with a financial professional about the best way to do it for your particular situation.

ESOPs vs 401(k) Plans

Although ESOPs and 401(k)s are both retirement plans, the funding and distribution is different for each of them. Both plans have advantages and disadvantages. Here’s a side-by-side comparison of their pros and cons.

ESOP

 401(k)
Pros

•   Money is invested by the company, typically, and requires no contributions from employees.

•   Employees get fair market value for shares when they leave the company.

•   Company may offer dividend reinvestment.

•   Many employers offer matching funds.

•   Choice of options to invest in.

•   Generally easy to get distributions when an employees leave the company.

Cons

•   ESOPs are invested in company stock only.

•   Value of shares may fall or rise based on the performance of the company.

•   Distribution may be complicated and take time.

•   Some employees may not be able to afford to contribute to the plan.

•   Employees must typically invest a certain amount to qualify for the employer match.

•   Employees are responsible for researching and choosing their investments.

Recommended: Should You Open an IRA If You Already Have a 401(k)?

3 Other Forms of Employee Ownership

An ESOP is just one kind of employee ownership plan. These are some other examples of plans an employer might offer.

Stock options

Stock options allow employees to purchase shares of company stock at a certain price for a specific period of time.

Direct stock purchase plan

With these plans, employees can use their after-tax money to buy shares of the company’s stock. Some direct stock purchase plans may offer the stock at discounted prices.

Restricted stock

In the case of restricted stock, shares of stock may be awarded to employees who meet certain performance goals or metrics.

Investing for Retirement With SoFi

There are different things to consider when starting a retirement fund but it’s important to remember that time is on your side. No matter what type of plan you choose, the sooner you begin setting money aside for retirement, the more room it may have to grow.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

Easily manage your retirement savings with a SoFi IRA.

FAQ

Can employees contribute to an ESOP?

In most cases, the employer makes contributions to an ESOP on behalf of employees. Rarely, employers may allow for employee contributions to employee stock ownership plans.

What is the maximum contribution to an ESOP?

The maximum account balance allowed in an employee stock ownership plan is determined by the IRS. For 2023, this limit is $1,330,000 though amounts are increased periodically through cost of living adjustments.

What does ESOP stand for?

ESOP stands for employee stock ownership plan. This is a type of qualified defined contribution plan which allows employees to own shares of their company’s stock.

How does ESOP payout work?

When an employee changes jobs, retires, or leaves the company for any other reason, the company has to buy back the shares in their account at fair market value or at the current sales price, depending if the company is private or publicly-traded. The payout to the employee may take the form of a lump sum or be spread over several years. Check with your ESOP plan for specific information about the payout rules.

Is an ESOP better than a 401(k)?

An ESOP and a 401(k) are both retirement plans, and they each have pros and cons. For instance, the employer generally funds an ESOP while an employee contributes to a 401(k) and the employer may match a portion of those contributions. A 401(k) allows for more investment options, while an ESOP consists of shares of company stock.

It’s possible to have both an ESOP and a 401(k) if your employer gives you that option. Currently, almost 94% of companies that offer ESOPs also offer a 401(k), according to the ESOP Association.

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