income tax

Tax tail wags investment dog

New study finds rapid growth in exchange trade funds (ETFs) is driven by their ability to defer recognition of capital gains. Bad news for the income tax base and efforts to curb income inequality.

Capital gains and ETFs

Tax considerations drive the rapid growth in ETF assets according to a recent paper by three business professors, Rabih Moussawi, Ke Shen, Raisa Velthuis, “The Role of Taxes in the Flow Migration from Active Mutual Funds to ETFs,” (December 2020). The paper is interesting to a tax geek like me. It is worth reading, even though it is pretty long (over 70 pages with tables, graphs, notes etc.). Disclaimer: the paper is posted on SSRN, but has not been peer reviewed or published by a journal. However, the research methods look solid to me, although I’m unfamiliar with the data they use and am not an econometrician.

ETFs are more tax efficient than standard mutual funds because their structure and operating practices allow deferring capital gain taxes (or entirely avoiding them for those affluent enough to use the Buy/Borrow/Die avoidance plan, as described by Professor Edward McCaffrey). Their results were surprising to me and are concerning on a couple fronts. If accurate, they augur further erosion of the income tax base and will reinforce the trend toward more inequality by further undercutting the taxation of high-net-worth individuals.

ETFs came on the scene in the early 1990s and were initially a niche product, an open-end mutual fund that trades on the stock market. In the old days, only closed-end funds traded on stock exchanges; open-end funds were purchased with their prices set once per day. ETFs have grown dramatically in popularity over the last decade and US ETFS now have over $5.5 trillion in assets (traditional funds have about $18 trillion). Some observers think ETFs will eclipse and may supplant traditional open-end funds. See John Rekenthaler, “Farewell Mutual Funds” (Morningstar 1/21/21) for one account (1/25/21 follow up column responding to critics).

I am modestly familiar with ETFs and have personally invested in them for over a decade. I had always thought their tax advantage was a minor attraction because ETFs initially consisted mainly of passive, index products and traditional index mutual funds were already tax efficient. The main attractions of ETFs, in my mind, were their lower expense ratios (why they attracted me) and the ability to trade them in real time, not just once per day as with traditional open-end funds. The article says otherwise and seems convincing (at least to me).

ETF’s tax advantage

ETFs’ tax advantage stems from their ability to avoid making capital gain distributions when the ETF trades the securities it holds. Traditional mutual funds pass most of their net realized gains through to their shareholders, even though the shareholder has not sold any of her mutual shares. Both traditional mutual funds and ETFs are taxed under the same federal tax rules (i.e., as regulated investment companies) on a pass-through basis like partnerships and S corporations. So, when capital gains are realized, they are deemed to be distributed pro rata to their shareholders. In theory both ETFs and traditional mutual funds can avoid distributing capital gains by making “in-kind” distribution of the securities they wish to trade to their shareholders (rather than giving them cash for redemptions) or authorized participants (for ETFs). But for structural reasons only ETFs routinely do that, thereby avoiding distributing most of their realized gains to their shareholders. Why that is so requires a little explanation.

Two typical events trigger mutual funds to realize capital gains. If a fund’s shareholders sell or redeem their funds (i.e., withdraw their money), the fund may need to sell some of its holdings to raise cash to pay them. That typically occurs only if a lot of shareholders “head to the exits” selling their shares when a fund underperforms or otherwise falls out of favor and the redemptions exceed their usual cash holdings. Obviously, the typical shareholder wants money, not to be paid off “in-kind” (i.e., to be tendered shares of the securities the fund holds). If the shares that are sold have appreciated over the fund’s tax basis in them, capital gains are triggered. Second, repositioning the fund’s portfolio may trigger gains. For a managed fund, this occurs when the investment managers no longer wish to hold the securities. For an index fund, it happens because the index changes. For example, Tesla gets added to the S&P 500. That is a more common case with smaller or niche indexes, such as a small cap, smart beta, or sector funds, since the composition of narrower indexes is more fluid than the S&P 500 or a total stock market index fund.

By contrast, an ETF shareholder does not get money directly from the fund, but instead sells her shares on the stock exchange. To maintain liquidity in the ETF shares and to deal with circumstances when investment in the ETF increases or decreases, the ETF contracts with an authorized participant or AP (or market maker) to supply and take the securities the ETF invests in and to make a market in the ETF stock – such a mechanism is necessary to allow an open-end fund to trade in real time. Thus, when an ETF’s investors sell shares on net, it will tender some of the portfolio’s underlying securities to the AP. Low basis securities are tendered (consistent with the portfolio construction obviously) to bleed away the capital gains. This structure and practice mean when a lot of an ETF’s shareholders head to the exits, capital gain distributions will typically not be triggered for the remaining shareholders, as is the case with traditional mutual funds. Somewhat counterintuitively, a lot of shareholders selling creates an opportunity for the ETF to tender its low basis securities and to reduce the potential for future capital gains. (That connection is not something that had occurred to me but is obvious on a moment’s reflection.)

What I did not realize and what the article uses to test tax sensitivity is a second technique, “heartbeat trades.” If capital gains would be triggered by realigning the portfolio (e.g., a managed portfolio or because of changes in the index) or other events, the ETF can engage in a second mechanism whereby the AP buys ETF shares, pumping money into the ETF that is used to buy more securities for its underlying portfolio. Shortly thereafter (but at least two days later to satisfy the tax law) the AP sells ETF shares. That outflow is satisfied by the ETF tendering low-basis securities (i.e., not the ones just purchased) to the AP, draining potential capital gains away from the ETF. These are referred to as “heartbeat trades” because when you graph them, they show up as spikes similar to graphing an EKG heart monitor’s output.

The research and findings

ETF assets have grown dramatically. The paper reports US equity ETFs had assets under management of about $2.4 trillion in December 2019. A year later that had grown to $3.2 trillion. The authors’ hypothesis is that ETFs’ tax advantage (the ability to defer capital gain taxes and to entirely avoid them for those passing on ETF shares at death) is a principal driver of the growth. To test the hypothesis, they analyze a sample of mutual fund data assembled from the SEC, Center for Research in Security Prices, Lipper, and other sources, including data on heartbeat trades and holdings by advisors to high-net-worth investors. The strategies use sophisticated statistical analysis to determine (1) the general relationship of fund performance, expense ratios, and taxes on investment flows (i.e., to which fund types is money flowing), (2) differences between high- and more average net-worth investors, and (3) the impact of the capital gains tax rate increases in 2012-13 as a natural experiment. All the results point to taxes as the big factor in driving the flow of money into ETFs, particularly out of traditional active or managed mutual funds (where investment managers pick stocks to “beat the market”).

The first step obviously is to calculate/estimate the relative tax advantage of ETFs versus managed mutual funds and index funds. To do this they determine the differences in capital gain distributions (broken down by short and long term, since the former are subject to higher taxes) relative to the funds’ net realized gains, adjusted for investment styles. They then convert the differences into estimates of tax for top-bracket taxpayers and express it as a percentage of the funds’ assets. That makes the burden like an annual property tax and conveniently makes it equivalent to a fund’s expense ratio. The descriptive statistics showing the ETF advantage are quite striking. I expected that for managed funds, where higher portfolio turnover typically generates more capital gains, but it is also true for passive or index funds. Over the period they analyze, the tax advantage compared to actively managed funds was 86 basis points or bps (0.86% of assets) and for the last five years (2013 – 2017) was 112 bps. (pp. 22 – 24) Obviously, the difference for index funds was smaller. They make the point that the advantage roughly is of the same size as the expense ratio advantage that index funds and ETFs have compared with actively managed funds. (As an aside, reputable investment and personal finance advisors have been harping on the importance of seeking out low-expense funds as the one sure way to increase returns – finding high-return investments, by contrast is a fraught exercise. Finding a fund or advisor who is consistently above average is next to impossible over the long run, unless they office in Lake Woebegone. By contrast, expense ratios are transparent and easy to compare.) As they observe, “For all investment styles, ETFs distribute less than 0.14% in capital gains, a trivial amount compared to [traditional] mutual funds.” (p. 24). Heartbeat trades are a big contributor to this, particularly in reducing short term gains, which otherwise would generate the highest tax burdens.

Their graph of the annual amounts between 1999 and 2017 shows the stark advantage and how ETFs (solid blue line) systematically keep capital gain distributions low, even though they have realized net gains that are about the same as comparable traditional funds according to the authors’ data.

Effects on flows by fund type. The authors use data on distributed and realized gains by funds and information on fund holdings to test whether performance, fees or taxes are the biggest determinant of which type of fund attracted money using regression analysis. They found that taxes were the strongest factor driving the outflow from managed funds and into ETFs. Managed funds with larger distributions of capital gains were more likely to have outflows. Tax sensitive investors headed for the exits after funds announced their capital gain distributions but before the actual distribution dates.  One of the anomalies of mutual fund mechanics is that traditional funds announce capital gain distribution amounts well before distributing them. As a result, investors with a high basis in the fund shares can exit before the distribution date and avoid tax on the distributions (if their bases in fund shares are well below the market this strategy doesn’t work obviously). The authors used this data to analyze outflows.

Sorting active traditional funds by those with higher capital gain distributions (i.e., those triggering more tax liability for their shareholders) revealed that these funds tended to have larger outflows, while ETFs of the same style/investment type experienced large inflows. By contrast active funds with the lowest distributions paired with flows into traditional passive, index funds. As the authors observe:

This tax-related flow migration is not an active to passive phenomenon, but strictly a flow migration into ETFs.

Rabih Moussawi, Ke Shen, Raisa Velthuis, “The Role of Taxes in the Flow Migration from Active Mutual Funds to ETFs,” (December 2020), p. 34

ETFs and high-net-worth investors. To further test the hypothesis, the authors analyzed data on the use of ETFs by advisors to high-net-worth individual investors who they (and I) presume are tax sensitive. They found a strong correlation:

[A]llocations to ETFs by investment advisors of high-net-worth clients are nearly four times more than investment advisors with low or no high-net-worth clients and have reached 32.4% of the overall 13F [investment manager] assets managed by these advisors in 2017, compared to less than 9% for other investment advisors, respectively.

Rabih Moussawi, Ke Shen, Raisa Velthuis, “The Role of Taxes in the Flow Migration from Active Mutual Funds to ETFs,” (December 2020), pp. 35 – 36.

Their graph, perhaps, shows it best.

2012-13 capital gain tax increases. Finally, they used the two capital gain tax increases Congress enacted in the Affordable Care Act and the American Taxpayer Relief Act of 2012 as a natural experiment to test the effect on flows into ETFs (difference-in-difference regression analysis with ETF allocations of advisors of high-net-worth individuals as the dependent variable). They found a big effect:

[W]e document an overwhelming increase in allocations and flows into ETFs [by advisors of high-net-worth individuals] relative to advisors with lower fractions of high-net-worth clients especially after the increase in capital gains tax rates after 2012. * * * Overall, our evidence points to the dominant role of ETF tax efficiencies behind the massive outflows from active mutual funds and the dramatic surge of flows into ETFs in recent years.

Rabih Moussawi, Ke Shen, Raisa Velthuis, “The Role of Taxes in the Flow Migration from Active Mutual Funds to ETFs,” (December 2020), p. 39.

They finally conclude that:

Without a doubt, the tax efficiency of ETFs is likely to continue exacerbating the active-to-ETF flow migration and inevitably lead to more mutual fund conversions for tax purposes.

Rabih Moussawi, Ke Shen, Raisa Velthuis, “The Role of Taxes in the Flow Migration from Active Mutual Funds to ETFs,” (December 2020), p. 41.

Policy implications

The authors note the resulting unevenness of the taxation of investors in different types of fund structures. A main concern is the resulting inefficiency. Of course, the fund industry (Investment Company Institute position) has for years advocated to exempt reinvested capital gain distributions from capital taxes until the fund shares are sold. That would resolve the inefficiency and inequity by blowing an even bigger hole in the income taxation of capital income. So far Congress has not appeared to be interested; at least, the provision did not make the cut for any of the various versions of the TCJA Congress seriously considered.

They estimate that the current level of domestic equity ETFs will result in reduced federal tax collections (by deferring capital gains) of $400 billion to $679 billion over the next decade. (pp. 40 – 41) Those calculations are based on ETF AUM of $2 trillion and the authors say they ignored future flows into ETFs. (p. 41) Since that equity AUM has already increased to $3 trillion as of December 2020, I assume that their numbers should be increased by 50% or so to adjust for just that growth. If they are correct about the migration to ETFs continuing, the federal revenue impact will grow. The amount could easily exceed the amount of the estimated tax cut under TCJA, if their numbers are right (I don’t have a high degree of confidence in that) and flows into ETFs continue, substantially replacing traditional funds in most taxable accounts. There are limits to that migration, of course – primarily low-basis investments in traditional funds whose redemptions would trigger big capital gain liabilities.

My observations

  • The wisdom of using ETFs, rather than traditional funds, for one’s taxable investments seems obvious. I plan to take that to heart as I convert RMDs to taxable investments.
  • Their results provide yet one more illustration of how difficult it is to tax capital and particularly capital gains.
  • Using an ETF structure will allow high-net-worth individuals a workaround for one of the biggest challenges of holding low basis securities until death (the lock-in effect and resulting lack of portfolio diversity).
  • It is one more piece of evidence supporting the need to eliminate the step-up in basis on death, which creates a big hole in capital taxation.  Ideally, Congress would tax gain on death as both Obama and Biden had/have proposed, but I don’t expect it to happen any time soon if ever. A more modest fix would be to make heartbeat trades more difficult to do (expensive because APs will bear more market risk and charge more for their services) by increasing the minimum 2-day holding period to something much longer (why not apply 30 days, which is used for wash sales, e.g.?).
  • The relatively low effective tax rates on capital income are, of course, an obvious contributor to the growing inequality. The ETF effect will only make matters worse. However, my instinct is that society would be better off following the model used elsewhere in the developed world – i.e., a healthy consumption tax (VAT obviously) that funds a more generous social safety net – and reduce the focus on trying to make the income tax ever more progressive as the primary way to address income inequality. It simply doesn’t work for reasons of practical political economy. I think Ed Kleinbard was generally right that focusing on the overall fiscal system, rather than the progressivity of the tax system, is preferable We Are Better than This (chapter 12)
  • Minnesota relies more heavily on revenues from taxing capital gains than most states (nothing like California, of course). It relies heavily on the income tax and taxes long term capital gains at the same rate as ordinary income. An obvious and often discussed drawback of that is revenue volatility, since revenues hang on the ups and downs of the stock market. But the paper illustrates another drawback – the potential for long-term erosion. Fortunately, capital gain distributions from regulated investment companies are not a huge part of the overall tax base, but they are important and every bit matters.

2 replies on “Tax tail wags investment dog”

Thanks, Joel. Once again, I learned a lot from your article. I also was attracted to ETFs by their low fee costs and the built in diversity of their holdings (S&P 500 ETFs). I never thought about the way they minimize capital gain taxes (to a large extent). I will continue using ETFs for investment of my taxable assets. I hope you are dong well. Look forward to seeing you when it’s safe. Rich.


Thanks, Rich. Yes, looking forward to the end of this pandemic when we can get together again. I think there is a light at the end of the tunnel – both Amy and I got our first dose of the vaccine this week.


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