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ETFs Are Tax Efficient, but Is That Sound Policy?

ETFs are privileged by happy accident, and it's poor public policy to favor them over mutual funds.

Most investors know that exchange-traded funds are often more tax-efficient than mutual funds. A subset of those know that this is because ETFs use a primary market in which shares are created (or redeemed) in exchange for a basket of securities by a special breed of market makers known as authorized participants. These in-kind transfers allow ETFs to avoid the capital gains that mutual funds would incur by selling appreciated securities, which are in turn taxed if they are held in a taxable account.

This raises a question: Since investors respond to incentives, should policymakers be incentivizing ETFs over traditional open-end mutual funds? Is the structure of an ETF so desirable that the government should a send a strong signal to invest in ETFs instead of mutual funds?

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