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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?

First, let's get a handle on how strong the incentives are by quickly reviewing how much more tax-efficient ETFs are relative to mutual funds. In short: quite a bit. Part of ETFs' advantage comes from vast majority employing passive investment strategies, so for an apples-to-apples analysis we compare passive ETFs to passive mutual funds. We see that 56% of passive mutual funds had a taxable capital gain distribution compared to 7.5% of ETFs in 2018. In other words, the structure of ETFs overwhelms the strategy, at least for the all-important question of whether an investor is likely to face any tax headwind for investing in a fund.

But that's not all. The structure confers tax advantages on index strategies that look more like active strategies, specifically strategic-beta ETFs. We might expect investors would end up with more frequent capital distributions from these ETFs because they track indexes that have turnover rates that exceed those of market capitalization weighted benchmarks by a wide margin.

But, again, the structure of the ETF is more important than the strategy: We see virtually no difference in the percentage of strategic-beta ETFs that pay capital gains distributions in our data and only modest increases in the number of ETFs that paid a capital distribution over multiple years. For more detail on this, see this lengthier analysis from Morningstar's Ben Johnson.

These differences matter because ordinary investors strongly prefer to avoid holding investments in taxable accounts that could force them to pay capital gains before they sell an investment. (It is worth noting that, in the final analysis, the actual tax burden could be the same since the fund's net asset value will go down by the capital gain, reducing future capital gains when an investor sells. However, for a variety of reasons--the time value of money, the uncertainty of future tax laws, and the drag of paying taxes before reinvesting--this is small comfort to investors.)

So why do policymakers privilege ETFs? It seems to have been a happy accident--at least for the ETFs. Most market-distorting tax policy is either trying to solve a market failure (for example, we want people to buy electric vehicles) or responding to corporate interests. But ETFs got a tax advantage by "luck of the arcane tax rules" to coin a phrase.

Should U.S. policy continue to encourage investment in ETFs? There does not seem to be a reason to do so. There are already other advantages to ETFs that do not come from arcane, unintended tax policy. For example, they reduce the costs of trading, which are borne by buyers and sellers rather than shareholders, as is the case with traditional open-end mutual funds. On the other hand, investors need to use more caution when purchasing an ETF than a traditional mutual fund. The same structure that makes them tax-efficient also can lead to mispricing of ETFs relative to their underlying securities.

In short, policymakers never meant to create the tax benefits for ETFs, and they should at least think about leveling the treatment of mutual funds and ETFs. Ideally, the U.S. would join much of the rest of the world and avoid forcing mutual fund investors to take capital gains because of securities trades in the fund or redemptions over which ordinary investors have no control. (Such a switch could eventually be revenue neutral, as investors would have higher capital gains in the future, if it were paired with other reforms.) But in any case, arbitrarily privileging one investment structure over another for arcane reasons is poor public policy.