ETFs Are Tax Efficient, but Is That Sound Policy?

Aron Szapiro

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?