The Role of Taxes in the Rise of ETFs

Abstract

The immense growth of ETFs is often attributed to their intraday liquidity and low expenses, which are favored by short-term investors. This paper argues that lesser known, yet economically significant, tax elimination and deferral features of ETFs’ security design are critical to their success in the last two decades. By relying on the in-kind redemption exemption, authorized participants help ETFs avoid distributing realized capital gains and reduce their tax overhang, partly by deploying “heartbeat” trades. We estimate that the tax efficiency of ETFs relative to mutual funds increases long-term investors’ after-tax returns by an average of 0.92% per year in recent years. Exploiting cross-sectional and time-series variations in investors’ tax burden, we document that tax efficiency is likely the driver of the capital migration by high-net-worth investors from active mutual funds into ETFs. Our results suggest an equilibrium where taxable mutual fund assets migrate or convert to ETFs.

Keywords: ETFs, Mutual Funds, Capital Gains, Fund Flows, In-Kind Redemptions, Section 852(b)(6) Exemption, Heartbeat Trades, Tax Deferral, High-Net-Worth Individuals, Step-up in Basis

JEL Classification: G11, G23, G28, K22