ETF Heartbeat Trades, Tax Efficiencies, and Clienteles: The Role of Taxes in the Flow Migration from Active Mutual Funds to ETFs

Abstract

We study the use of “heartbeat trades” by ETFs in explaining their superior tax efficiency. By relying on the in-kind-redemption exemption rule, authorized participants help ETFs avoid distributing realized capital gains and reduce their tax overhang. In recent years, ETFs end up with 0.92% lower tax burden per year than active mutual funds, partly due to heartbeat trades. Challenged by ETFs’ tax efficiencies, mutual funds exhibit higher flow-tax sensitivity than flow-fee sensitivity. Active mutual funds with relatively higher tax burdens had more outflows from tax-sensitive investors at the same time when ETFs with similar investment styles experienced stronger inflows. Using holdings data of institutions with high-net-worth clients, we find that investment advisors with tax-sensitive investors allocate four times more assets to ETFs than other institutions, representing an important driver behind the overall surge in ETF flows, especially after the increase of capital gains tax rate in 2013. We conclude that the migration of flows from active mutual funds to ETFs is driven primarily by tax considerations.

Keywords: ETFs, Mutual Funds, Capital Gains, Tax Deferral, Fund Flows, Heartbeats, High-Net-Worth Individuals, Step-up Basis

JEL Classification: G11, G23, G28, K22