The Role of Taxes in the Rise of ETFs

142 Pages Posted: 11 Dec 2020 Last revised: 9 Mar 2024

See all articles by Rabih Moussawi

Rabih Moussawi

Villanova University - Department of Finance; University of Pennsylvania

Ke Shen

Lehigh University -- Perella Department of Finance

Raisa Velthuis

Villanova University - Department of Finance

Date Written: March 8, 2024

Abstract

This paper argues that a lesser-known yet economically significant tax-deferral feature of ETFs’ security design is crucial to their success. By relying on the in-kind redemption exemption, authorized participants help ETFs avoid distributing capital gains and reduce their tax overhang, partly by deploying heartbeat trades. We estimate that the ETF tax efficiency has increased long-term investors’ after-tax returns by 0.92% per year relative to similar mutual funds in recent years. Exploiting cross-sectional and time-series variations in investors’ tax burden, we show that tax efficiency is a significant driver of the capital migration by high-net-worth investors from mutual funds into 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

Suggested Citation

Moussawi, Rabih and Shen, Ke and Velthuis, Raisa, The Role of Taxes in the Rise of ETFs (March 8, 2024). Available at SSRN: https://ssrn.com/abstract=3744519 or http://dx.doi.org/10.2139/ssrn.3744519

Rabih Moussawi (Contact Author)

Villanova University - Department of Finance ( email )

800 E Lancaster Ave
Bartley Hall, 2051
Villanova, PA 19085
United States

HOME PAGE: http://www.homepage.villanova.edu/rabih.moussawi

University of Pennsylvania ( email )

3733 Spruce Street
216 Vance Hall
Philadelphia, PA 19104-6301
United States

HOME PAGE: http://www.rabihmoussawi.com/

Ke Shen

Lehigh University -- Perella Department of Finance ( email )

621 Taylor St
Rauch Business Center
Bethlehem, PA 18015
United States
(610) 758-1084 (Phone)

HOME PAGE: http://sites.google.com/view/ke-shen-finance

Raisa Velthuis

Villanova University - Department of Finance ( email )

United States

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