The Role of Taxes in the Rise of ETFs

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: 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