How Wall Street's 'Dirty Little Secret' Affects Investor Portfolios

11 Pages Posted: 3 Jul 2021 Last revised: 20 Jul 2021

See all articles by Christoph Frei

Christoph Frei

University of Alberta - Department of Mathematical and Statistical Sciences

Liam Welsh

University of Alberta - Department of Mathematical and Statistical Sciences

Date Written: July 18, 2021

Abstract

In the United States, exchange-traded funds can defer capital gains taxes of their investors by taking advantage of a legal loophole, sometimes referred to as Wall Street's "dirty little secret". To quantify the impact of this tax loophole on investor portfolios, we study a rank-dependent expected utility model. We develop an approximation formula for the sensitivity of the optimal investment strategy with respect to changes in the expected asset returns. By applying this approximation formula, we are able to quantitatively estimate how much investor portfolios may change depending on the investment horizon if the tax loophole is closed.

Keywords: Portfolio Allocation, ETFs, Mutual Funds, Capital Gains Tax

JEL Classification: G11, G28, K22

Suggested Citation

Frei, Christoph and Welsh, Liam, How Wall Street's 'Dirty Little Secret' Affects Investor Portfolios (July 18, 2021). Available at SSRN: https://ssrn.com/abstract=3870958 or http://dx.doi.org/10.2139/ssrn.3870958

Christoph Frei (Contact Author)

University of Alberta - Department of Mathematical and Statistical Sciences ( email )

Edmonton, Alberta T6G 2G1
Canada

HOME PAGE: http://www.math.ualberta.ca/~cfrei/

Liam Welsh

University of Alberta - Department of Mathematical and Statistical Sciences ( email )

Edmonton, Alberta T6G 2G1
Canada

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