How Wall Street's 'Dirty Little Secret' Affects Investor Portfolios
11 Pages Posted: 3 Jul 2021 Last revised: 20 Jul 2021
Date Written: July 18, 2021
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: Suggested Citation