Beating the Index with ETFs

Abstract

This paper uncovers a new source of tax efficiency for ETFs---using highly correlated ETFs to harvest capital losses without violating the wash-sale rule. By exploiting the tax loophole, investors can potentially earn a better return than the index. The study reveals that highly correlated ETFs have an average monthly tax-loss trading volume of 9.1% of their assets under management, which accounts for 20.7% of their total trading volume. Tax-loss harvesting is negatively related to past returns, especially for recent and negative ones. ETFs with high past volatility have higher tax-loss trading volumes, while smaller and less liquid ones have lower tax-loss trading volumes. This paper develops a parsimonious model to explain the relationship between tax-loss harvesting and past price movements. Simulations with the model predict an annual tax revenue loss of 0.52% of assets under management for highly correlated ETFs, equivalent to approximately 25 billion USD in 2021.

Keywords: ETF, Tax-Loss Harvesting, Trading Volume

JEL Classification: G11, G12, G18