The Role of Taxes in the Rise of ETFs

The growing popularity of Exchange-Traded Funds (ETFs) among long-term investors is, to a large extent, driven by their fee and tax efficiencies. Leveraging their unique security design, ETFs achieve their tax efficiency through the in-kind redemption process and the use of heartbeat trades, by offloading low-basis stocks without triggering a taxable event, pursuant to the exemption provided by Section 852(b)(6) of the U.S. Internal Revenue Code. The ETF tax efficiency is particularly appealing to high-net-worth individuals and other tax-sensitive investors. Our paper provides novel evidence underscoring the importance of the in-kind redemption exemption in realizing ETFs’ superior tax efficiency and pinpoints the resulting tax-driven investor migration from mutual funds to ETFs by focusing on the behavior of investment advisers that manage the assets of high-net-worth individuals.

ETFs are hardwired to take advantage of Section 852(b)(6), which exempts the distribution of capital gains when the appreciated shares are handed “in kind” to redeeming investors. Therefore, ETFs are inherently tax efficient because redemptions are generally made “in kind” with authorized participants, thereby avoiding capital gains distributions and their tax consequences for taxable investors. In contrast, mutual funds, absent the layer of authorized participants, typically engage in “cash” transactions to meet investor redemptions. Because in-kind redemptions are much costlier for mutual fund investors and are only possible for redemption transactions above $250,000, mutual funds have historically made little use of the in-kind redemption exemption.

To maximize the benefits of the in-kind redemption exemption, ETFs occasionally utilize a synthetic creation/redemption process known as “heartbeat trades.” In these trades, an authorized participant initiates a significant inflow into the ETF by creating new ETF shares, and, within a few days, reverses the process by executing an in-kind redemption of similar magnitude. This allows the ETF to offload appreciated securities via the in-kind redemption basket, avoiding any capital gains distributions that would have occurred if these securities were sold directly by the ETF. Therefore, heartbeat trades are often strategically deployed by index ETFs around rebalancing dates and when other irregular index deletions occur.

The adoption of SEC’s Rule 6c-11 in 2019 (also known as the ETF Rule) simplified the custom basket exemption, allowing ETFs to deploy heartbeat trades more efficiently by permitting the redemption basket to consist only of the appreciated securities leaving the fund. The ETF Rule also paved way for another phenomenon: conversions of mutual funds into ETFs, in order to provide ETF tax benefits to existing taxable fund investors. Guinness Atkinson charted the path and completed the first tax-free conversions of two of its mutual funds into ETFs on March 29, 2021, and at least 79 conversions have since been announced. Similarly, dozens of fund families have filed to adopt the ETF share class structure following Vanguard’s ETF share class patent expiration in May 2023, aiming to extend the superior ETF tax efficiency to taxable mutual fund investors.

As a result of the in-kind redemption exemption, ETF capital gains are realized without being distributed to investors, resulting in the majority of ETFs not distributing any capital gains in recent years. Our empirical evidence first documents that open-end mutual funds distribute capital gains significantly more often and in larger magnitudes than ETFs, despite having comparable realized capital gains yields. For many years, the fraction of mutual funds that distribute capital gains has been about ten times larger than that of ETFs. Furthermore, even when ETFs distribute capital gains, the amount distributed is merely a small fraction of the net realized capital gains. ETFs are able to avoid distributing capital gains by taking advantage of the embedded in-kind redemptions for ordinary investor outflows, when sufficiently available, and by deploying heartbeat trades when needed. The near-zero short-term and long-term capital gains distributions effectively enable investors to defer taxation on short and long-term capital gains until they sell their ETF shares. Additionally, when ETF shares are transferred upon an investor’s death to their heirs, a “step-up” in basis is applied based on the fair market value at the time of transfer, adjusting the cost basis of the appreciated assets for tax purposes.

Overall, we establish that the ETFs’ annual tax savings relative to active mutual funds represent 1.05%, on average, since 2012. Within investment styles characterized by higher capital gain realizations, such as small-cap and growth strategies, this ETF “tax alpha” is even greater. This ETF tax efficiency is especially appealing to tax-sensitive investors. Using holdings data of institutional investment advisers serving primarily high-net-worth clients and other tax-sensitive individuals, we observe a strong preference for ETFs, with allocations reaching nearly 47% of their overall 13F-reported assets in 2023. Even though tax-sensitive advisers represent less than 10% of overall institutional 13F assets, their combined ETF ownership has surged past 27% of total ETF market capitalization in 2023, representing 42% of the overall institutional ownership in ETFs. Leveraging the increase in capital gains tax rates after 2012 as a quasi-natural experiment further confirms the migration of active fund flows from tax-sensitive investors, with a higher sensitivity of outflows to tax burdens and a sharper increase in ETF allocations mainly by the investment advisers with tax-sensitive clientele. Therefore, we conclude that ETF tax efficiency is among the primary drivers behind the migration of flows from mutual funds to ETFs, which propelled the growth and popularity of ETFs in recent years.

Our empirical analysis suggests that, if U.S. equity ETFs were to distribute capital gains, these distributions would amount to somewhere between 2.11% to 3.72% per year based on the average distribution yields for similar index and active mutual funds, respectively. Given that U.S. equity ETFs have surpassed  $6.8 trillion in assets by the end of 2024, it is reasonable to assume that these ETFs would contribute to the deferral of the tax on at least $1.4 trillion and up to $2.5 trillion in short- and long-term capital gains distributions over the next decade. These projections would significantly increase if we incorporate additional ETFs traded in the U.S. (non-U.S. equity and fixed income ETFs with the in-kind redemption feature, estimated to be more than $3 trillion in 2024) as well as future investors’ flows into ETFs and mutual funds with ETF share classes.

The tax-deferral feature of ETFs also allows tax-free compounding of short- and long-term capital gains, creating larger accumulated future capital gains. ETFs provide investors not only the flexibility to time the realization of their capital gains when it is most optimal for tax purposes but also the possibility to indefinitely defer capital gains taxes. Furthermore, investors can forgo paying taxes on the accumulated capital gains altogether if they bequeath their ETF shares due to the step-up in basis rule, disproportionally benefiting wealthier investors who have been migrating to ETFs in recent years.

For these reasons, researchers and policymakers may want to further study the societal costs of the ETF tax efficiency. In addition to the controversial application of tax-free heartbeat trades, the reduced application of short-term capital gains taxes and in some cases long-term capital gains taxes due to the step-up in basis rule represents forgone income for tax agencies, benefiting wealthier taxpayers, and presenting a more profound challenge to the existing tax code and taxation philosophy. The tax efficiency of ETFs is likely to continue exacerbating the flow migration from active mutual funds to ETFs and inevitably lead to more mutual fund conversions and ETF share class structure applications, ultimately resulting in a new equilibrium where ETFs dominate the taxable investment space.

 

The full paper is available for download here.