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According to a team of academics, the shift of U.S. investors from mutual funds to exchange-traded funds is driven primarily by a tax loophole, rather than a perk inherent in the ETF’s structure.
Over the past decade, U.S. investors have withdrawn $ 1 billion from actively managed U.S. mutual funds, with a similar amount going into ETFs.
Although the mutual fund industry is still much larger, the majority of U.S. mutual fund lines have seen net outflows every year since 2014, according to the Investment Company Institute, even though around three-quarters of ETFs have registered entries.
This drastic change is leading some large asset managers, such as Dimensional Fund Advisors, Fidelity and T Rowe Price, to convert some of their existing mutual funds to ETFs or launch ETF clones of their existing funds.
However, research by Rabih Moussawi, Ke Shen, and Raisa Velthuis from Villanova University, Wharton School at University of Pennsylvania, and Lehigh University suggests that migration to ETFs is primarily driven by tax considerations. , rather than by other factors such as ETFs typically. lower costs and greater liquidity.
“The ETF tax advantage is the main catalyst for the massive migration from active mutual funds to ETFs over the past two decades,” they wrote.
“It was kind of a surprise for us,” Moussawi said. “Everyone is talking about the importance of expense and underperformance in driving these rides. [from mutual funds]. “
The greater tax efficiency of ETFs, at least in the United States, stems from a quirk of the capital gains tax system.
When mutual fund investors wish to redeem their units, the fund sells a portion of its underlying holdings in a “cash” transaction.
If these holdings have appreciated since the fund bought them, a capital gains tax liability is triggered for the fund and all of its investors, even those who do not redeem. This liability can also be triggered whenever the fund manager makes changes to the underlying portfolio.
From a political point of view, I think [the different tax treatment of ETFs and mutual funds] must be approached head-on. It’s not fair and it’s not a level playing field
In contrast, when faced with redemption requests, ETFs generally do not need to sell their underlying securities. Instead, they can deliver baskets of securities “in kind” to their authorized participants, the big banks that create and redeem stocks in ETFs.
As a result, trading activity, and any resulting capital gain, occurs outside the fund, so there is no pass-through to the end investor.
It can make a significant difference. Last year, some mutual funds managed by companies like Columbia Threadneedle, Invesco, JPMorgan and T Rowe Price made capital gains tax distributions equivalent to double-digit percentages of their net assets, some up to 30%, according to Morningstar.
Previous research has estimated that a group of around 400 ETFs investing in U.S. stocks deferred taxes on more than $ 211 billion in earnings in 2018 alone.
By avoiding the distribution of realized capital gains, the average ETF has had a tax burden that is 0.92 percentage points lower than that of a typical mutual fund over the past five years, Moussawi et al.
Their research looked at individual mutual funds with a relatively high tax burden and found that they saw more outflows from tax-sensitive investors at the same time as ETFs with similar investing styles enjoyed high levels of investment. inputs.
Additionally, the paper found that ETF adoption is most pronounced among investment advisers registered with high net worth clients, who are most likely to be subject to capital gains tax. In 2017, ETFs represented 21% of the overall portfolio of these advisers, compared to 5% for RIAs with clients of more modest means.
This divergence widened sharply after 2012, when President Barack Obama raised the capital gains tax rates to 23.8% for short-term gains and to 43.4% for longer-term gains. (rates then lowered by President Donald Trump), according to research.
“The tax change has accelerated the substitution. People wanted to get out of mutual funds. Tax management is a great benefit of RIA for high net worth investors, ”Moussawi said.
Todd Rosenbluth, head of ETF and mutual fund research at CFRA Research, said he was “surprised” by the discovery that greater tax efficiency was the main driver of flows to ETFs, given that “Investors who do it pay less and their focus is on relative performance.”
While the tax liability is, in theory, only deferred, not avoided, it allows investors to convert short-term capital gains into long-term gains, thereby reducing the tax rate. Even without this benefit, Jack Bogle, the father of index investing, described the deferral as an interest-free government loan reinvested in the ETF.
In addition, Moussawi said that some high net worth investors pass their portfolios to their heirs “so we are seeing more and more that these investors pay no CGT on their ETF investments.”
The results come at a time when calls to end the disparate tax treatment of mutual funds and ETFs are starting to gain some political clout.
The favorable tax treatment of ETFs “leads to externalities on other investors and taxpayers,” the newspaper said. “Policymakers may want to further investigate who bears the costs of ETF tax efficiency, especially since it presents unfair treatment of different investors.
Whereas “removing the exemption would be difficult. . . politically, I think it should be tackled head-on. It is not fair and it is not a level playing field, ”Moussawi said.
If nothing changes, “we will have [tax exempt] retirement accounts and then all taxable investments for ETFs. From a tax policy perspective, is this something they want to happen? ” he said.
Ben Johnson, director of global ETF research at Morningstar, said many people have raised this issue, which “to some appears to be unfair tax treatment between mutual funds and ETFs, and that the treatment of FNB is a loophole that must be closed. “
However, Johnson said: “What Morningstar has long argued is that where appropriate the playing field should be leveled by taxing mutual funds the same way ETFs are effectively taxed, and the same way that mutual fund investors are taxed in our other tax regimes. “
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