For decades, a 1969 tax law has allowed U.S. investors to postpone and avoid taxes on capital gains made from exchange traded funds. Social and political pressure is now mounting to close (or at least shrink) that loophole — which could cause a significant amount of capital to flow from ETFs into mutual funds, according to new academic research.
The loophole — referred to in the study and by the financial media as “Wall Street’s dirty little secret” — is a byproduct of a Nixon-era U.S. tax law. The law allows ETF managers to dodge taxes by asking a third party, like an investment bank, to quickly dump assets into the fund and then take them out — a trade that is known as a “heartbeat,” according to Christoph Frei, a professor at the University of Alberta and co-author of the study.
“Therefore, the individual investors will not need to pay or declare realized capital gains,” Frei said in an interview with Institutional Investor. “They will only need to do that when they sell their investment.”
For investors, Frei said this practice has two main advantages. First, investors can decide to sell their ETF investments during periods of lower additional income, when the overall capital gains tax rate is lower. Second, investors can defer their tax and invest in the fund for a longer period without the high costs.
Over the years, various academics and critics have argued that the loophole provides an “unfair tax benefit” to ETF managers and investors, according to Frei’s paper. In one 2017 study, researchers found that the loophole caused increased capital flows from active mutual funds to passive ETFs, resulting in the rising popularity of ETFs amongst high-net worth individuals.
In their study published June 21, Frei and co-author Liam Welsh, a graduate student at the University of Alberta, explored how investor portfolios with both ETFs and mutual funds would be affected if the loophole was closed. Frei and Welsh placed the portfolios in two hypothetical scenarios: one with the existing tax rules, and one with a closed loophole.
“We were comparing investor portfolios containing mutual funds and ETFs because those are fairly common investments for investors,” Welsh said. “And, importantly, this loophole is available for the ETFs but not mutual funds.”
In the scenario with the open loophole, capital flowed to ETFs, mirroring reality. Under the second scenario, the assets allocated to ETFs decreased along with the funds’ tax efficiency, causing a shift in capital from ETFs to mutual funds.
In the event of a closed loophole, Frei and Welsh noted that the actual amount of capital that shifts to mutual funds will depend on various parameters like the time horizons of investors and expected asset returns. Hypotheticals aside, Frei said there’s no way to know when or if the loophole will be closed.
“It’s a political question,” he said. “But there is overall increasing pressure as it becomes more and more known to the public.”
According to Frei, the current financial situation in the U.S. has put pressure on politicians to demand additional tax revenues, particularly from high-net-worth individuals such as those who invest in ETFs.
For institutional investors, the loophole — and its potential closure — has varying effects depending on the fund type. For example, Frei said the loophole doesn’t matter to public pension funds because they’re already tax exempt. Private equity and hedge fund investors are taxed, but these entities can easily pass the burden onto individual investors or managers, he said.
“It really depends on the type of institutional investor,” said Frei. “The underlying idea is similar. The loophole still allows them to defer realization of capital gains, and therefore also at least to a partial deferral of tax.”
