The Role of Taxes in the Rise of ETFs

Research

148 Pages

This paper argues that a lesser-known yet economically significant tax-deferral feature of ETFs’ security design is crucial to their success. By relying on the in-kind redemption exemption, authorized participants help ETFs avoid distributing capital gains and reduce their tax overhang, partly by deploying heartbeat trades.

Key Takeaways

ETF Tax Edge: We estimate that the ETF tax efficiency has increased long-term investors’ after-tax returns by 1.05% per year relative to mutual funds in recent years.
Capital Migration Driver: Exploiting cross-sectional and time-series variations in investors’ tax burden, we show that tax efficiency is a significant driver of capital migration by high-net-worth investors from mutual funds into ETFs.
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