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Wealthy Americans fleeing tax increases can switch to a turbocharger to the ETF

The thriving ETF industry may be set to raise even more money in the coming years as wealthy Americans facing higher taxes on capital gains seem to limit what they owe to Uncle Sam.

President Joe Biden plans to double the interest rate, which earns more than $ 1 million a year on investment gains, will accelerate a change that has already seen hundreds of billions of dollars migrate from mutual funds to exchange-traded funds, market observers say. This is because ETFs are usually more efficient than taxation, allocating fewer capital gains payments, which for some may soon become much more expensive.

Actually from one measure, the tax efficiency of the ETF is the single most important driver behind the tectonic change in asset allocation in recent years. Although the administration̵

7;s plan remains in its infancy and is sure to be tightly monitored by lawmakers in the coming months, even a gradual increase in capital gains is likely to encourage further use of the ETF, according to David Perlman, UBS ETF strategist. Global Wealth Management.

“If the tax rates on capital gains are higher, if you have a choice of structure that helps defer capital gains and gives you more control over when to recognize those gains, you will be more likely to go into that direction, ‘said Pearlman.

Moving tides

ETFs make money while mutual fund flows dissipate

Sources: Investment Company Institute, Bloomberg Intelligence

When an investor exits a mutual fund, the fund manager must sell the securities to raise cash for redemption. The same investor who leaves the ETF may sell his shares to another investor, which means that neither the fund nor its manager has made a taxable transaction.

Meanwhile, the in-kind process used to create and repurchase shares in an ETF – in which the ETF issuer exchanges the fund’s underlying securities with a market maker instead of making cash transactions – means that ETFs rarely make taxable sales.

A December study by researchers at Villanova and Lehigh universities found that over the past five years, ETFs have averaged a tax burden 0.92% lower than active mutual funds. In addition, especially for investors with a high net worth, tax considerations outweigh both performance and fees as a major driver of active mutual fund flows and ETFs, the findings show.

“There is no doubt that Biden’s plan to raise capital gains tax could be a boon to the ETF,” said Nate Geraci, president of the ETF Store, a consulting firm, by email. “Despite significant gains in ETF market share over the past decade, there are still trillions of dollars locked into less tax-efficient mutual funds.”

Last year alone, the ETF industry took in nearly $ 500 billion, while mutual funds lost about $ 362 billion, according to data compiled by Bloomberg.

Advantage of ETF

Today, most ETFs make almost no capital gains to shareholders. Only 3 of the 585 in the CFRA’s analysis made payments in 2020, Todd Rosenblut, head of the company’s ETF and mutual fund research, said in a report on April 26. In the same period, 37 out of 39 internal mutual funds from T. Rowe Price Group Inc. have earned capital gains, the analysis shows.

“We expect more people who mix ETFs and mutual funds to be more inclined to focus on strategies to avoid paying higher taxes on capital gains in the future,” Rosenbult wrote.

Even investors who are not affected by the higher rate can migrate to the ETF, he added. Simply discussing capital gains reminds investors of the industry’s innate tax advantages over mutual funds.

Read more: Tax evasion from ETFs is a dirty little secret on Wall Street

Others are not convinced that a higher rate of capital gains will go a long way in increasing ETF inflows. Wealthy investors will have to sell their mutual fund shares to make the change, causing significant tax liabilities in the process, said Michael Sigmont, head of trading and research at Harvest Volatility Management.

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