Study finds 'new source of tax efficiency for ETFs'

Exchange-traded fund investors are taking advantage of "a regulatory gray area of U.S. tax law" that gives the products an edge over index mutual funds, according to a new study.

Tax-loss harvesting strategies that avoid capital gains and violations of IRS wash-sale rules by trading one ETF for another similar product — such as selling holdings in the SPDR S&P 500 ETF Trust and buying the iShares Russell 1000 ETF — are driving up the transaction volumes among the "correlated" products, according to a working paper posted this fall by Wentao Li of the University of Oxford's Saïd Business School. As a result of the tax-loss harvesting, at least 9.1% more of the assets under management with these "paired" ETFs are turning over each month when compared to "unpaired" products, the paper found. Li's study, which is entitled "Beating the Index with ETFs," described that as a "new source of tax efficiency for ETFs." 

"The paper shows that the tax efficiency of the ETF comes from not only owning it but also trading it," the study said. "Owning an ETF helps investors track the index closely, while trading ETFs allows investors to reduce the taxable income of the whole portfolio, making ETFs more valuable than the index. Through buying and selling highly correlated ETFs, investors effectively avoid the wash-sale rule that disallows tax deduction with trades only for tax purposes."

Reducing capital gains through tax-loss harvesting has emerged as a key element making the case for direct indexing — investing directly in the underlying stocks of a broad market fund rather than in the products. A client's level of wealth and the timing of the transactions play large roles in the potential tax savings.

While "nothing in this study contradicts that direct indexing in general will be superior," Smartleaf President Jerry Michael has "never seen a quantitative measure of how the market reacts to the availability of a better substitute," he said in an interview. His software and asset management firm provides automated systems for portfolio personalization and tax optimization to firms such as SEI Investment Management, Hightower, Altruist, Apex Clearing and AdvisorEngine.

"The study is a study of what people actually do in the real world. There may be all this theory about how you should do tax-loss harvesting. What do they actually do?" Michael said. "If there's a better substitute, we see more loss harvesting."

Holders of mutual funds and their financial advisor "should be aware of the pending capital gains associated with that fund" toward the end of the year and consider taking steps to offset them, said Brad McMillan, the chief investment officer of Commonwealth Financial Network. The tax benefits of ETFs come on top of being less expensive in general, he noted.

"It's a regulatory arbitrage where you're gathering that tax loss, you're gaining that tax alpha," McMillan said. "It's largely a matter of cost. You've already seen ETFs eat a large part of the passive market simply because of lower cost."

The additional trading volume that Li uncovered for the paired ETFs using a statistical technique called a "difference-in-differences" regression represented 20.7% of their monthly transactions, the study showed. Evidence of tax-loss harvesting highlights the fact that the federal government is losing "billions of dollars" in potential tax revenue from ETF investors using the strategy, he wrote. 

"It is unfair to tax investors of ETFs and individual stocks differently," the paper concluded. "Since the wash-sale rule can be avoided using paired ETFs, the current tax policy effectively subsidizes ETFs. Besides, the current tax code treats index mutual funds and ETFs differently. An index ETF and an index mutual fund serve the same purpose — facilitating investors to hold a diversified portfolio with a relatively low transaction cost, but they have different tax treatments."