Ke Shen Explains Exchange-Traded Funds

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In this episode of Lehigh University’s College of Business ilLUminate podcast, host Stephanie Veto sits down with Dr. Ke Shen to explore the popularity of exchange-traded Funds (ETFs). Dr. Shen explains how wealthy investors are leveraging ETFs, while also highlighting why they can be a smart choice for everyday investors.

Dr. Shen joined the Perella Department of Finance in 2017. His research focuses on asset management, institutional investors, and financial intermediation, with particular emphasis on (ETFs), mutual funds, and bond market investors.

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Below is an edited excerpt from the conversation. Read the complete podcast transcript [PDF].

Veto: How do ETFs differ from mutual funds?

Shen: In some sense, ETFs are similar to mutual funds because both of them are defined as investment companies. So, they're actually investment companies registered with the SEC. And there are also mutual funds tracking the same S&P 500 index, as an example. They are called index mutual funds. Now, the difference between ETFs and mutual funds is that ETFs are traded like stocks. So, you can buy and sell ETF shares during the day when the exchange is open. On the other hand, you cannot really trade mutual funds. During the day, mutual funds can only be bought and sold after the market is closed.

Veto: Why are ETFs so attractive and efficient for investors?

Shen: I think the main reason is because, first of all, an ETF is a very low-cost investment vehicle.The cost of holding ETFs on an annual basis could be lower than 10 basis points. That's 0.1% of the amount of money you invest in an ETF. That's the first cost advantage. And the second advantage is because ETFs can be traded like a stock. So, you have the liquidity benefit, which means you can buy and sell anytime during the day when the market is open.

Another benefit is the diversification benefit, because it is basically tracking an index of almost 500 stocks. That gives you the benefit of diversification versus you only investing in one single stock. Now, there comes the fourth benefit, which is the tax benefit. It is the subject of our study. What we found is basically if you buy and hold an ETF, not actively trading it, you can actually take advantage of the tax benefit. Which means it doesn't really distribute those capital gains. And so there is no tax consequence from those capital gains.

Veto: And does that mean that there's a tax exemption? Do investors have to pay taxes if they sell the ETF?

Shen: It's not really a tax exemption at all. You cannot really avoid paying taxes if you decide to sell the ETFs. It is more of a tax deferral. Think of it this way, if you're a long-term investor, you buy and hold those ETF shares and never intend to sell them. Because there's no capital gains distribution from those ETFs, the investor will never need to pay capital gains taxes. Until, of course, the investor decides to sell the ETF shares. Then, there will be tax consequences. And that's the main difference from ETFs versus mutual funds.

Mutual fund shareholders, when they sell their shares, will be forced to liquidate part of their portfolio. And by liquidating those portfolios, if there's any capital gains, those capital gains will have to be distributed to the remaining mutual fund shareholders. Now, if there is distribution, then there's going to be tax consequences. So, that's where the advantage of the tax efficiency for ETFs kicks in compared to mutual funds.

Veto: Is the tax loophole the primary attraction to ETFs when it comes to investors?

Shen: Based on our study, that is correct. In some sense, I wouldn't really call it a tax loophole because that tax advantage is also available to mutual funds. But because the way ETFs are designed, it makes ETFs more advantageous to actually take advantage of those tax efficiencies. Mutual funds simply cannot do that.

Veto: What is a tax sensitive investor?

Shen: Tax sensitive investors, as the literature defines, are mostly high-net-worth individuals or families. You can think of those investors as having a lot of assets that they can invest in the stock market or in the bond market with. And they are relatively long-term. If they are long-term investors, they can also benefit from the tax efficiency of ETFs. For those high-net-worth individuals or families, they can benefit the most from the tax efficiency of ETFs, simply because they can afford to buy and hold an asset for a very long time. There is an inheritance law called a step-up in basis, which means the old generation passes their wealth to their new generation. Those assets will adjust the cost basis to the market value at a time of inheritance.

Imagine if you buy and hold an asset or basket of assets for almost 50 years. There are a lot of capital gains during those 50 years. And if anyone sells those assets, there's going to be a huge capital gain realization, which means there's also a tax consequence for those capital gains. But because of the step-up in basis, those assets could be passed to the next generation tax-free, simply because the cost basis will be readjusted at a time of inheritance. That's a huge benefit. And I think especially for those high-net-worth individuals or families, they can benefit the most from holding ETF assets.