Story by Rachel Curry
Ke Shen’s research shows why wealthy investors are flocking to ETFs.
Since the first ETF (exchange-traded fund) hit the U.S. in 1993, the stock-like investment vehicle has taken off. Over the course of 2024, ETFs saw record net inflows of $1.17 trillion, with much of that money crossing over from legacy mutual funds.
While the majority of the attraction to ETFs stems from their affordability (they often have lower expense ratios than mutual funds) and liquidity (investors can buy and sell them throughout a trading day, whereas mutual funds trade at market close), there’s a third element that one Lehigh Business researcher says is increasingly prevalent: the tax benefit.
“We think, especially for high-net-worth individuals, they realize the tax benefit of owning an ETF, and that’s been driving the flow,” says Ke Shen, assistant professor in the Perella Department of Finance.
According to the research from Shen and his colleagues at Villanova University, investors prioritizing ETFs saved an average of 1.05 percent in taxes each year since 2012 compared to active mutual funds. When considering the portfolio values that wealthy investors carry, this amounts to substantial savings over time. Plus, at investment firms for individuals with high net worths, ETFs accounted for nearly 47 percent of overall reported assets in 2023, signifying an overt preference for tax-sensitive investors.
This tax advantage stems from a uniquely American exemption: Section 852(b)(6) of the U.S. Internal Revenue Code. “ETFs achieve their tax efficiency through the in-kind redemption process and the use of heartbeat trades, by offloading low-basis stocks without triggering a taxable event,” explain Shen and his colleagues in a writeup of their research in the Harvard Law School Forum on Corporate Governance.
Let’s break that down: Asset managers rebalance mutual funds in a way that can trigger a taxable event, even for investors who don’t sell shares. This is not the case for ETFs thanks to something called in-kind redemptions, in which ETFs work with a Wall Street investment bank or other authorized participant to rebalance the fund without that taxable capital gains distribution. ETFs generally use heartbeat trades—scheduled quarterly or semi-annual re-balancings that look like an EKG when graphed—to pursue these in-kind redemptions.
In 2019, the Securities and Exchange Commission instated Rule 6c-11, also known as “The ETF Rule,” which made this workaround even easier.
Shen says wealthy investors realize the benefit ETFs give over mutual funds when it comes to taxes. The only downsides, he says, are for public finance (the loss of tax revenue) and the mutual fund industry. “The mutual fund industry definitely realizes the disadvantage they face compared to ETFs, so they are actively looking for ways to transform their product,” he says. One such way may be the dual share class mutual fund, where every mutual fund has an ETF share class.
“If there’s going to be any policy to try to level the playing field, you will see a lot of lobbying going on from the ETF industry to try to prevent that from happening,” says Shen.
On the public finance side of things, descendants save even more on taxes for their ETF investments thanks to a rule that changes the initial cost basis of the investment to the fair market value at the time of transfer (dubbed the “step-up” in basis). Given that we’re living through the largest transfer of generational wealth in history, the tax revenue—or lack thereof—from wealthy investors makes a marked difference in the U.S. economy.
For Shen, this research serves to illuminate the mechanics and consequences of the different market structures.
Why it Matters
The makeup of the U.S. investment landscape is swiftly changing, and both the mutual fund industry and public finance landscape face a reckoning. Shen’s research can underscore any future policy decisions made on these fronts.