Expect Higher Taxes to Hasten the Move from Mutual Funds to ETFs

By Solomon G. Teller, CFA, Chief Investment Strategist, Green Harvest Asset Management

Higher tax rates may accelerate the current transition of hundreds of billions of dollars migrating from mutual funds to ETFs. For high-income investors, in particular, recent research indicates that taxes may have even been the primary driver of this switch.1

As the Financial Times just highlighted, tax exposure is a growing risk for mutual fund investors, especially with the prospect of higher tax rates. Both mutual funds and ETFs must distribute gains when they sell a stock that has appreciated. However, unlike mutual funds, ETFs have a mechanism for reducing that gain to shareholders, as thought to have happened last week – see below-left chart. Moreover, given their structure, mutual funds face the risk of having to realize gains simply to raise cash in the event the investors choose to redeem their money. This dynamic may create the potential for a negative feedback loop – see below right chart.

Increasingly, higher income investors have been adopting ETFs as their tool of choice for portfolio construction and tax-beneficial investing. It will be interesting to see if that trend now accelerates. Visit our website or talk to your financial advisor to find out more.

1 Other potential advantages include lower transaction costs, less cash drag, transparency, intraday liquidity and lower expense ratios.


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