Exchange-traded funds (ETFs) are giving mutual funds a run for investors’ money because ETFs get around the tax hit that investors in mutual funds encounter. Mutual fund investors pay capital gains tax on assets sold by their funds and they’re subject to the wash-sale rule. ETFs don’t subject investors to the same tax policies.
ETF providers offer shares “in kind,” with authorized participants a buffer between investors and the providers’ trading-triggered tax events. Financial experts have raised concerns regarding ETFs’ impact on market dynamics and tax regulations. They’ve nonetheless experienced significant growth and have had an impact on investment strategies and market valuation.
Key Takeaways
- ETFs help investors avoid the wash-sale rule, as they’re often linked to an index rather than a “substantially identical” security.
- ETF structures allow investors to dodge taxable events typically seen with mutual funds.
- Many investors use ETFs to exploit tax advantages, raising concerns about potential manipulation of IRS rules.
- The growing popularity of ETFs is reshaping markets and could lead to valuation distortions.
Understanding the IRS Wash-Sale Rule
Investors who buy “substantially identical stock or securities“ within 30 days before or after selling at a loss are subject to the wash-sale rule. The rule prevents an investor from selling a security at a loss, booking that loss to offset the tax bill, and then immediately buying the security back at, or near, the sale price.
ETF investors enjoy an advantage that worries Harold Bradley, once Kauffman Foundation’s chief investment officer from 2007 to 2012. “It’s an open secret,” he told Investopedia. “High net worth money managers now are paying no taxes on investment gains. Zero.” Bradley says that ETFs are used to avoid the IRS wash-sale rule.
Challenges in Enforcing ETF Tax Rules
According to Bradley, the wash-sale rule is not enforced for ETFs. “How many sponsors are there of an S&P 500 ETF?” he asks. Most indexes have three ETFs to track them—ignoring leveraged, short, and currency-hedged variations—each provided by a different firm.
That makes it possible to sell, for example, the Vanguard S&P 500 ETF (VOO) at a 10% loss, deduct that loss, and buy the iShares S&P 500 ETF (IVV) immediately with the underlying index at the same level. “You basically can take a loss, establish it, and not lose your market position.”
Michael Kitces, the author of the Nerd’s Eye View blog on financial planning, told Investopedia by email that “anyone who (knowingly or not) violates those rules remains exposed to the IRS,” but “there’s no tracking to know how widespread it is.”
Kitces points out that, from the IRS’s perspective, a “widespread illegal tax loophole” translates to a “giant target for raising revenue.” An IRS spokesperson told Investopedia by phone that the agency does not comment on the legality of specific tax strategies through the press.
Bradley is not so sure, though. “High net worth people don’t have any interest in having the government understand” the loophole, which he thinks is “the biggest driver of ETF adoption by financial planners. Period. They can justify their fees based on their ‘tax harvesting strategies.'”
Total ETF Assets
The Rise in Popularity and Impact of ETFs
If Bradley is right, the implications of this practice go beyond tax-dodging by the wealthy. So much capital has flowed into index-tracking ETFs, he says, that markets “are massively broken right now.” Money has poured out of individual stocks and into ETFs, leading to “massive” valuation distortions,
Bradley argues: “The meteoric rise in Low Volatility ETFs (150% annual asset growth since 2009) as a key driver of the 200%+ surge in relative valuations of low beta stocks to never-before-seen premia.” The problem is not limited to low-beta stocks, Bradley says. “People have never paid more for a penny of dividends. People have never paid more for earnings; people have never paid more for sales. And all of this is a function of people believing that someone else is doing active research.”
Bradley is not optimistic. “You are undermining the essential price discovery feature that has been built into stocks over time, which says, this is a good entrepreneur who’s really smart, and he needs money to grow and build his company. That’s been lost as a primary driver of the capital markets.”
What Is a Tax Loss Harvesting Strategy?
Tax loss harvesting is a tax strategy that involves selling an asset with a capital loss to lower or eliminate the capital gain realized by other investments for income tax purposes.
Why Can ETFs Avoid the Wash-Sale Rule?
ETFs can avoid the wash-sale rule because ETFs typically are an index for a sector or a group of stocks and are not “substantially identical” to a single stock.
When Are Two Investments Considered “Substantially Identical”?
The term “substantially identical stock or securities” pertains to tax rules published by the U.S. Internal Revenue Service (IRS) regarding wash sales. Substantially identical securities are not different enough to be separate investments. Securities usually fall into this category if the market and conversion prices are the same and cannot be counted in tax swaps or other tax-loss harvesting strategies.
The Bottom Line
Exchange-traded funds are structured in a way that avoids the wash-sale rule because the investments are typically tied to an index for a group of stocks. They’re not “substantially identical” to a single stock.
This is a major benefit that ETFs provide in terms of tax advantages and potential market impact.