20 Oct New proposal to close loophole meeting resistance from ETFs
The new bill proposed by senior Democrat US lawmaker Ron Wyden is aimed at closing the loophole which allows investors to move from mutual funds to EFTs or exchange traded funds, and as a result, avoid paying tax.
This legislation would help generate tax revenues in their billions of dollars for the US federal government.
Exchange Traded Funds
An exchange traded fund (ETF) is a fund that can be traded on an exchange, such as a stock, meaning it can be bought and sold throughout the day. According to Investopedia, “an exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other assets, but which can be purchased or sold on a stock exchange the same way a regular stock can.”
Major ETF investment management firms such as State Street and BlackRock have reportedly criticised the bill, suggesting it would deny investors a major tax advantage that has boosted the industry’s growth.
Both BlackRock and State Street have expressed their concern about new policies being introduced that would raise costs for long term investors and retirement savers because that would greatly reduce their returns.
The move by the Chair of the Senate Finance Committee comes at a time when President Biden is focused on finding ways to fund social programmes.
The EFT Loopholes
The exchange traded fund tax bill by lawmaker Wyden will aim to close loopholes that provide a tax benefit to ETFs over mutual funds. According to ETFGI, the ETF market has almost doubled from $4.8tn in 2018 to $9.7tn today, thanks to record inflows and rising markets.
How the exchange traded fund differ
The EFT differs from other open end mutual funds in the way that they process investor inflow and outflow.
EFTs are generally passively managed, while mutual funds are actively managed. The former typically track a specific market index that can be bought and sold like stocks. Mutual funds are managed to buy and sell assets to beat the market and provide profitable returns for investors.
ETFs have greater flexibility to respond to demand by creating and redeeming new units sold on the market. In contrast, capital gains taxes are paid on the financial gains made through portfolio management companies on a fund.
Distributions by trading groups and banks that work with ETFs can trade units in return for a basket of stocks or assets that equal the original fund. Because of this, ETFs can evade the same capital gains taxes that mutual funds incur.
Exchange traded funds have traditionally been more tax efficient and provide many benefits, including greater trading flexibility, risk management advantages, lower costs, portfolio diversification and of course, tax benefits.
The proposed bill by US Democrat Wyden would see ETF investors paying capital gains at the end of each financial year on their investments. It is understandable why the federal government would want to benefit from introducing a tax on this when less than 5% of US listed ETFs reported taxable gains last year, according to Georgia Bullitt, a partner at the New York law firm Willkie Farr & Gallagher.
The heavyweights in the US Exchange traded funds industry such as State Street, BlackRock and Invesco have seen increased growth, and that isn’t something they will want to lose on when the global ETF market is predicted to grow $15tn by 2025.
The Vanguard investment management company have greater concerns if the legislation goes ahead due to the structure they have in place. Their structure pairs ETFs with mutual funds, which provides a tax advantage for both.
All those with an interest in the Exchange traded funds market are now waiting to see how the draft progresses because the changes would have repercussions for all those involved in the ETF industry.
Investors and investment management companies are well experienced in adapting and finding other ways to reduce costs and increase returns. They will do so even if that bill is passed but would clearly rather it didn’t.
Direct indexing is another option for investors who want to seek an alternative. Those who want to diversify within direct indexing often work with an advisor. As a result, many of the major players in this sector have now started making acquisitions to increase their presence in this area.