A tax loophole in the US tax system, predominantly exploited by exchange-traded funds (ETFs), is estimated to cost the Treasury Department around $48 billion each year due to deferred or avoided capital gains tax. This financial advantage primarily benefits the wealthiest Americans, and these savings are projected to nearly double following a recent policy shift. The mechanism behind this tax avoidance involves "heartbeat trades," which saw funds shed $293 billion of assets last year. The practice has grown as a booming stock market made tax avoidance more challenging for fund managers without it, and a 2019 rule change by the US Securities and Exchange Commission (SEC) expanded its use.
Previously, only a few managers, including large index-fund providers like Vanguard Group and BlackRock Inc., had special permission from the SEC to engage in these heartbeat trades. However, the 2019 rule change opened the door for any ETF to utilize this technique. This change has contributed to the rapid growth of actively managed ETFs, which rely more heavily on heartbeats than their passive counterparts. Last year, heartbeats comprised 18% of net daily outflows in active vehicles, compared to 9% for passive funds.
Another significant development involves the expiration of Vanguard's patent on a method that grafted a more tax-efficient ETF onto an existing mutual fund, allowing the ETF to siphon appreciated stocks out of the mutual fund without triggering capital gains taxes. This technique, which Vanguard has used since 2001 to report zero capital gains on $191 billion in gains for some mutual funds, is now becoming more widely accessible. If the entire mutual fund industry were to adopt an ETF share class, an additional $40 billion in deferred or avoided taxes could result annually, with $35 billion benefiting individuals and $4 billion benefiting businesses.
While SEC Chairman Atkins described the policy change as a benefit to "everyday investors," Bloomberg estimates suggest that the highest-earning 1% of American households currently save approximately $13,000 annually from this tax break, with those in the middle wealth distribution saving around $23. If the entire mutual fund industry were to adopt an ETF share class, the wealthiest could see their taxes decrease by another $11,000. These benefits are concentrated among top earners because ownership of mutual funds and ETFs outside of tax-advantaged retirement accounts is highly concentrated among this group.
The Investment Company Institute has requested guidance from the US Treasury Department regarding a fast-growing ETF strategy known as 351 conversions. These conversions enable investors to transfer concentrated stock positions or entire portfolios into ETFs without immediately incurring capital-gains taxes, and the industry group seeks clarity on regulators' stance on this practice.
