A recent academic paper concluded the tax advantage ETFs have in the US over their mutual fund counterparts is the key factor driving the industry’s rapid growth, however, the European ETF market shows why this is not the case.
The study, conducted by Rabih Moussawi and Raisa Velthuis of Villanova University and Ke Shen of Lehigh University, found ETFs have a 0.92% lower tax burden every year, driven by partially by heartbeat trades – a process where investors buy an ETF only to redeem a few days later in order to avoid significant capital gains tax
This tax loophole, the research said, has been the key driver for the migration of flows from active mutual funds to ETFs with tax-sensitive investors four times more likely to allocate to ETFs than other institutions.
“The shift from active to passive, and specifically to ETFs, is expected to have monumental consequences on market efficiency and capital formation,” the academics warned. “For these reasons, policymakers may want to further study who bears the costs of ETF tax efficiency.”
While this loophole exists in the US, mutual funds in Europe do not pay capital gains tax either meaning there is no advantage for the ETF structure from a tax perspective.
Despite the lack of tax advantage, ETFs this side of the pond have also grown at a frightening pace. According to data from PwC, ETFs listed in Europe have grown at a compound annual growth rate (CAGR) of 20.5% between 2008 and June 2020, almost triple the growth rate of broader UCITS assets.
Last year proved to be no different with ETFs seeing €102.7bn inflows over the 12 months, just shy of the record €107bn set in 2019, taking over assets under management (AUM) to €1.1trn, according to data from Morningstar.
This is very impressive considering March was a record month for outflows as investors reacted to the impact of coronavirus on global economies.
So if it is not tax then what are the other factors at play? The most telling two are the fees ETFs charge versus their active mutual fund counterparts and consistent manager underperformance in certain markets.
Highlighting this, the average ETF in the US charges 0.2% versus 0.7% for active mutual funds which enables them to “compete for investor flows” not only with mutual funds but even with the futures market and other index products, the academic paper said.
Added to this, active managers have failed to justify the higher fees they charge over the long term by consistently underperforming the market.
One only has to look at S&P Dow Jones’ bi-annual SPIVA scorecards to see the challenge the average manager faces when trying to beat the market. For example, just 11% of European-listed US active managers consistently beat the S&P 500 over the past five years.
There is no doubting the tax loophole in the US has been a huge tailwind for ETFs but to say it is the primary driver would be a disservice to the wrapper and the advantages it brings from an investment perspective.