Exchange-traded funds (ETFs) are giving mutual funds a run for investors' money, and one reason is that ETFs can get around the tax hit that individual investors in mutual funds can encounter.

Mutual fund investors pay capital gains tax on assets sold by their funds, with occasionally wrenching consequences. During the financial crisis, for example, many mutual funds were forced to sell some of their holdings to honor redemptions; these generated capital gains taxes, meaning that investors had to pay tax on assets that had fallen sharply in value.

ETFs​, on the other hand, don't have to subject their investors to such harsh tax treatment. ETF providers offer shares "in kind," with authorized participants serving as a buffer between investors and the providers' trading-triggered tax events.

No wonder ETFs have become so popular, with assets in U.S.-listed ETFs and exchange-traded notes (ETNs) ballooning from about $102 billion in 2002 to nearly $5 trillion in 2020. (Mutual funds aren't going anywhere. Their total assets in 2020 were about $24 trillion.)

Avoiding the Wash-Sale Rule

But ETF investors enjoy another advantage that worries Harold Bradley, who was the 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." 

The reason, he says, is that ETFs are being used to avoid the IRS' wash-sale rule, which 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. If you've bought a "substantially identical" security within 30 days of the sale—before or after—you're not allowed to deduct the loss.

What Is "Substantially Identical"?

According to Bradley, that rule is not enforced when it comes to ETFs. "How many sponsors are there of an S&P 500 ETF?" he asks. Most major indices 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) right away, while the underlying index is at the same level. "You basically can take a loss, establish it, and not lose your market position."

It's difficult to verify how widespread this practice is in fact. 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," though "there's no tracking to know how widespread it is." He points out that, from the IRS' 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.'"

The Growth 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."

According to a Bank of America Merrill Lynch report, 45% of assets in U.S. equity funds were being invested passively in 2020, up from 19% in 2009.

Do ETFs Distort the Market?

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 that 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." If he's right, this hollowing-out of capitalism's modus operandi comes down to tax policy.