How Wall Street's "Dirty Little Secret" Affects Investor Portfolios

  • Author / Creator
    Welsh, Liam
  • In the United States, investors of exchange-traded funds (ETFs) and mutual funds are required to pay tax on the capital gains that their funds have made throughout the year. However, ETFs are able to avoid making taxable capital gains by taking advantage of a legal loophole, subsequently benefiting ETF investors. This loophole is referred to as Wall Street's ``dirty little secret''. By contrast, mutual funds do not benefit from this loophole, and their investors must pay capital gains tax when the fund is selling appreciated assets. In this thesis, we explore the impact that the ETF tax loophole has on investor decisions and how an investor's asset allocation would change in the event the loophole is closed. However, investor biases have been observed between active and passive funds, so a classical model cannot be used. As such, we use a rank-dependent expected utility model allowing us to incorporate these biases. Given a particular setting, the investor's optimization problem can be solved explicitly. In a more general model, this problem is not explicitly solvable, but we can still obtain the approximate impact that the tax loophole has on an investor's portfolio. As the tax loophole allows ETF investors to defer capital gains tax, its impact increases with the investor's holding period. In the event the loophole is closed, we estimate that for holding periods between three and five years the investment in ETFs will decrease by approximately 2.75% to 7% of the total portfolio allocation, and the investment in mutual funds will increase by approximately 2.5% to 5.5% of the total portfolio allocation.

  • Subjects / Keywords
  • Graduation date
    Fall 2021
  • Type of Item
  • Degree
    Master of Science
  • DOI
  • License
    This thesis is made available by the University of Alberta Libraries with permission of the copyright owner solely for non-commercial purposes. This thesis, or any portion thereof, may not otherwise be copied or reproduced without the written consent of the copyright owner, except to the extent permitted by Canadian copyright law.