The ETF industry could be a big winner if President Biden is successful in passing his capital gains tax hike proposal, according to new analysis from CFRA Research.

The advantage of ETF investing in an environment where capital gains taxes could go as high as 39.6%, as they would under Biden’s proposal, is multifold, according to Todd Rosenbluth, CFRA’s head of ETF and mutual fund research. 

“Just three of the 585 equity ETFs offered by iShares, Invesco, Schwab State Street Global Advisors, and Vanguard, and star rated by CFRA, passed along any capital gains to shareholders in 2020 that maintained positions throughout the year,” Rosenbluth said.

That is very different than many mutual funds that did pass along capital gains burdens even to loyal shareholders who stayed invested in their funds all year, he said.

“ETF-focused advisors and investors in 2020 received fewer surprises at year end and we expect more people that mix ETFs and mutual funds together will be more inclined to shift toward strategies to avoid paying higher capital gains taxes in the future,” Rosenbluth said.

Tax efficiency will become even more coveted in an increasing tax rate environment, he said. ETFs are generally more tax efficient than mutual funds because, unlike mutual funds, ETFs generally do not sell securities when investors redeem their shares, Rosenbluth said. Instead, ETFs “do most of their trading in the secondary market where they are able to cross their sell orders with buy orders,” he said.

As a result, “ETF redemptions by other shareholders do not typically create a taxable event for long-term ETF holders as they would with mutual funds,” Rosenbluth said.

According to CFRA, “Market-cap weighted ETFs such as iShares Core S&P 500 ETF (IVV) and Technology Select Sector SPDR (XLK), smart-beta ETFs such as Invesco S&P 500 Equal Weight ETF (RSP) and Vanguard Dividend Appreciation ETF (VIG), as well as actively managed BlackRock U.S. Equity Factor Rotation ETF (DYNF) and Vanguard US Multifactor ETF (VFMF) all incurred zero capital gains in 2020."

Zero capital gains will become even more attractive to wealthy individuals, who could see their federal rates soar as high as 43.4% if Biden and Democrats are able to pass a 39.69% capital gains hike, the report said.

iShares Evolved U.S. Innovative Healthcare ETF (IEIH), with $37 million in assets, was responsible for the largest capital gain as a percentage of net asset value. “This actively managed sector fund paid out capital gain of $0.57 a share, equal to 1.7% its NAV,” Rosenbluth said.

For Blackrock’s two other “sinning” ETFs, the capital gain represented less than 0.08% of their NAVs, he added.

Meanwhile, “Invesco, Schwab, State Street Global Advisors, and Vanguard had zero equity ETFs that did pass along any capital gains to shareholders. The firms’ lineup includes market-cap weighted XLK, and smart-beta RSP and VIG. Investors in these and other equity ETFs do face tax consequences when they sell their shares,” Rosenbluth said.

“When share sales exceed demand, ETF shares are redeemed through an authorized participant using an in-kind mechanism that allows the fund to reduce the likelihood of capital gains. In addition, index-based equity ETFs typically have lower turnover rates—IVV and XLK have an annual turnover rate of just 4%—than active mutual funds where the management team has discretion to take profits throughout the year. With less trading at the fund level, fewer capital gains are incurred with equity ETFs,” he added.

Dimensional Fund Advisors is also moving to convert a suite of their tax-managed mutual funds to ETFs. “While the company said the six mutual funds being converted have delivered tax efficiency like what is available in the existing ETF market, their conversion will provide an additional tool to manage capital gains, supporting the funds’ goal to deliver higher after-tax returns by minimizing tax impact,” Rosenbluth said.

The movement of assets to ETFs is continuing throughout the marketplace, according to the Investment Company Institute. Equity mutual funds incurred $117 billion of net outflows year-to-date through April 14, while equity ETFs issued $229 billion in new shares, continuing their multiyear market share gains, ICI reported.

“If President Biden and the Democrats successfully raise the capital gains tax rate in 2021 ... even more investors may prefer to control their tax-paying destiny and sell some existing mutual fund positions in exchange for ETFs,” Rosenbluth said.