How the Closure of a U.S. Tax Loophole May Affect Investor Portfolios

Christoph Frei; Liam Welsh

doi:10.3390/jrfm15050209

How the Closure of a U.S. Tax Loophole May Affect Investor Portfolios

J Risk Financ Manag. 2022 May 4;15(5):209. doi: 10.3390/jrfm15050209. eCollection 2022 May.

Authors

Christoph Frei¹, Liam Welsh²

Affiliations

¹ Department of Mathematical and Statistical Sciences, University of Alberta, Edmonton, AB T6G 2G1, Canada.
² Department of Statistical Sciences, University of Toronto, Toronto, ON M5G 1Z5, Canada; liam.welsh@mail.utoronto.ca.

Abstract

In the United States, exchange-traded funds can defer capital gains taxes of their investors by taking advantage of a legal loophole. To quantify the impact of this tax loophole on investor portfolios, we study a rank-dependent expected utility model. We develop an approximation formula for the sensitivity of the optimal investment strategy with respect to changes in the expected asset returns. By applying this approximation formula, we are able to quantitatively estimate how much investor portfolios may change depending on the investment horizon if the tax loophole is closed.

Keywords: ETFs; capital gains tax; mutual funds; portfolio allocation.

Grants and funding

This research was funded by the Social Sciences and Humanities Research Council of Canada through Insight Grant 435-2018-0049 and a Canada Graduate Scholarship.