How a capital gains tax increase could lead a shift towards ETFs

Todd Rosenbluth, Head of ETF and Mutual Fund Research at CFRA, joins Yahoo Finance’s Sibile Marcellus and Alexis Christoforous to discuss impacts tax policy changes could have on ETFs.

Video transcript

ALEXIS CHRISTOFOROUS: Time now for today's "ETF Report" brought to you by Invesco QQQ. I want to bring in Todd Rosenbluth, head of ETF and Mutual Fund Research at CFRA. Todd, always good to see you.

So I want to mix a little politics in here. We don't normally do that, but President Biden's going to give his first State of the Union on Wednesday. As part of that, he's going to unveil his wish list for tax increases to pay for all the spending we're seeing coming out of Washington. What might the impact be on the ETFs?

TODD ROSENBLUTH: Right. So President Biden has talked about, throughout the campaign, that a capital gains tax increase could happen. And if that does happen, we think that's going to spur greater interest in ETFs relative to mutual funds. Historically, ETFs have been significantly more tax efficient-- particularly the equity ETFs.

It's really rare for an equity you have to pay or pass on capital gains to oil shareholders. Whereas if you own a mutual fund, you quite likely received a capital gains tax passed along to you, even if you held on throughout the year. So I think we're going to see a greater shift towards ETF adoption. This trend is going to continue, in part because of the tax implications.

SIBILE MARCELLUS: Why is it that mutual funds are a bigger tax burden for investors than ETFs?

TODD ROSENBLUTH: So if I own a mutual fund and I wanted to take my money back and be able to pay for my son's college education or anything else that might have been to achieve my goals, I would reach out to the fund company through my brokerage account, I would ask for redemption. The manager would often have to sell stock in order to meet my redemptions and that of other shareholders-- selling the stock and then passing on capital gains to other shareholders.

If I want to sell an ETF, I put in a sell request through a brokerage account, and somebody who's looking to buy shares of that ETF, that same exact ETF, matches me in the secondary market the same way that it would happen from a stock perspective. And the rest of the shareholders are not impacted.

So most ETF trading takes place in the secondary market and does not impact the underlying fund or the shareholders, whereas mutual funds-- mutual fund companies deal directly with their shareholders. And thus, there's a capital gains that takes place if the fund did exactly as you would want it to do, which is that it made money for the underlying stocks.

ALEXIS CHRISTOFOROUS: Todd, what some of the ETF themes you're seeing right now, and have they changed from the first quarter to the present quarter?

TODD ROSENBLUTH: So one of the things that we're seeing is a greater adoption and usage of smart beta or factory [INAUDIBLE] or more market or non-market cap weighted products. So they're not tied to broader S&P 500 or the Russell 1000. We've seen, actually, the Invesco S&P 500 equal weight ETF, RSP, be extremely popular this year.

We're starting to see greater interest in that ETF as an alternative to it. We've seen a focus on various themes-- you know, we're showing on the screen here about some of the technology-oriented ETFs. They still are in favor, but we've seen a shift towards more the value oriented sectors like energy, like financials. Investors have been looking to adopt ETFs that can go where the action is. And so value-oriented strategies, more equally-weighted strategies have been increasingly popular as we started the second quarter of 2021.

ALEXIS CHRISTOFOROUS: All right, we're going to leave it there-- Todd Rosenbluth of CFRA, thanks as always for being with us.