What is the new ETF rule?

Every so often, something occurs that changes the way we invest, and we think it best to keep our clients informed regarding these changes. This year, one such change occurred:

The Securities and Exchange Commission (SEC) has adopted the ETF Rule, which allows Exchange-Traded Funds (ETFs) to exchange securities within their portfolios for different securities on a tax-free, “like-kind” basis with investors such as market makers.

Advantages of the new ETF rule

What the ETF rule means is that ETFs can now purge their funds of low cost-basis securities without realizing capital gains and will rarely be making capital gains distributions in the future. This offers a tax-deferral advantage over mutual funds that are held in taxable accounts.

Consider also the difference in trading costs between buying mutual-fund shares and ETF trading:

When you buy mutual-fund shares, you are sending cash to the mutual fund itself. The mutual fund uses your cash to purchase securities. This trading carries hidden costs, which are borne by all of the mutual-fund shareholders. Likewise, when you sell, the mutual fund must sell securities to meet your demand for cash, resulting in trading costs for all shareholders.* In other words, a mutual fund shareholder is paying ongoing trading costs, even if they are simply holding the shares.

Contrast that with ETF trading. When you buy ETF shares, you are not transacting with the ETF itself; rather, you are buying the ETF from another shareholder. You pay your own one-time trading cost through a bid-ask spread, but your activity has no effect on other ETF shareholders. The holder of ETFs does not pay trading costs as a result of the activity of other shareholders.

In summary, all else equal, the new ETF rules give ETFs a tax and trading cost advantage over mutual funds. For a more complete discussion, see our website under What To Know/ Blog/ the ETF rule and Custom Baskets.

There can be legitimate reasons to stay with mutual funds, especially mutual funds that are already as tax-efficient and cost- effective as the ones we utilize in your accounts. However, in the coming years, expect to see your accounts populated with more ETFs, especially your taxable accounts.

*Individual purchases and sales do not necessarily result in mutual fund trading, as mutual funds have cash positions and can offset purchases and sales. However, in aggregate, purchases and sales result in trading.