(c) 2006 
Dow Jones & Company, Inc. Reproduced with permission of copyright owner. Further reproduction or distribution is prohibited without permission.Exchange traded funds (ETFs) are an increasingly popular investment. ETFs are open-end mutual funds that, unlike traditional open-end funds, trade on exchanges, such as the NYSE and AMEX. The fact that they can be bought or sold throughout the day is one of their advantages over ordinary open-end funds, which only allow purchases and sales at the end of the day.
But the big advantage of ETFs is that the sale of securities inside the fund does not typically generate taxable capital gains for ETF shareholders. Investors in traditional open-end funds must pay taxes each year on any net capital gains generated by trades inside the fund. As recent recipients of 1099s well know, these capital gain taxes are due regardless of whether the investor has sold any fund shares. ETFs avoid irksome capital gain distributions through the clever use of exchanges in kind -- trades of mutual fund shares for securities in the fund -- with arbitrageurs. Because these trades are not taxable events, ETFs are typically able to rebalance their portfolios without realizing capital gains. In effect, ETF shareholders are taxed as if the ETF is just another security; they pay taxes on dividends distributed by the fund, but they are only hit with capital gain taxes when they sell their ETF shares. This gives ETFs a substantial advantage over traditional open-end funds in the competition for customers.
We suggest a simplification of the tax code that levels the playing field for ETFs and ordinary funds. Taxation of distributed dividends continues. (It hits the shareholders of ETFs and ordinary funds in the same way.) But taxation of capital gains occurs only when fund shareholders redeem their shares. In other words, we suggest that mutual fund capital gains should be taxed in the same way as gains on other securities. This is the system in many other countries.
The advantage of this simplification of the tax code for investors is obvious. It will save taxpayers thousands of tedious hours as they fill out their tax returns each year. It will also save mutual funds millions of dollars in administrative and processing costs. These savings will quickly find their way into the funds' returns.
Does the IRS suffer from this simplification of the tax code? The change we suggest doesn't reduce the total tax paid on capital gains. It just shifts the tax into the future, when shareholders redeem fund shares. The loss to the IRS is thus the time value of money: Taxes paid now versus later. As finance professors we are quick to agree that money does have time value.
Our basic point, however, is that this loss to the IRS is already a moot issue. ETFs have come up with a way to make the taxation of capital gains to their shareholders conform to our simplification. If traditional funds don't also find an antidote, ETFs will eventually dominate the fund industry. The gate is open; we expect that in the near future most mutual fund shareholders will effectively pay taxes as if our suggested simplified rule for capital gains is in place.
The real question, then, is: What is the point of the current complicated mutual fund tax code for capital gains if it is unlikely to generate the intended benefits to the IRS? Why not adopt our simplification and so level the playing field for ETFs and ordinary funds?
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Mr. Fama is the Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago. Mr. French is the Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business at Dartmouth.
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