This was originally published in Traders Magazine.
By Dave Choate, COO, CAPIS
Public markets rely on investors making informed choices. When investors evaluate companies, distinguish between strong and weak fundamentals and allocate capital accordingly, markets are better able to reward performance and support long-term growth. Without that discipline, outcomes becomes driven more by flows and scale than by underlying business strength.
Active management drives this process. Yet today, the conditions in which active strategies operate are increasingly influenced by structural factors, such as tax policy, that shape investor behavior at the long-term expense of our public markets.
How does tax policy shape investor behavior?
More than 22.8 million U.S. households hold open-end mutual funds, or ’40 Act funds, in taxable accounts. For many middle-income Americans building toward retirement, these funds remain a primary savings vehicle. It is important to understand that the investment goals of these long-term investors are perfectly aligned with the daily subscription and redemption process associated with mutual funds. However, current tax law disadvantages mutual fund investors relative to ETF investors, and the problem is getting worse.
Open-ended ’40 Act mutual funds are regulated investment companies (RICs) under the Internal Revenue Code and are treated as pass-through entities. When securities are sold for cash, capital gains may be realized within the fund, and those gains must be distributed to shareholders and taxed in the year distributed.
The mechanics are straightforward. Consider a $100 million large-cap mutual fund that receives a $5 million redemption request. The redeeming investor receives NAV on trade date. To raise cash, the fund sells portfolio securities on T+1. If those securities are sold at a gain, the fund realizes capital gains that are distributed to the remaining shareholders, imposing a tax burden these shareholders did not create. The larger the redemption, the larger the problem.
This tax policy creates a perverse incentive for investors to ditch their ’40 Act funds in exchange for ETFs, which take advantage of in-kind transactions to avoid taxation. However, this solution comes with an unintended consequence that may be detrimental to active management. In most cases, active managers rely on research acquired through trading relationships, which disappear when ETFs seek in-kind transactions to avoid capital gains taxation. Over time, this dynamic weakens the very active management infrastructure that supports merit-based capital allocation.
How do we level the playing field?
At its core, this is a taxation issue. Revisiting this framework would help restore parity across pooled investment vehicles.
The current framework reflects IRS interpretations requiring capital gains realized within RICs to be passed through to shareholders. A more equitable approach would eliminate the taxation of realized gains within the fund and only tax investors upon redemption of their fund shares.
In other words, allow mutual funds to sell securities for cash without triggering mandatory passed-through gains for RICs. Such reform would remove the structural headwind facing millions of taxable mutual fund holders and ease pressure on the primary vehicles through which active management is delivered to individual investors.
Importantly, it would also allow ETF managers greater flexibility to transact without relying exclusively on the in-kind mechanism to preserve tax efficiency. Managers would regain greater discretion over trading execution and commission flows — reinforcing the research ecosystem that supports merit-based capital allocation.
If public markets are to remain robust, capital must continue to be allocated by merit, not weighting. That requires active participation — and it requires tax policy that does not inadvertently undermine it. Few conversations today focus on how structural tax incentives are reshaping market behavior. They should.
If we care about resilient public markets, we must support active management and ensure the rules governing capital flows align with that goal.