“Invest in low-cost index funds, then leave it alone,” advised a political comic on HBO’s “Last Week Tonight.” The show’s host, John Oliver, praised the fiduciary rule for its mandates that would encourage investors to do just that.
Sen. Elizabeth Warren (D-MA), one of the leading progressive voices on financial policy, said that “the index fund is essentially the Honda Civic of the investment world.” She argues that passively-managed index funds, like the Honda Civic, are low-cost, safe, and reliable. She views these funds, which simply match an index such as the S&P 500, as a smart investment choice for the average American.
A legislative proposal that she and other Democrats are supporting, however, will throw sand in the gears of these “Honda Civic” index funds. The Democratic Party platform just approved at the party’s Philadelphia convention supports a financial transaction tax that targets Wall Street and high frequency traders. In reality, such a tax will almost certainly make it harder for Main Street investors to compete with Wall Street institutions.
The bill levies a .03% tax on all stock, bond, and derivatives trades. That figure may seem small, but such a tax will significantly impact the cost of index funds and their long-term return to investors.
Exchange-traded funds (ETF) and mutual funds, of which index funds are a subset, are taxed at many levels. Investors are taxed when they buy and redeem shares of the fund and then again when the fund uses that money to buy and sell securities. Furthermore, these funds trade very frequently and are subject to multiple layers of taxation. Over the lifetime of a retirement investor, the returns from an ETF would be significantly hindered by a financial transaction tax on top of these other taxes.
The tax would almost certainly reduce returns for individuals investing in low risk investment funds. Diversification, essential for minimizing risk, would be reduced for middle-class savers due to taxes paid to the government.
The tax also discourages portfolio turnover, which is when the manager changes which securities a fund holds. This is crucial to how these funds work. An index fund can’t hold every stock in an index, so it picks a small representative sample of that index. But in order for this sample to be truly representative of the market, it must frequently buy and sell stock as the market changes. By punishing these transactions, the tax will encourage the fund to change the sample stocks in the portfolio less frequently, ultimately making the investment more risky.
A representative of BlackRock, which provides index funds to individual and institutional investors, testified against a financial transaction tax in Europe. The company argued that the tax incentivizes investors to “undermine sound asset management principles such as diversification, proper hedging and efficient execution.”
Alain Dubois, chairman at ETF provider Lyxor Asset Management, warned that a financial transaction tax will have an “effect of tectonic proportions” on the ETF industry, which would hit index funds and other individual investment options.
While individual retirement accounts will face a very real burden from a financial transaction tax, many big Wall Street institutions will be able to escape by moving parts of their operations to other countries. Institutions which can transact abroad will continue to reap the benefits of diversification while Main Street suffers.
The purpose of all so-called sin taxes is to discourage consumption. Soda and cigarette taxes are enacted to nudge the public away from products politicians think are bad for them. But in this case, the “sin” that would be discouraged is middle-class saving. No one should endorse such a policy. Progressives need to realize that a financial transaction tax would place a much heavier burden on drivers of Honda Civics than it would on those folks being chauffeured in their Rolls-Royces.