Wall Street's Newest Tax Trick: How Wealthy Investors Are Dodging Capital Gains Through ETFs

The rich have found a new way to avoid the IRS. It's legal, and it's booming.

Stock markets are near record highs. That usually means investors owe Uncle Sam a lot of capital-gains tax. Wealthy Americans have found ways around that, and the trend is accelerating fast, according to reporting from the Wall Street Journal and Bloomberg.

The old standby is direct indexing: buying individual stocks that mimic an index, then selling losers to offset gains elsewhere. There's $1.1 trillion sitting in that strategy right now, according to research firm Cerulli Associates, cited by the Wall Street Journal's Miriam Gottfried and Peter Santilli.

Problem is, in a market that keeps grinding upward, direct indexing doesn't generate as many losses to harvest. So financial advisers built something more aggressive: leveraged, long-short tax strategies, sometimes called "tax-aware alpha." More than $150 billion has already flowed into these vehicles, according to Brent Sullivan, who tracks the industry on his newsletter Tax Alpha Insider.

These leveraged strategies aren't free. Direct-indexing fees run as low as 0.05% a year. The newer long-short products cost 1.5% to 3%, once you count management, financing and borrowing fees, per the Journal. And they carry real risk: the IRS wash-sale rule blocks investors from claiming a loss if they buy back the same stock within 30 days. Managers can also fail to properly track the index if they can't find suitable stock substitutes.

Neither strategy erases capital gains taxes. It defers them, and often just shifts the tax bill down the road. Investors still owe taxes eventually if they cash out winning positions.

The ETF version might be the bigger story

Separately, what's happening inside exchange-traded funds themselves is more significant, according to Bloomberg's Zachary Mider and Surya Mattu. ETFs have a structural tax advantage that mutual funds don't: they can swap out appreciated stock for other assets without triggering a taxable sale. Bloomberg estimates this mechanism now costs the Treasury about $48 billion a year, with the benefit flowing almost entirely to the highest earners.

The newest twist on that advantage is the "351 exchange" ETF. Named for the tax code section that allows it, a 351 exchange lets an investor hand over appreciated stock, a concentrated position, an old direct-indexing portfolio, whatever, in return for ETF shares, without paying capital gains tax at the moment of the swap, according to reporting from Emile Hallez at The Daily Upside.

Cambria Investment Management just launched its third such fund, the Cambria Global EW ETF (GEW), which pulled in $150 million before it even started trading last Thursday. Its earlier two 351 funds, Tax Aware ETF (TAX) and Endowment Style ETF (ENDW), raised $30 million and $100 million respectively before launch. Cambria founder Meb Faber told The Daily Upside he expects the next one to bring in "many multiples" of that, and predicts "the end of this year and Q1 of next year will be the dam breaking on assets."

There are now at least four of these 351 exchange ETFs on the market, according to Morningstar Direct data cited by The Daily Upside, though they require investment minimums to get seeded.

Not everyone thinks this is fine

Sen. Ron Wyden, an Oregon Democrat, introduced legislation aimed at shutting down these asset-transfer tax dodges, according to The Daily Upside. The bill, by that outlet's own account, faces "slim odds in Congress." No hearing date or vote has been reported.

Fordham University law professor Jeffrey Colon put it bluntly in a paper published this summer, writing that ETFs used as swap funds let an investor get an after-tax result "that could not be obtained had the investor carried out the investment strategy directly." He calls this "an inappropriate tax arbitrage."

That's a fair objection. If a strategy only works because it's wrapped in an ETF, and produces a tax outcome unavailable to someone doing the exact same trade directly, that's a real distortion in the tax code, not just clever planning. Congress wrote the tax-deferral mechanism into ETF structure decades ago for a different purpose, mainly to keep fund prices tracking their underlying assets, not to let millionaires dodge $48 billion a year.

The other side of that argument: none of this is illegal. Every strategy described here—direct indexing, long-short SMAs, 351 exchanges—operates within the tax code as written. Fund managers aren't hiding anything. Cerulli, Morningstar, and the funds themselves disclose the mechanics. If regulators or Congress think the loophole is too generous, the fix is legislative, not enforcement action against anyone currently using it.

No agency has announced an investigation into any of these products. No charges have been filed. This is a policy gap, not a fraud story.

What happens next depends on Washington. Wyden's bill sits without momentum. Meanwhile Faber and Cambria are betting the floodgates open wider by early 2027, and more asset managers are expected to file for their own 351 exchange ETFs before then.