Investors holding mutual funds in taxable accounts face a classic externality. The after-tax return of their investment depends on the behavior of others. In particular, redemptions may force the mutual fund to sell some of its equity positions in order to pay off the liquidating investors. As a result, it may be forced to distribute taxable capital gains to its shareholders. On the other hand, new investors convey a positive externality upon existing investors by diluting the unrealized capital gain position of the fund. This paper's simulations show that these externalities are important determinants of the after-tax performance of equity mutual funds.
Shareholderlevel taxes are taken into account in determining the perfor mance of growth and growth and income mutual funds over the 1963 1992 period. We rank a sample of funds on a before-and after-tax basis for investors in different income classes facing various investment hori zons. The differences between the relative rankings of funds on a before and after-tax basis are dramatic, especially for middleand high-income investors.For instance, one fund that ranks in the 19th percentile on a pretax basis ranks in the 63rd percentile for an upper-income, taxable investor. We also present an analysis of the extra taxes that shareholders bear because of the failure of mutual funds to manage their realized capital gains in such a way as to permit a substantial deferral of taxes.
This paper reconsiders the literature on tax options by examining the ability to defer net capital gains realizations within an equity portfolio whose constituents change over time. Unlike previous studies on the value of tax options, this paper examines after-tax returns to shareholders within an equity mutual fund. The mutual fund context allows certain features of the United States' tax laws-namely, wash-sale rules and the offsetting of short-term and long-term capital gains and losses-to be incorporated in assessing the potential improvement in post-tax returns to investors engaging in tax minimization strategies. Specifically, this paper examines the feasibility of managing open-end and closed-end Standard and Poor's 500 index funds which defer net capital gains realizations. A combination of HIIFO (highest in, first out) accounting procedures and the systematic booking of significant losses in portfolio constituents would have allowed the open-end fund variant to match the annual pre-tax return of Vanguard's Index 500 Fund while improving annual after-tax performance by as much as ninety-seven basis points through the elimination of all capital gains realizations between 1977 and 1991. Deferring capital gains is shown to be easier for open-end funds relative to closed-end funds while the additional turnover required to implement these strategies is quite modest. The authors name the tax-sensitive funds in this paper "SURGE (Strategies Using Realized Gains Elimination) funds."
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