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Tax Externalities of Equity Mutual Funds

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National Tax JournalVol. LIII, No. 3, Part 2


Joel M. DicksonThe Vanguard Group,Inc.

John B. ShovenStanford University,Department ofEconomics, Stanford,CA 94305 and NBER,Cambridge, MA 02138

Clemens SialmStanford University,Department ofEconomics, Stanford,CA 94305

Abstract - Investors holding mutual funds in taxable accountsface a classic externality. The after-tax return of their investmentdepends on the behavior of others. In particular, redemptions mayforce the mutual fund to sell some of its equity positions in order topay off the liquidating investors. As a result, it may be forced todistribute taxable capital gains to its shareholders. On the otherhand, new investors convey a positive externality upon existinginvestors by diluting the unrealized capital gain position of thefund. This paper’s simulations show that these externalities are im-portant determinants of the after-tax performance of equity mu-tual funds.

INTRODUCTION

Mutual funds have played an increasingly important rolein meeting the financial goals of U.S. investors over

the last several decades. As shown in Table 1, the growth ofequity mutual fund assets has been remarkable. Accordingto the Investment Company Institute (ICI)—the mutual fundtrade association—total assets of equity mutual funds haveincreased from $40 billion at year–end 1980 to $2,503 billionat year–end 1998,1 representing a compound annual growthrate of 25.8 percent over the period. Overall, the mutual fundindustry has benefited from a broader shift away from house-holds investing directly in equities to indirect ownership ofequities. This trend is documented in detail by Poterba andSamwick (1995).

The mutual fund industry benefited greatly from the intro-duction and growth of new retirement accumulation vehicles(e.g., 401(k) plans, Individual Retirement Accounts). However,a majority of mutual fund assets are still held outside tax-qualified vehicles. A lot of attention has recently been devotedto the tax efficiency of mutual fund investments. Dickson andShoven (1994, 1995) argue that mutual funds have not gener-ally considered the tax implication of their trading activityand suggest ways in which portfolio managers could improveafter–tax returns for their shareholders. More recently,Bergstresser and Poterba (1999) consider how different port-folio characteristics affect after–tax returns and mutual fundcash flows. The topic of mutual fund tax efficiency has also

1 The figures exclude equities held in variable annuities, which would addabout $475 billion to the total as of year–end 1998.

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TABLE 1EQUITY MUTUAL FUND ASSETS

Year

Source: ICI calculations

Equity Mutual Fund Assets ($ billions)

Total($)Held Outside Employer

Plans, IRAs ($)% Outside Employer

Plans and IRAs

19801985199019951998

40.0113.5228.3

1,080.72,503.3

33.977.3

131.0575.0

1,339.5

84.868.157.453.253.5

received attention from legislators, as evi-denced by the introduction of H.R. 1089(“The Mutual Fund Tax Awareness Act of1999”), which would direct the Securitiesand Exchange Commission to improvedisclosure of after–tax returns for mutualfunds.

While a lot of research has focused onthe persistence of mutual fund perfor-mance (see, for example Carhart (1997)),there has been somewhat less discussionabout the mutual fund structure as an in-vestment vehicle. This paper considershow the tax situation of investors is af-fected by the mutual fund structurethrough the actions of other shareholders.We also discuss choices made by the mu-tual fund managers that can affect—posi-tively or negatively—the after–tax returnsrealized by their shareholders. The differ-ence between the after–tax performanceof mutual funds and directly held invest-ments centers mainly on how mutual fundcash flows can impact returns over time.

Although mutual funds were estab-lished as pass–through vehicles, there aretax differences between funds and indi-vidually managed accounts. In particular,there are three significant differences thatcould impact the relative attractiveness of

a mutual fund investment. First, Subchap-ter M of the Internal Revenue Code—originally enacted in 1936 to provide forthe tax treatment of pass–through entities,including mutual funds—does not in-clude a provision to pass–through thecharacter of short–term capital gains fortax purposes.2 Thus, while mutual fundsreport short–term capital gain distribu-tions to their shareholders, these distribu-tions are treated as ordinary income divi-dends and not as short–term capitalgains.3 This difference matters only if ataxpayer has realized losses that wouldnot otherwise be offset by gains. In otherwords, the tax liability of a mutual fundshareholder could be greater if short–termlosses were offset by long–term gains thatcould otherwise have been offset by short–term gains from the mutual fund. Second,mutual funds can not distribute net real-ized losses. Instead, funds can use losscarry–forwards for up to eight years fol-lowing the year of the loss. The net effectof this treatment is to accelerate the taxliability of mutual fund shareholders ver-sus individually managed accounts,where net losses can be declared in theyear they occur and used to offset othergains or up to $3,000 of taxable income.4

2 Legislation permitting the pass through treatment of long–term capital gains through a mutual fund wasenacted in 1942. The legislative history provides no indication as to why short–term gains also were notprovided with this pass through treatment. This omission appears to have been more of an oversight than aconscious effort to treat short–term gains differently for mutual funds.

3 Although short-term gains are combined with ordinary dividends for tax purposes, short–term gains do notqualify for the dividends–received deduction available to corporate investors.

4 This argument assumes that capital gain tax rates remain constant. If capital gains taxes were to increasesignificantly, this relationship could reverse because losses could be used to offset a higher potential futuretax liability.


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These two negatives are offset by a sig-nificant benefit for mutual fund share-holders: the pass–through of the fund’sexpenses. Mutual funds distribute net in-vestment income to shareholders, whichis income received by the fund lesscharged expenses. Take, for example, amutual fund whose underlying portfolioof securities generates a 2 percent grossdividend yield. If the fund’s expense ra-tio—e.g., investment advisory, custody,distribution, shareholder servicing ex-penses—is 1 percent, then the net incomedistribution to shareholders would be 1percent. If the expense ratio were 0.5 per-cent, then the dividend would be 1.5 per-cent. Effectively, fund expenses are fullydeductible for all taxpayers because theylower the taxable income received byshareholders. Generally, investment feesassessed in a non–registered investmentvehicle (e.g., individually managed andtrust accounts) are itemized deductionsthat can be used only to the extent theyexceed 2 percent of adjusted gross income.

Mutual fund shareholders are taxedthrough two different mechanisms. Eachyear, a fund passes–through its incomeand capital gains realizations in the formof distributions made to the fund’s share-holders. These distributions result fromthe actions of the portfolio manager andaffect all shareholders in the fund becauseeach shareholder receives their pro–ratashare of the distribution (as of thedistribution’s record date). Although theportfolio manager’s trading activity leadsto the fund’s distributions, the tradingactivity could have been initiated by the

portfolio manager or imposed on the port-folio manager as a result of shareholderactivity (net cash flow). It is this latter casethat distinguishes the mutual fund orother commingled vehicles from “sepa-rate” accounts.5 As such, a mutual fundinvestment is subject to a classic external-ity because the actions of other existingand potential investors can affect the tax-able distributions to all shareholders.

This paper explores the positive andnegative externalities resulting from mu-tual fund cash flows and how these exter-nalities can be affected by the manage-ment and accounting practices of the fund.Mutual fund redemptions are generallyviewed as a negative relative to an indi-vidually managed account because re-demptions can force capital gains to berealized and distributed to shareholders,accelerating their tax liability. Anotherargument is that negative cash flows canmake otherwise tax–efficient funds un-stable (Warther 1996). An implicit assump-tion in these arguments is that mutualfunds use average cost accounting.6 Infact, mutual funds have significant flex-ibility in choosing how they account forsecurity sales, and we will show how thechoice of accounting technique can eitherexacerbate or reduce the magnitude of themutual fund tax externality.

We also consider the other side of thecash flow argument; positive cash flowsbenefit mutual fund shareholders versusan investment vehicle with no ongoingcash flow (i.e., a separate account).7 Thepositive externality associated with mu-tual fund cash flows has not been gener-

5 This paper will use the terms “separate account” or “individually managed account” interchangeably to referto a portfolio of securities managed for one investor. These accounts are not subject to the tax rules of Sub-chapter M of the Internal Revenue Code and are exempt from registration under the Investment CompanyAct of 1940.

6 Although mutual funds cannot explicitly use the “average cost” basis methods that are available to mutualfund shareholders in determining realized gain or loss, a fund could mimic average cost accounting by iden-tifying upon sale those tax lots closest to the security’s average cost.

7 Our discussion and simulations consider a separate account to have an initial investment but no ongoing cashflow (except dividends from the underlying investments). This is, of course, quite stylized because separateaccounts will generally have some cash flow—positive or negative—over the investment horizon. However,we do not consider these situations because it does not represent an externality as in the mutual fund context.


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ally discussed and can represent a signifi-cant benefit to investors in mutual funds.Such cash flow dilutes the unrealized capi-tal gains position of the fund and gener-ally makes tax–sensitive accounting tech-niques more powerful in reducing theoverall tax burden of the investment. Wewill also show that these benefits can in-crease over time relative to a portfoliowithout cash flows.

In addition to the tax imposed on mu-tual fund distributions, mutual fundshareholders also may face an additionaltax liability upon the sale of such assetsto the extent the market value upon saleis greater or less than their accumulatedcost basis (which is the sum of the valueof all purchases, including reinvested dis-tributions). Obviously, these two forms ofshareholder taxation are not mutually ex-clusive and represent a difference in thetiming of tax payments. Postponing therealization of capital gains decreases thepresent value of the tax liability and al-lows individuals to take advantage of thelower long–run capital gains tax rates.Timing differences (i.e., the deferral oracceleration of tax liabilities) resultingfrom different mutual fund characteristicsare an important focus of our analysis.

The rest of the paper is organizedaround investigating the externalities as-sociated with mutual fund investments.The next section briefly describes the posi-tive and negative externalities associatedwith mutual fund management and howmanagement practices can affect these re-lationships. The third section is the bulkof the paper and presents a simulationmethodology that allows us to investigatethe magnitude of the externalities. Thissection looks at how certain tax–manage-ment techniques can affect after–tax re-turns in both a separate account and a

mutual fund environment. In addition, weconsider the effects of accounting tech-niques and “closing” funds on the after–tax returns for shareholders. The final sec-tion presents a brief conclusion and issuesfor policymakers to consider in helpinginvestors understand alternative invest-ment vehicles.

MUTUAL FUND TAX EXTERNALITY

The differences between mutual fundsand separately managed accounts and theeffect of tax externalities can be illustratedwith a simple example. Assume that amutual fund currently has three taxableshareholders whose initial purchases werecompleted at different times and wereused to buy the same equity security (XYZCompany).8 There are no other transac-tions in the fund. Table 2 gives the invest-ment position of the fund and each of itsshareholders.

Now assume that investor A redeemsher entire investment in the next period,with XYZ stock trading at $140 per share.If another shareholder invests at the sametime, then investor A can be paid with thecash received from the new shareholderswithout requiring any securities transac-tions at the fund level. However, if theredemption is the only shareholder trans-action, then the fund must sell some of itsholdings to raise the cash to pay the re-deeming shareholder. However, the gainor loss realized (and then distributed tothe remaining shareholders) would de-pend on the accounting treatment used.For example, selling the XYZ shares pur-chased with investor A’s initial invest-ment—which would also correspond tofirst-in first-out (FIFO) accounting—would result in a $40 gain that must bedistributed to the remaining sharehold-

8 Technically, a mutual fund that owned just one security would fail certain diversification tests that must bemet in order to qualify as a mutual fund. The example given is obviously for illustration only.


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ers.9 However, the existence of othershareholders has presented a way to miti-gate this potential externality. In particu-lar, if the fund sells the shares purchasedat $150 that resulted from investor C’s in-vestment, then the fund would realize a$10 loss that would result in no currenttaxable capital gain distribution to the re-maining shareholders and could be usedto offset future capital gain realizations.It is important to stress that these differ-ences affect the timing of the remainingshareholders’ tax liabilities as opposed tothe elimination of any tax liability. Wheninvestors B and C ultimately sell theirshares, they will owe taxes based on thecapital gains realized upon redemption.10

No matter which tax treatment is used bythe fund, investor A still pays tax basedon the difference between the marketvalue of the redemption ($140) and hercost basis ($100).

Construction of Mutual Funds

More generally, consider a portfolio of(equity) securities. Its market value (MV)and cost basis (CB) can be represented bythe following relationships:

MVt = pitSit = pit sij

[2] CBt = pifsij

where pij is the price of security i at time j,and Sit is the total number of shares of se-curity i held at time t. Sit equals the sumof the holdings of the shares sij, whichwere initially purchased at time j. (Note:the relationships are a portfolio snapshotat time t. Net security positions, sij, maydiffer at times t and t + 1 to the extent thereare sales or purchases of the fund’s secu-rities.) Also, the difference between theportfolio’s value and its cost basis—or thenet unrealized gain (UG)—is:

The net unrealized gain of the portfoliois a combination of positions at a loss andthose at a gain (both across securities andwithin an individual security’s tax lots).It is important to recognize that theamount of gain or loss recognized from a

TABLE 2ILLUSTRATION OF TAX-EXTERNALITY

Time Shareholder Action Fund Action Total Fund Position

1

2

3

Investor A purchases $100of fund shares

Fund buys $100 of XYZstock at $100/share

1 share of XYZ stock;Market value = $100;Cost basis = $100

Investor B purchases $125of fund shares


2 shares of XYZ stock;Market value = $250;Cost basis = $225

Investor C purchases $150of fund shares


3 shares of XYZ stock;Market value = $450;Cost basis = $375

9 The distribution of the realized gains (to the extent they are not reinvested in additional fund shares) wouldalso be a negative cash flow event that could force further realizations. This is described in more detail inDickson (1994) and Warther (1996).

10 Any deferred tax liability could be eliminated to the extent such shares pass through an estate (i.e., stepped–up basis) or used for certain charitable contributions.

Σ Σ[1] Σn n t

i=1i=1 j=1

ΣΣn t

i=1 j=1

[3] UGt = (pit – pij)sijΣΣn t

i=1 j=1


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partial sale of the portfolio’s assets can-not be determined without further as-sumptions. Instead, the UGt relationshiprepresents the net amount of gain or lossrecognized if the portfolio were to be com-pletely liquidated at time t.

Equation [3] demonstrates that the dis-persion in unrealized gain liabilities and,hence, in capital gain realizations, is animportant determinate in the ability tocontrol the capital gain realizationsthrough accounting procedures. In par-ticular, the larger the standard deviationof (pit – pij) conditional on sij > 0, the moreability the manager has to minimize ormaximize tax realizations. In this context,a separate account with minimal cashflow will have very little ability to con-trol gain realizations. On the other hand,a mutual fund with positive cash flowover time and that tends to buy smallamounts of each security at differentpoints in time will tend to have muchmore flexibility.

The fund has four sources of cash flows.First, the stocks held in the mutual fundpay dividends dt at time t. Second, thefund pays expenses of xt to its fund man-agers. Third, the fund is required to dis-tribute annually the received dividendsnet of expenses and the realized capitalgains to its shareholders, if they are posi-tive. Realized capital losses are carriedforward and subtracted from future real-ized capital gains. The total fund distri-butions are denoted by fdt. The investorsin the fund must pay taxes on those dis-tributions. Dividends and short–termcapital gains (i.e., gains of assets held forone year or less) are taxed at the marginalincome tax rate on ordinary income andlong–term capital gains (i.e., gains of as-sets held for more than one year) are taxedat the lower capital gains tax rate. Fourth,investors buy or redeem shares of themutual fund. Those exogenous cash flowsare denoted by ct. Additional flows resultfrom the re–investments of distributions

by the fund’s shareholders. The propor-tion α of the dividend distributions andthe proportion β of the capital gains dis-tributions are automatically re–invested.Total cash flows must be absorbed by netasset sales. The total cash flows at time tare given by:

[4] cft = dt – xt – ( fdtD + fdt

SCG + fdtLCG)

+ (ct + αfdtD + β( fdt

SCG + fdtLCG))

The rest of the paper investigates howportfolio management decisions, account-ing procedures, and shareholder cash flowcan affect the recognition of capital gainsor losses in the fund.

No Cash Flows

A separate account of directly held se-curities may have little or no ongoingcash flows after the initial investment inthe portfolio. Although dividends—tothe extent they are reinvested—may pro-vide some positive cash flow, the new po-sitions resulting from reinvested divi-dends would likely be relatively smallcompared with the initial investments.These portfolios would not be subject tothe tax externality described in the intro-duction because the account owners de-cide when to sell the assets, and the as-sociated tax liability does not depend onthe activity of any other shareholders(though discretionary portfolio manage-ment decisions could impact the accountowners).

There is a tradeoff for control over theportfolio’s tax liability, however. With nonew cash flows, the portfolio’s net unre-alized gain will increase if security pricesrise over time. This has the potential toaccelerate the tax liability for a share-holder in certain cases. For example, ifpositions are sold to maintain theportfolio’s security weightings over time(e.g., to maintain diversification of the


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portfolio’s assets), then gains may be re-alized instead of being able to direct cashflow to rebalance the portfolio. Also, if aforced realization of capital gains occurs(e.g., merger and acquisition activityamong the portfolio’s holdings), the port-folio may have a higher ratio of marketvalue to cost basis than a mutual fund thathas had positive cash flows.

Net Cash Flows

A mutual fund or other commingledinvestment vehicle is subject to the cashflow patterns of both existing and newshareholders. Cash flows affect securitytransaction activity within the fund. Assuch, actions of other shareholders cancause positive or negative effects for allother shareholders.

First, consider the case of positive cashflow. Assuming the fund is in a net unre-alized gain position, the existence of posi-tive cash flow dilutes the overall capitalgain position of the fund because themarket value and cost basis of any newinvestment are equal, whereas theportfolio’s market value exceeds its basis.An equivalent way of stating this relation-ship is that the new securities come in, inaggregate, at a cost higher than the aver-age cost basis of the portfolio. This dilu-tion is positive for the existing sharehold-ers from a number of perspectives. First,it spreads any capital gain realizationsacross a larger shareholder base (i.e., theper–share value of any distribution is re-duced). Second, it provides a means to off-set negative cash flows that might other-wise require a liquidation of some equitypositions. Finally, and most importantly,the addition of new cost lots at differentprices through security purchases in-creases the power of the fund’s account-ing techniques to mitigate any future re-demption activity by allowing for greaterchoice among tax lots. Overall, cash flowscan represent a positive externality.

What about negative net cash flows?Unambiguously, if securities are sold attheir average cost, then the portfolio willrealize capital gains to the extent theportfolio’s basis is less than its marketvalue. However, the portfolio does nothave to realize gains or losses at their av-erage costs. The decisions of the fund’sadviser—specifically, the accounting tech-nique chosen—can mitigate the potentialtax externality. That said, continuous re-demptions can cause an accelerated taxliability over time even in a tax–efficientportfolio if share prices generally rise andthe fund’s accounting techniques elimi-nate much of the gross unrealized loss inthe portfolio.

A number of studies have investigatedthe relationships affecting net cash flows(Barclay, Pearson, and Weisbach, 1998;Sirri and Tufano, 1998; Bergstresser andPoterba, 1999). However, many of theserelationships have been performancebased, which can often be fleeting. Onthe other hand, to the extent cash flowsare positively correlated with equitymarket movements, it could imply thatthe tax–efficient accounting techniquesdescribed below are even more power-ful because the portfolio would be buy-ing when prices are rising and sellingwhen prices are falling (and possibly re-alizing losses).

The academic studies suggest that un-realized capital gains may be a factor infuture net cash flow patterns and thatmanagers might consciously control the“tax overhang” in order to remain attrac-tive for future shareholders (Barclay,Pearson, and Weisbach, 1998). However,a tax efficient investor would probablyprefer a buy–and–hold portfolio with alower level of net cash flows than one inwhich that tax liability was accelerated inorder to supposedly attract a high levelof new cash. In other words, such a strat-egy significantly reduces the benefit of apositive cash flow. Another approach


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would be to advertise the fund, if this weresuccessful in generating new cash flowover time. Most directly, the cash flow re-lationship can be affected by a decision tolimit new cash to the fund—e.g., closingthe fund to new investors. Closing a fundis often done for investment reasons inorder to maintain the fund’s character andinvestment process. However, there is apotentially significant negative to such anapproach: it makes negative cash flowsand their associated externalities morelikely. We investigate closing a fund in oursimulations in the following section.

Accounting Techniques

Mutual funds are subject to the samerules as other owners of equity securitieswhen accounting for security sales;namely, specific identification of the taxlots sold.11 Currently, mutual funds arenot required to disclose how they accountfor security sales in any prospectus orshareholder report. As demonstrated inthe next section, this information could beuseful to shareholders because differentaccounting techniques can have a mate-rial impact on the after–tax performanceof mutual fund investments.

It is also interesting to note that tax–efficient accounting techniques benefit allcurrent fund investors. That is, account-ing for security sales in different waysdoes not affect the fund’s pre-tax return—the objective of a fund’s tax–deferredshareholders—but can improve thefund’s after–tax return—the objective ofthose shareholders holding the fund out-side of a tax–qualified vehicle. Within thiscontext, certain regulatory practices couldaffect the ability to use accounting tech-

niques to affect the after–tax return forshareholders. In particular, a proposal inPresident Clinton’s fiscal year 1998 bud-get proposal would have required all se-curity sales to use average cost account-ing. Although this proposal was notincluded in the final budget for that year,the simulations in the next section sug-gest that such a move could accelerate thetax liability for shareholders in funds thatcurrently use more tax-friendly account-ing.

Although a survey of accounting tech-niques among mutual funds is not avail-able, we will consider a range of potentialaccounting techniques: first–in first–out(FIFO), last–in first–out (LIFO), averagecost, and tax-sensitive accounting. Aver-age cost identifies for sale the security po-sition that is closest to the average cost ofthe overall position in the security, orequivalently sells a fixed fraction of all thelots purchased at different points in time.FIFO is simply identifying for sale the old-est lot for each position. It is usually a tax–inefficient strategy to the extent securityprices rise over time. LIFO is selling themost recently purchased lot of each posi-tion. The last technique we consider istax–sensitive accounting, which is often re-ferred to as highest–in, first–out (HIFO) ac-counting. HIFO accounting identifies thehighest cost lot in each security for sale.12

These techniques and their ability to af-fect relative after–tax performance are in-vestigated in the next section.

The ability to use accounting tech-niques to affect after–tax performancedepends on the management and struc-ture of the investment vehicle. In particu-lar, accounting techniques are more pow-erful when there is a greater dispersion

11 As mentioned in footnote 6, mutual fund shareholders—but not mutual funds themselves—are allowed touse “average cost basis” methods, which are not forms of specific identification. For both mutual funds andtheir shareholders, FIFO is the default method for determining gain or loss.

12 Tax–efficient accounting is more general than HIFO accounting. For example, it might be preferable to realizea larger dollar amount of long–term gains than a smaller amount of short–term gains because of their differ-ences in marginal tax rates. Also, a fund with capital loss carry–forwards that will soon expire might want toswitch accounting techniques to realize a lot of gain.


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of cost lots for each security. Accountingprocedures can mitigate the potentialnegative effects of redeeming investors onthe other shareholders. On the otherhand, a separate account with a large ini-tial investment relative to its overall port-folio does not have as much ability to le-verage accounting techniques because thefund’s holdings would be much moreconcentrated at specific points in time(i.e., HIFO, LIFO, FIFO, and average costare close to equivalent because there isminimal dispersion of cost lots). Similarly,active management techniques—wheresecurities may be bought or sold in shorttime frames—may be less able to use ac-counting techniques than passively man-aged vehicles—where small slices ofmany securities tend to be transacted.However, for those portfolios with moreconcentrated buying and selling, the abil-ity to effect trading strategies (e.g., har-vesting losses) can have a relativelygreater impact on after–tax returns. Weinvestigate these inter–dependent rela-tionships in the next section.

SIMULATIONS OF MUTUAL FUNDS

In order to look at how tax–manage-ment policies can affect after–tax returnsand the importance of externalities be-tween shareholders, we constructed asimulator to isolate different factors thatcan affect after–tax returns, some of which(like the choice of accounting technique)are under the control of investment man-

agers. These simulations attempt to quan-tify the magnitude of the effects discussedin the previous sections and how choicesby mutual fund managers can mitigate orexacerbate the externalities betweenshareholders.

We report results for simulated portfo-lios that invest in the fifty largest compa-nies (in terms of market capitalization) in1983 and track the returns of these port-folios over the next 15 years.13 We calcu-late returns using the actual monthly re-turns of the component stocks minus anexpense charge of five basis points permonth. We assume that 90 percent of thefund distributions of dividends and capi-tal–gains are automatically reinvested inthe mutual fund.14 The after–tax returnsare computed for an investor facing a 39.6percent marginal income tax rate on divi-dends and realized short–term capitalgain distributions and a 20.0 percent mar-ginal tax rate on realized long–term capi-tal gain distributions. These are the cur-rent rates for someone in the top federalincome tax bracket. We apply these ratesto the entire 1984–98 period.15 Further, weignore state and local income taxes. A de-tailed description of the data set is con-tained in the Appendix. First, we evalu-ate four different accounting policies: (1)always using the average cost basis for de-termining capital gains and losses, (2) us-ing FIFO (using the cost basis of the old-est lots of a particular stock), (3) usingLIFO (using the cost of the most recentlyacquired lots),16 and (4) using HIFO (us-

13 We used the CRSP data set to determine the identity of these 50 companies and to track their monthly returnsand distributions from 1984 through 1998. If a company was merged into another company, we followed thestock of the acquirer. If a company was bought out for cash, we replaced it with the largest market capitaliza-tion company (in December 1983) that was not already in the data set.

14 The expense ratio and reinvestment percentage assumptions are made to approximately real–life portfolios;however, the results reported in this section are not sensitive to these assumptions.

15 We computed as well the returns with actual tax–rates over the period between 1984 and 1998 for high– andmedium–income individuals. We did not summarize the results with actual tax rates because they are verysimilar to the results reported in this section.

16 We present the results for LIFO in just the first simulations. Generally, the results are similar—but slightly lesstax efficient—to the HIFO case in the generally rising equity market over the simulation period. Also, LIFO isnot a widely used method among mutual funds because of the significant wash–sale restrictions that areencountered in a daily cash flow environment.


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ing the cost of the most expensive lots).The cost basis of the remaining shares ofa particular security also depends on thechoice of accounting technique. If HIFOis used, for instance, the cost basis ofthe remaining shares will be lower (i.e.,the unrealized capital gain position ofthe fund will be greater) than if one ofthe other techniques is chosen. By choos-ing accounting technique, the fund deter-mines the timing of taxes of its sharehold-ers.

Second, we evaluate portfolios that fol-low active and passive investment strat-egies. In our simulations, passively man-aged funds track either an equally– or avalue–weighted index of the 50 compa-nies in our dataset. Our actively managedfunds are assumed to hold 30 of the 50 se-curities at all points in time. The 30 stocksare held in value–weighted proportions.Each month, the actively managed fundscompletely divest themselves of two oftheir 30 positions and bring in two ran-domly selected companies from the 20that have been outside the fund.17 Theportfolio is rebalanced so that the newholdings are proportional to the marketcapitalizations of the members. The factthat the new entrants are randomly cho-sen probably reflects our bias towards theefficient market hypothesis.

We examine three alternative rules forchoosing which two securities to kick outof the mutual fund each month. One ruleis to drop the two firms that have the larg-est gains relative to their cost bases. A sec-ond rule is exactly the opposite—to sellthe two firms that have the lowest pricerelative to cost basis. This is a relativelytax efficient strategy, although it is not thetax minimizing strategy which wouldkeep track of the difference between shortand long–term gains and losses and whichwould make the number of stocks liqui-dated dependent on the cost basis. Thethird rule chooses the two stocks to be

deleted each month randomly. Under thisregime, the actively managed funds aretrue noise traders, exchanging randomlychosen positions for equally randomlychosen replacements.

It is important to note that the threedifferent security selection processes ofour active fund simulations will resultin different portfolios and, hence, differ-ent pre–tax returns. A portfolio that sellstwo stocks with the greatest appreciationwill obviously sell different stocks in agiven month than an otherwise similarportfolio that sells the two stocks withthe least amount of appreciation. Hence,the constituents and portfolio weights ofthe portfolios will differ over time. Thisis different from our index–fund simu-lations, where the differences among theportfolios—accounting technique andcash–flow patterns—do not affect pre–tax returns among the simulated portfo-lios.

Third, we also consider the impact ofnet mutual fund sales on the after tax re-turns that the fund offers its long–termshareholders. The first net sales regimeapplies to a fund that has a trend of netsales equal to one percent of assets permonth. The second regime, roughly cor-responding to a fund that is closed to newpurchases (or at least to some classes ofpotential buyers), is for a fund with a trendrate of net sales of minus one percent ofassets per month. That is, on average itexperiences net redemptions.

PASSIVE MANAGEMENT

Equally–Weighted Fund

The results in Table 3 detail the simula-tion of an equally–weighted index fundthat holds all 50 stocks. That is, 2 percentof the fund’s assets are invested in eachof the 50 securities. The maintenance ofthe 2 percent weights implies a monthly

17 This corresponds to an annual turnover rate of approximately 80 percent.


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rebalancing of the portfolio—sellingstocks whose relative price has risen andbuying additional shares in those whoserelative price has fallen. Table 3 displaysthe before– and after–tax average monthlyreturns for the entire period 1984–98 foran equally–weighted index fund experi-encing deterministic net sales. It is impor-tant to note that the after–tax returns inTable 3 represent buy–and–hold returnsthat tend to overstate the actual differ-ences for investors that will ultimately selltheir holdings because of the timing dif-ferences of gains realizations among thedifferent simulations considered. Weshow results for investors who liquidatetheir investment at the end of the horizonlater in the discussion.

Panel A simply reminds us that the be-fore–tax return is exactly the same for thedifferent accounting techniques and dif-ferent patterns of net sales of the fund be-cause portfolio constituents and theirweights are unaffected by the choice ofaccounting technique or cash flow. Thismeans that an investor holding the fundin a tax–qualified pension account (suchas an IRA or 401(k) account) would be in-different to the arguments of this sub–sec-tion.

On the other hand, Panel B confirms ourintuition and previous discussion.Namely, that accounting techniques andnet cash flow can have important affects

on after–tax returns. In other words, a tax-able investor who was in one of thesefunds for the entire period 1984–98 wouldcare a lot about which cell in the panel hisfund has chosen for him. Our separateaccount simulation where there is no on-going cash flow (other than dividends re-ceived and the assumed ten percent ofdividend and capital gains distributionsthat are not reinvested) shows a differenceof 7.72 basis points per month in after–tax returns between a fund that uses HIFOaccounting and one that uses FIFO. Per-haps more realistically, the difference be-tween HIFO and average cost accountingis 6.09 basis points per month or 73 basispoints per year. Over long holding peri-ods, such as ten or fifteen years, an an-nual 73 basis points differential can bevery significant.

The externality effects of cash flows aredemonstrated in the relative returns of agrowing fund versus a shrinking fund.The individual buy–and–hold investor inthe fund with 1 percent net sales permonth experiences a much higher after–tax return—10.09 basis points per monthwhen the funds use HIFO accounting—than the investor in the shrinking fund.This is a difference of slightly more than121 basis points per year—an enormousamount considering that the two fundshold exactly the same securities with thesame weights and use the same account-

TABLE 3AVERAGE MONTHLY RETURNS FOR PASSIVELY MANAGED FUNDS WITH EQUAL WEIGHTS

AND DETERMINISTIC SALES, 1984–98

A. Average Before–Tax Monthly Returns

Net Sales/Assets Average Cost FIFO LIFO HIFO

–1% 1.5000 1.5000 1.5000 1.5000 0 1.5000 1.5000 1.5000 1.5000 +1% 1.5000 1.5000 1.5000 1.5000

B. Average After–Tax Monthly Returns

Net Sales/Assets Average Cost FIFO LIFO HIFO

–1% 1.2347 1.2220 1.2630 1.2821 0 1.2894 1.2731 1.3183 1.3503 +1% 1.3296 1.3137 1.3475 1.3830


618

ing techniques. This difference is due tothe externality between existing share-holders and new shareholders that wediscussed in the previous section of thepaper. The fund with a steady supply ofnew shareholders is continuously buyingnew lots of the 50 securities and can ac-complish the monthly rebalancing (to re-tain the two-percent weights) with far lesstax consequence than the fund experienc-ing steady net redemptions. The interac-tion between these effects shows evengreater dispersions in after–tax returns.For example, the difference between own-ing a tax–sensitive HIFO index fund ex-periencing net new sales every month andan average–cost basis index fund experi-encing net redemptions is 14.83 basispoints per month or more than 1.78 per-cent per year.

Table 4 looks at whether the magnitudeof these externalities may change as theportfolios age. Our simulated passivelymanaged funds begin in 1984 with newlyacquired positions in all 50 stocks. Initially,there is not much advantage to one ac-counting technique over the other becauseall of the original lots carry the same costbasis. The advantage of HIFO and LIFOover FIFO and average cost accountinggrows as the number of lots of purchasesto choose amongst for partial liquidationsgrows. To examine this effect, we calcu-late the different accounting choices andnet sales makes for the years 1994–8 forour funds begun in 1984. The averagemonthly before–tax return for the sampleof 50 equally weighted stocks was 1.7981percent for the 1994–8 period. This is cer-tainly a much better than average periodof time for large capitalization stocks such

as those in our sample. The average af-ter–tax returns for 1994–8 are shown inTable 4.

The gain from the relatively tax efficientHIFO policy is larger than before. For ex-ample, with zero exogenous net sales, thedifference between HIFO and FIFO is10.19 basis points per month and the dif-ference between HIFO and average costaccounting is 7.37 basis points per month.The difference between the after–tax per-formance of growing and shrinking fundsis also wider for the five years 1994–8 thanit is for the entire time period 1984–98.Now, comparing the HIFO results for onepercent net sales with the HIFO resultswith minus one percent net sales, thegrowing fund offers its high–tax share-holders a 13.17 basis points a month ad-vantage. This is more than 30 percentgreater than the difference over the entire15 year period, a difference that we al-ready thought was enormous. For the fiveyears 1994–8, the difference in after–taxreturn for a HIFO index fund experienc-ing one percent per month net sales andan average cost index fund experiencingone percent net redemptions is 18.00 ba-sis points per month or 2.16 percent peryear.

These results—and the results of theother simulations reported below—mustbe tempered somewhat by the fact that eq-uity returns were very strong over theperiod of our simulations. In a generallyrising equity market, accounting differ-ences have the potential to add more valueon an after–tax basis because HIFO ac-counting would tend to realize a smallgain or loss on a relatively recent securitypurchase (to the extent cash flow allowed

TABLE 4AVERAGE AFTER–TAX MONTHLY RETURNS FOR PASSIVELY MANAGED FUNDS

WITH EQUAL WEIGHTS AND DETERMINISTIC SALES, 1994–8

Net Sales/Assets Average Cost FIFO HIFO

–1% 1.5158 1.4949 1.5641 0 1.5846 1.5564 1.6583 +1% 1.6335 1.6052 1.6958


619

for security purchases). FIFO accounting,on the other hand, would realize old se-curities at a much larger gain (on average).In a declining equity market, accountingand net cash flow differences would likelyhave a somewhat smaller effect becausethere would be more losses to realizethroughout the portfolio, resulting in agenerally lower tax liability.

Value–Weighted Fund

The assumption that the passive fundshold their positions with equal weightscauses them to realize gains and losses inthe process of monthly rebalancing. If thefund held positions with value or marketcapitalization weights, rebalancing wouldbe greatly reduced. With value weights,rebalancing is necessary only if the com-panies in the index issue or repurchaseshares or if the composition of the largest50 companies changes due to mergers andacquisitions. Besides, it could be arguedthat market capitalization weights aremore consistent with the indexing phi-losophy. We have examined the effect ofthe same accounting and net sales as-sumptions for the case with value weights.The results are shown in Table 5. For therecord, the average monthly before–tax

return on value–weighted portfolios is1.4972 percent for 1984–98 and 2.0275 per-cent for 1994–98.

The results confirm our intuition: theaccounting technique is much less impor-tant with value weights because much lessrebalancing is necessary.18 The choice ofaccounting technique is most importantwhen a portion of a position is being sold.Here that happens to a much smaller ex-tent than with equal weights becausevalue weights automatically adjust tomarket movements. Hence, portfolio salesare largely dictated by changes to the in-dex being tracked (which are minimal inour data set) and negative cash flow. Thisexplains the convergence of the results inTable 5 when cash flow is non–negative.In these cases, there is very little selling ofthe index’s underlying securities; hence,their after–tax returns are nearly identi-cal. However, it is important to note thatthe externality imposed by the presenceor absence of new investors is still presentand is essentially undiminished. The dif-ference between HIFO accounting with1 percent new sales and 1 percent newredemptions is 9.01 basis points permonth over the entire 1984–98 period andis 13.05 percent per month for the 1994–8period.

TABLE 5AVERAGE AFTER–TAX MONTHLY RETURNS FOR PASSIVELY MANAGED FUNDS

WITH MARKET CAPITALIZATION WEIGHTS AND DETERMINISTIC SALES

A. 1984–98


–1% 1.3122 1.3070 1.3190 0 1.3895 1.3863 1.4015 +1% 1.4044 1.4017 1.4091

B. 1994–8


–1% 1.8390 1.8313 1.8424 0 1.9487 1.9432 1.9655 +1% 1.9666 1.9618 1.9729

18 It should be noted, however, that our “index” funds have even less turnover than most index funds tied to aparticular market benchmark (e.g., S&P 500). As shown in the data appendix, there was very little change tothe portfolio’s underlying holdings over the time period examined. As the rate of change in an index fund’sconstituents changes, accounting techniques would become more important.


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Liquidation Tax

The calculations in Tables 3, 4, and 5 arefor funds operating on an ongoing basis.Individual investors who joined the fundat inception could have experienced thereturns shown in these tables. If they donot sell their mutual fund holdings untilthey pass through an estate, the gains fromtax deferral could translate into perma-nent gains. The estate or heir could sellthe mutual fund shares at net asset valueand owe no taxes on the difference be-tween NAV and the cost basis of the mu-tual fund shares (or the cost basis of theunderlying shares in the fund for thatmatter). However, it is true that the fundsusing HIFO accounting are carrying theirportfolio positions at significantly lowercost bases than funds using average costaccounting or FIFO.

By looking at cases where the invest-ment is liquidated at the end of the timeperiod, we can get a better sense of thevalue of the timing differences. Table 6shows after–tax return figures for inves-tors in the funds from the beginning in1984 whose investment was liquidated atthe end of 1998. The average before–taxreturn is still 1.5000 percent per month,just as it was in Table 3.

Although the magnitude of the differ-ences are somewhat reduced relative tothe results reported in Table 3, the advan-tage of tax–efficient accounting (i.e.,HIFO) instead of average cost accountingremain substantial. For instance, with zeroexogenous net sales, the difference be-tween HIFO and average cost accountingis 3.37 basis points per month over the 15year period. Even ignoring compounding,

that means that after 15 years the HIFOfund will leave its holders with more thansix percent more after–tax wealth than theaverage cost accounting fund. More strik-ingly, the externality between early share-holders and new shareholders is stillpresent in undiminished form. Even if afund is going to be liquidated at the endof 15 years, taxable holders are far betteroff being in a fund that grows until theend rather than one that steadily losesshareholders. Of course, the value of taxdeferral increases with time, and the 15year horizon analyzed in these simula-tions is probably much longer than thetypical investor’s holding period. Thus,the cash flow and accounting differencesdiscussed here would be much less im-portant to an investor who plans to buyand sell their investments relatively fre-quently.

Randomness of Fund Sales

Funds don’t experience the steady ex-ogenous supply of new buyers that wehave been examining. The next questionwe look at is the cost of random ebbs andflows that funds actually experience. Todo this, we examine the after–tax averagereturns of both equally weighted andmarket capitalization–weighted indexfunds experiencing fluctuating net sales.We superimpose a standard deviation of4.5 percent per month on the underlyingtrend of net sales and a serialautocorrelation of 0.25. These values cor-respond with the data on observedmonthly net sales for a sample of roughly800 equity mutual funds over the period1992–9. This simulation is repeated 100

TABLE 6AVERAGE AFTER–TAX MONTHLY RETURNS (1984–98) FOR PASSIVELY MANAGED FUNDS

WITH EQUAL WEIGHTS, DETERMINISTIC SALES, AND LIQUIDATION IN 1998


–1% 1.1884 1.1883 1.2012 0 1.2478 1.2416 1.2815 +1% 1.2922 1.2842 1.3283


621

times and the following tables report theaverage after–tax returns. The results forboth fluctuating net sales and determin-istic net sales are shown in Table 7.

As we saw before, the value–weightedindex fund needs to do very little rebal-ancing in our simulations, so the gainsfrom tax–efficient accounting techniquesare minimal with deterministic cash flows.However, Panel B indicates that fluctuat-ing cash flows make the choice of account-ing technique very important. The reasonis that “ebbs” force the funds to sell offsome of their positions and this is just thecircumstance where accounting tech-niques matter. When an index fund sellspositions, it sells small slices of each of itsholdings. Because our simulated fundswould then engage in 50 partial redemp-tions, the choice of accounting techniquemakes a significant difference in theamount of taxable gains realized.

Panel B indicates that mere fluctuationsin net redemptions alone reduce the av-erage monthly after–tax rate of return by5.45 basis points a month if the value–weighted fund uses average cost account-ing. On the other hand, HIFO accountingreduces the impact of net sales fluctua-tions by more than 80 percent. The HIFOfund with fluctuating net sales has an av-erage after–tax return that is less than one–

half basis point per month below the av-erage cost accounting firm without fluc-tuating sales. Perhaps more importantly,the HIFO fund has a five basis points amonth advantage over the average costfund in an environment of fluctuating netsales. These same patterns are apparentfor the equally weighted index funds ofPanel A, although the magnitudes differ.

The basic lesson that we take from Table7 is that the externality of fluctuating saleson existing shareholders can be signifi-cantly and in some cases greatly reducedby mutual fund managers if they adoptthe appropriate accounting policies. Un-der HIFO the ebbs and flows of othershareholders have only a very slight im-pact on the buy and hold fund partici-pants. The same cannot be said for aver-age cost or FIFO accounting.

ACTIVE MANAGEMENT

We now turn to our stylized versionsof actively managed funds.19 Table 8shows after–tax returns for the three dif-ferent strategies of choosing which two ofthe 30 stocks to eliminate from the port-folio each month. Panel A is for a fund ex-periencing a trend rate of net sales of 1percent (with a standard deviation of 4.5percent per month and a coefficient of se-

TABLE 7AVERAGE AFTER-TAX MONTHLY RETURNS (1984–98) FOR PASSIVELY MANAGED FUNDS;

DETERMINISTIC VS. FLUCTUATING NET SALES

A. Equally–Weighted Portfolios


+1% Deterministic 1.3296 1.3137 1.3830+1%, 4.5% SD 1.3075 1.2918 1.3688Difference .0221 .0219 .0142

B. Market Capitalization Weighted Portfolios


+1% Deterministic 1.4044 1.4017 1.4091+1%, 4.5% SD 1.3499 1.3272 1.3997Difference .0545 .0745 .0094

19 As in the simulations of index funds with fluctuating net cash flow, we report the average results of 100simulations.


622

rial correlation of 0.25). Panel B is for afund with no net sales (e.g., an individu-ally managed account). Panel C shows thesame asset strategies for funds that areexperiencing trend net redemptions of 1percent per month.

The choice of accounting technique con-tinues to play a significant role, with thedifference between HIFO and average costaccounting varying between two andeight basis points per month. The differ-ence in investment policy is even larger.For instance, in Panel A, the difference inaverage after tax return of discarding los-ers and discarding winners is almost 27basis points per month.20 This is despitethe fact that the before–tax return isslightly (three basis points) higher for thediscarding winners strategy than the dis-carding losers one.21 The overall differ-ence between choosing a growing fundwhich is discarding losers and using HIFO

and an alternative actively managed fundthat sells winners, uses average cost ac-counting and is experiencing trend net re-demptions is 33.07 basis points per monthor 4.0 percent per year. This is an enor-mous difference for two funds experienc-ing the same market returns and choos-ing from the same universe (large capstocks) of securities. Almost all of the ad-vantage of one fund over the other is duein some way to the management of thefund.

It is interesting that the mutual fundthat uses HIFO and a policy of discard-ing losers in Panel A of Table 8 has ahigher after–tax return than the HIFOvalue–weighted index fund in Panel B ofTable 7. To make the cases comparable,one wants to look at the case of fluctuat-ing net sales. This certainly indicates thata tax–sensitive actively managed fundcan outperform a tax–sensitive index

TABLE 8AVERAGE AFTER–TAX MONTHLY RETURNS (1984–98) FOR ACTIVELY MANAGED FUNDS

WITH MARKET CAPITALIZATION WEIGHTS

A One Percent Trend Growth

Investment Policy Average Cost FIFO HIFO

Sell Winners 1.1391 1.1540 1.1585Random Sells 1.2480 1.2446 1.2621Sell Losers 1.3470 1.3343 1.4268

B. Separate Account (zero percent growth)



C. Negative One Percent Trend Growth



20 In the “selling winners” scenario, the portfolio manager sells the two positions with the highest ratios ofmarket value to cost basis. Similarly, the “selling losers” case looks at selling the two positions with the lowestratios of market value to cost basis (which may or may not result in realized losses).

21 As discussed above in the description of these simulations, the security selection process (i.e., selling “win-ners,” selling “losers,” or random sales) results in different portfolios because the securities sold from theportfolio differ under the three scenarios. Unlike the simulations of index funds where all of the portfolioshold the same stocks in the same weights, our actively managed funds simulated here will have different pre–tax returns.


623

fund, although a number of our assump-tions affect this result. There are no bid–ask spreads in our model and we chargethe same expenses to both index and ac-tively managed funds. On the other hand,we have a particularly rigid actively man-aged strategy. A real–world tax–sensitiveactively managed fund would not me-chanically replace two positions eachmonth. They would opportunistically re-place positions with large losses as theyoccur.

Liquidation Tax

For completeness, we also examine thecases where actively managed fundsare liquidated at the end of our 15 yearperiod in order to quantify the timing el-ement of capital gains deferral and ulti-mate realization. The results are shown inTable 9.

While the advantage of the investmentstrategy of selling the biggest losing posi-tions in the fund each month is reducedby between three and eight basis points amonth, it still is the strategy with the high-est after–tax monthly return. In fact, thedifferences across investment strategy arestill extremely large and the differencesacross accounting policies are significant.

The fund with the best combination ofpolicies (HIFO, selling losers, and a posi-tive trend of net sales) beats the fund withthe worst combination (average cost ac-counting, selling winners, and a negativetrend of net sales) by an after–tax marginof 27.57 basis points per month. Consid-ering that all of these funds are choosingfrom the same 50 stocks over the sametime frame and they all are being liqui-dated at the end of the period, this differ-ence in monthly after–tax returns has tobe considered enormous.

Closing the Fund

The next issue we examine is the im-pact on long–term holders of closing anactively managed fund to new investorsor to certain classes of new investors.Mutual funds, particularly large mutualfunds such as Vanguard Windsor and Fi-delity Magellan, have taken this action.The stated reason is usually that the man-agers of the fund cannot find productiveinvestments in which to place additionalfunds. The fund may also be concernedabout establishing such large positions asto lose liquidity.22 The question that weare concerned with is the externality ef-fect on the long–term holders.


WITH MARKET CAPITALIZATION WEIGHTS; LIQUIDATED IN 1998

A. One Percent Trend Growth



B. Negative One Percent Trend Growth



22 One suggestion that is often made is to split a fund into two without closing it. However, that approach doesnot work if the fund faces liquidity constraints. While smaller funds have greater liquidity, one must considerliquidity issues across all funds that a manager advises. As such, a fund that is split still represents one largepool of assets managed by the adviser and does not enhance liquidity.


624

Are the long–term holders harmed bythe absence of new buyers of the fund?We assess this issue by reexamining theperformance of our actively managedsimulated funds. We compare the fundsin two different scenarios. In the first sce-nario, the fund is left open to new buyersfor the entire 15 years of our model. Thenet sales are random with a positive trendof 1 percent of assets per month and thesame 4.5 percent per month standard de-viation previously assumed. Under thesecond scenario, the fund is open for thefirst ten years with the same sales experi-ence, but it is then closed over 1994–8. Theclosed fund has negative net sales. Theseare generated from a trend of negative –1percent of assets per month and a stan-dard deviation of 4.5 percent a month.The resulting net sales distributions aretruncated so that net sales are alwaysnonpositive when the fund is closed tonew investors.23 The average redemptionsare approximately two percent per monthunder these assumptions.

Table 10 demonstrates that closing thefund to new investors likely has a largenegative impact on the taxable holders ofthe fund. In all cases, the impact is sig-nificant, but it is the largest for funds that

otherwise were following tax efficientpractices. The funds that systematicallydivest themselves of their largest loserscost their taxable shareholders between 18and 25 basis points per month in after–tax returns by closing the fund. The rela-tively tax–efficient investment policy ofselling losers still offers the highest after–tax rates of return, but its effectiveness isgreatly diminished by the closure of thefund to new investors. The most tax effi-cient strategy of all remains the combina-tion HIFO and selling losers. The fact thatits after–tax return in Table 3.14 is slightlybelow that of the FIFO fund with the sameinvestment policy is a result that the be-fore tax returns are not identical across thecells of these tables. While it is still truethat HIFO is the best of the accountingpolicies, its advantage is also significantlydiminished by closure of the fund.

CONCLUSIONS

Our overall conclusion is that the tax–induced externalities between mutualfund shareholders are extremely large andimportant and that they can be influencedby management policies. The costs of ran-dom fluctuations in net sales on the after–


WITH MARKET CAP WEIGHTS;

A. One Percent Trend Growth; Open to New Investors



B. Minus One Percent Trend Growth; Closed to New Investors



23 This is a very extreme and somewhat unrealistic form of a fund closing. Usually, a fund is closed to newinvestors and remains open for existing investors (sometimes with annual purchase limits). The exampleshown, though, is consistent with the goal of closing the fund; namely, to ensure that positive cash flow issignificantly reduced or reversed, so that it does not alter the fund’s investment approach or flexibility.


625

tax performance of the fund are greatlydiminished by choosing HIFO, for in-stance. The advantage of a fund with posi-tive net sales relative to one with net re-demptions is also extremely large. Netsales are presumably somewhat under thecontrol of management. The extreme ac-tion of management closing the fund tonew buyers is found to have a devastat-ing impact on the ability to pursue tax ef-ficient strategies. Finally, the active invest-ment policy of selling losing positionsrelative to selling off winners offers muchbetter after tax returns.

We find that there is nothing inherentlyinconsistent with tax–efficient activelymanaged portfolios. Active managementtechniques (e.g. selling losers vs. sellingwinners) appear to have a greater impacton after–tax returns than the choice ofaccounting technique. Both are very im-portant, however. In other words, large–capitalization index funds can generallygenerate good tax efficiency by simplychoosing a tax–efficient accounting tech-nique, whereas the tax efficiency of ac-tively managed funds requires both a tax–motivated investment strategy (such asselling losing positions) and the appro-priate tax–efficient accounting policy.With an aggressive combination of tax–efficient policies, the actively managedfunds we simulated could have providedgreater tax efficiency than similarly con-structed indexed funds that only use tax–sensitive accounting.

Given the sensitivity of after–tax re-turns to the accounting policies imple-mented by mutual fund managers, it ap-pears that fund investors could benefitfrom better information about how theirfunds account for security sales. Today,no disclosure is required to detail howsecurity positions are accounted for uponsale. Certainly our simulations indicatethat this information would be of valueto taxable mutual fund investors and canimpact after–tax returns by as much aseight basis points per month among oth-

erwise identical funds based on our simu-lations.

One significant area for future researchwould include a practical look at policiesthat mutual funds can implement to re-duce the externalities identified in thispaper. Many tax–managed funds cur-rently assess asset–based redemption feesthat are paid to the fund to compensateshareholders for the actions of short–terminvestors whose redemptions could forcecapital gain realizations on other share-holders. Although redemption fees maybe a good way to internalize the external-ity, the optimal structure of these feeswould be an interesting extension. An-other approach to these issues might bethe use of cash reserves as an “insurancepolicy” against having to sell stocks andrealize gains when faced with negativecash flow. Of course, there is a potentialtrade–off in holding cash in generally ris-ing equity markets (i.e., lowers the pre–tax return), and borrowing cash (i.e., le-verage) faces many regulatory hurdleswithin the mutual fund context.

We find that the tax externalities fac-ing mutual fund investors are importantconsiderations in choosing between mu-tual funds and direct investments. Wehave demonstrated that the existence ofpositive net cash flow can provide a sig-nificant benefit to existing mutual fundshareholders, and that any negative ex-ternalities resulting from mutual fund re-demptions can be mitigated by the man-agement practices of the fund. Althoughseparate accounts arguably providegreater direct control over an individual’sown tax situation, we have shown that atax–sensitive mutual fund can meet orexceed the after-tax returns of an indi-vidually managed account. Further re-search into the mutual fund versus sepa-rate account debate may be useful be-cause it seems that this subject has notreceived the attention that it deserves inboth the academic and popular literatureon portfolio choice.


626

Acknowledgments

The authors would like to thank OliviaLau of Stanford for superb assistancewith this research. We also have ben-efited from discussions, information, andideas from Harold Evensky, Fred Grauer,Keith Lawson, Davide Lombardo, JimPoterba, John Rea, Douglas Shackelford,an anonymous referee and conferenceparticipants at the NBER’s “The Eco-nomic Effects of Taxation.” Research sup-port from the Smith–Richardson Founda-tion and the NBER are gratefully ac-knowledged. The opinions expressed inthis paper are those of the authors anddo not necessarily reflect the views of TheVanguard Group Inc., its affiliates, or itsBoard of Directors.

REFERENCES

Barclay, Michael J., Neil D. Pearson, andMichael S. Weisbach.

“Open-end Mutual Funds and Capital-Gains Taxes,” Journal of Financial Economics49 No. 1 (1998): 4–43.

Berstresser, Daniel, and James Poterba.“Do After-Tax Returns Affect Mutual FundInflows?” Massachusetts Institute of Tech-nology. Mimeo, 1999.

Carhart, Mark M.“On Persistence in Mutual Fund Perfor-mance,” Journal of Finance 52 (1997): 57–82.

Dickson, Joel M.“Mutual Fund Economics and Performance:The Effects of Shareholder-Level Taxation.”Stanford University. Unpublished Ph.D. dis-sertation, 1994.

Dickson, Joel M., and John B. Shoven.“A Stock Index Mutual Fund Without NetCapital Gains Realizations.” NBER WorkingPaper No. 4717. Cambridge, MA: NationalBureau of Economic Research, 1994.

Dickson, Joel M., and John B. Shoven.“Taxation and Mutual Funds: An InvestorPerspective.” In Tax Policy and the Economy,vol. 9, edited by James M. Poterba. Cam-bridge, MA: The M.I.T. Press, 1995.

Poterba, James, and Andrew Samwick.“Stock Ownership Patterns, Stock MarketFluctuations, and Consumption.” BrookingsPapers on Economic Activity 2 (1995): 295–372.

Sirri, Erik, and Peter Tufano.“Costly Search and Mutual Fund Flows.”Journal of Finance 53 (1998): 1589–1622.

Warther, Vincent A.“Are Tax-Minimizing Mutual FundsStable? Mutual Fund Flows and CapitalGains Overhangs.” University of Michi-gan Business School. Mimeo, 1996.

APPENDIX: DATA

Our source for the return and distributiondata of the stocks used in the mutual fund simu-lations is the Center for Research in SecurityPrices (CRSP). CRSP maintains a comprehen-sive collection of standard and derived secu-rity data available for the NYSE, AMEX, andNasdaq Stock Market. The mutual fund simu-lations use the returns, the distributions, andthe market capitalizations of the 50 largest com-panies in December 1983 in terms of marketcapitalization. We used the CRSP data set toidentify those 50 companies. The returns anddividends were derived using CRSP’s holdingperiod returns with and without dividendsover the period from January 1984 to Decem-ber 1998.

Table A lists some summary statistics of thecompanies in our dataset. Seven of the 50 com-panies were delisted from the three stock ex-changes. If a company was merged into an-other company, we followed the stock of theacquirer after the merger. If a company wasbought out for cash, we replaced it with thelargest market capitalization company that isnot already in the dataset after taking into ac-count taxable cash–distributions. Standard Oilof Ohio merged with BP in June 1987 after pay-ing a small cash–distribution to its sharehold-ers. Shell, Marubeni, Getty Oil, Gulf Oil,Reynolds R J Industries, Texas Oil and Gas, andSuperior Oil were all bought out for cash andwere replaced by TDK Corp., Westinghouse


627

Electric, Halliburton, Smithkline Beckman,Xerox, Intel, and American InternationalGroup, respectively. Superior Oil never entersour dataset because it was already bought outin October 1984. The monthly return of anequally–weighted index of the 50 companieshad a mean of 1.50 percent and a standard de-viation of 4.12 percent. The correspondingsummary statistics for a value–weighted indexwere 1.50 percent and 4.11 percent. The means

and standard deviations of the two indices cor-respond closely to the performance of the Stan-dard & Poor’s 500 Index. Of the 43 companiesthat were in our dataset for 15 years, Pfizer hadthe highest monthly return of 2.37 percent andTenneco had the lowest return of 0.63 percent.Motorola’s returns had the highest monthlystandard deviation of 9.75 percent, whereasExxon’s returns had a standard deviation ofonly 4.42 percent.

74,508

59,39231,62326,65323,41914,82914,48113,74613,16312,614

12,42112,36512,06211,84611,69610,80210,8029,6729,4699,4229,2929,0468,9688,3417,8217,7657,7357,2957,1307,1276,9616,8816,6836,5366,2876,1605,8245,8065,7605,7145,7055,493

TABLE ACOMPANIES IN DATASET

1 INTERNATIONAL BUSINESS MACHS COR

2 AMERICAN TELEPHONE &TELEG CO

3 EXXON CORP 4 GENERAL ELECTRIC CO 5 GENERAL MOTORS CORP 6 STANDARD OIL CO IND 7 SCHLUMBERGER LTD 8 CANON INC 9 SEARS ROEBUCK & CO 10 EASTMAN KODAK CO 11 DU PONT E I DE NEMOURS

& CO 12 SHELL OIL CO 13 ROYAL DUTCH PETROLEUM CO 14 STANDARD OIL CO CALIFORNIA 15 MOBIL CORP 16 HEWLETT PACKARD CO 17 ATLANTIC RICHFIELD CO 18 MINNESOTA MINING & MFG CO 19 PROCTER & GAMBLE CO 20 MARUBENI CORP 21 TEXACO INC 22 SHELL TRANSPORT & TRADING 23 PHILIP MORRIS INC 24 G T E CORP 25 JOHNSON & JOHNSON 26 GETTY OIL CO 27 AMERICAN HOME PRODUCTS CO 28 COCA COLA CO 29 GULF OIL CORP 30 FORD MOTOR CO 31 AMERICAN EXPRESS CO 32 REYNOLDS R J INDUSTRIES INC 33 MERCK & CO INC 34 DOW CHEMICAL CO 35 HONDA MOTOR LTD 36 I TT CORP 37 UNION PACIFIC CORP 38 BELL CANADA ENTERPRISES 39 BRISTOL MYERS CO 40 TENNECO INC 41 PFIZER INC 42 UNOCAL CORP

IBM

TXONGEGMSNSLB

CANNYS

EK

DDSUORD

CHVMOBHWPARC

MMMPG

MARTYTXSCMOGTEJNJ

GETAHPKOGOF

AXPRJR

MRKDOWHMCITT

UNPBCEBMYTENPFEUCL

Jan-84-Dec-98

Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98

Jan-84-Dec-98Jan-84-May-85Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Apr-84Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Jan-84Jan-84-Dec-98Jan-84-Dec-98Jan-84-May-84Jan-84-Dec-98Jan-84-Dec-98Jan-84-Apr-89Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98Jan-84-Dec-98

1.16

1.601.651.901.111.350.851.161.261.07

1.542.991.771.431.571.561.241.151.849.971.301.702.221.431.9624.591.732.2914.122.111.693.162.311.381.481.331.011.191.870.632.371.12

7.67

6.904.426.157.584.917.797.947.936.45

6.619.285.645.835.509.456.425.626.14

17.355.956.307.315.166.67

5.926.22

13.217.828.27

10.046.616.978.506.646.685.255.666.857.568.00

TickerIn

Dataset

MeanReturn perMonth %Rank

Mkt.Cap.in Mio.

28-Dec-83

Std. Dev.per Month

%Company Name (in Dec. 1983)


628

TABLE A (Continued)COMPANIES IN DATASET

43 ABBOTT LABS 44 WAL MART STORES INC 45 STANDARD OIL CO OF OH 46 MOTOROLA INC 47 PHILLIPS PETROLEUM CO 48 ROCKWELL INTERNATIONAL

CORP 49 SUN INC 50 TEXAS OIL & GAS CORP 51 TD K CORP 52 WESTINGHOUSE ELECTRIC

CORP 53 HALLIBURTON COMPANY 54 SMITHKLINE BECKMAN CORP 55 XEROX CORP 56 INTEL CORP 57 SUPERIOR OIL CO 58 AMERICAN INTERNATIONAL

GROUP INC59 BRITISH PETROLEUM PLC

Equally–Weighted FundValue–Weighted FundStandard & Poor’s 500 Index

ABTWMTSOHMOT

P

ROKSUNTXOTDK

WXHALSKBXRXINTCSOC

AIGR

BP

Jan-84-Dec-98Jan-84-Dec-98Jan-84-May-87Jan-84-Dec-98Jan-84-Dec-98

Jan-84-Dec-98Jan-84-Dec-98Jan-84-Jan-86Feb-84-Dec-98

May-84-Dec-98Jun-84-Dec-98Jun-85-Jun-89Jun-86-Dec-98May-89-Dec-98

Jul-89-Dec-98Jun-87-Dec-98

Jan-84-Dec-98Jan-84-Dec-98Jan 84-Dec-98

5,4805,4395,3965,3665,286

5,0985,0815,0104,955

4,7924,7784,7064,6984,6914,676

4,665

1.972.301.931.511.08

1.180.91–1.751.17

1.231.001.691.823.62

2.021.32

1.501.501.48

6.217.636.849.757.75

7.117.227.839.25

8.729.478.208.09

10.68

6.406.42

4.124.114.33

TickerIn

Dataset

MeanReturn perMonth %Rank

Mkt.Cap.in Mio.

28-Dec-83

Std. Dev.per Month

%Company Name (in Dec. 1983)

637

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