Tax Externalities of Equity Mutual Funds

Transcription

1 Tax Exernaliies of Equiy Muual Funds Joel M. Dickson The Vanguard Group, Inc. John B. Shoven Sanford Universiy and NBER Clemens Sialm Sanford Universiy December 1999 Absrac: Invesors holding muual funds in axable accouns face a classic exernaliy. The aferax reurn of heir invesmen depends on he behavior of ohers. In paricular, redempions may force he muual fund o sell some of is equiy posiions in order o pay off he liquidaing invesors. As a resul, he muual fund may be forced o disribue realized capial gains o is shareholders. The axes of invesors saying wih he fund are acceleraed by he acions of hose leaving he fund. On he oher hand, new invesors convey a posiive exernaliy upon exising invesors by diluing he unrealized capial gain posiion of he fund. The simulaions presened in his paper show ha hese exernaliies are imporan deerminans of he afer-ax performance of equiy muual funds. Muual fund managers can significanly influence he magniude of hese exernaliies by choosing ax-efficien accouning echniques and invesmen policies. The auhors would like o hank Olivia Lau of Sanford for superb assisance wih his research. We also have benefied from discussions, informaion and ideas from Fred Grauer, Keih Lawson, Davide Lombardo, Jim Poerba, John Rea, Douglas Shackelford, and conference paricipans a he NBER s The Economic Effecs of Taxaion. Research suppor from he Smih-Richardson Foundaion and he NBER are graefully acknowledged. The opinions expressed in his paper are hose of he auhors and do no necessarily reflec he views of The Vanguard Group Inc., is affiliaes, or is Board of Direcors.

2 1. Inroducion Muual funds have played an increasingly imporan role in meeing he financial goals of U.S. invesors over he las several decades. As shown in Table 1.1, he growh of equiy muual fund asses has been remarkable. According o he Invesmen Company Insiue (ICI) he muual fund rade associaion oal asses of equiy muual funds have increased from $40 billion a year-end 1980 o $2,503 billion a year-end , represening a compound annual growh rae of 25.8% over he period. Overall, he muual fund indusry has benefied from a broader shif away from households invesing direcly in equiies o indirec ownership of equiies. This rend is documened in deail by Poerba and Samwick (1995). Table 1.1 Equiy Muual Fund Asses Year Equiy Muual Fund Asses ($ billions) Toal Held Ouside Employer Plans, IRAs % Ouside Employer Plans and IRAs 1980 $ 40.0 $ % 1985 $ $ % 1990 $ $ % 1995 $ 1,080.7 $ % 1998 $ 2,503.3 $ 1, % Source: ICI calculaions The muual fund indusry benefied grealy from he inroducion and growh of new reiremen accumulaion vehicles (e.g., 401(k) plans, Individual Reiremen Accouns). However, a majoriy of muual fund asses are sill held ouside ax-qualified vehicles. A lo of aenion has recenly been devoed o he ax efficiency of muual fund invesmens. Dickson and Shoven (1994, 1995) argue ha muual funds have no generally considered he ax implicaion of heir rading aciviy and sugges ways in which porfolio managers could improve afer-ax reurns for heir shareholders. More recenly, Bergsresser and Poerba (1999) consider how differen porfolio characerisics affec afer-ax reurns and muual fund cash flows. The opic of muual fund ax efficiency has also received aenion from legislaors, as evidenced by he inroducion of H.R ( The Muual Fund Tax Awareness Ac of 1999 ), which would direc he Securiies and Exchange Commission o improve disclosure of afer-ax reurns for muual funds. While a lo of research has focused on he persisence of muual fund performance (see, for example Carhar (1997)), here has been less discussion abou he muual fund srucure as an invesmen vehicle. This paper considers how he ax siuaion of invesors is affeced by he muual fund srucure hrough he acions of oher shareholders. We also discuss choices made by he muual fund managers ha can affec posiively or negaively he afer-ax reurns realized by heir shareholders. The difference beween he afer-ax performance of muual funds and direcly-held invesmens cener mainly on how muual fund cash flows can impac reurns over ime. 1 The figures exclude equiies held in variable annuiies, which would add abou $475 billion o he oal as of yearend

3 Alhough muual funds were esablished as pass-hrough vehicles, here are ax differences beween funds and individually managed accouns. In paricular, here are hree significan differences ha could impac he relaive araciveness of a muual fund invesmen. Firs, Subchaper M of he Inernal Revenue Code originally enaced in 1936 o provide for he ax reamen of pass-hrough eniies, including muual funds does no include a provision o passhrough he characer of shor-erm capial gains for ax purposes. 2 Thus, while muual funds repor shor-erm capial gain disribuions o heir shareholders, hese disribuions are reaed as ordinary income dividends on IRS Form 1099-DIV he ax form documening axable muual fund disribuions. In oher words, shor-erm capial gain disribuions from muual funds are repored on Schedule B (Ineres and Ordinary Dividends) of IRS Form 1040 insead of Schedule D (Capial Gains and Losses). This difference maers only if a axpayer has realized losses ha would no oherwise be offse by gains. In oher words, he ax liabiliy of a muual fund shareholder could be greaer if shor-erm losses were offse by long-erm gains ha could oherwise have been offse by shor-erm gains from he muual fund. Second, muual funds can no disribue ne realized losses. Insead, funds can use loss carry-forwards for up o eigh years following he year of he loss. The ne effec of his reamen is o accelerae he ax liabiliy of muual fund shareholders versus individually managed accouns, where ne losses can be declared in he year hey occur and used o offse oher gains or up o $3,000 of axable income. 3 These wo negaives are offse by a significan benefi for muual fund shareholders: he passhrough of he fund s expenses. Muual funds disribue ne invesmen income o shareholders, which is income received by he fund less charged expenses. Take for example, a muual fund whose underlying porfolio of securiies generaes a 2% gross dividend yield. If he fund s expense raio e.g., invesmen advisory, cusody, disribuion, shareholder servicing expenses is 1%, hen he ne income disribuion o shareholders would be 1%. If he expense raio were 0.5%, hen he dividend would be 1.5%. Effecively, fund expenses are fully deducible for all axpayers because hey lower he axable income received by shareholders. Generally, invesmen fees assessed in a non-regisered invesmen vehicle (e.g., individually managed and rus accouns) are an iemized deducion ha can be used only o he exen hey exceed 2% of adjused gross income. Muual fund shareholders are axed hrough wo differen mechanisms. Each year, a fund passeshrough is income and capial gains realizaions in he form of disribuions made o he fund s shareholders. These disribuions resul from he acions of he porfolio manager and affec all shareholders in he fund because each shareholder receives heir pro-raa share of he disribuion (as of he disribuion s record dae). Alhough he porfolio manager s rading aciviy leads o he fund s disribuions, he rading aciviy could have been iniiaed by he porfolio manager or imposed on he porfolio manager as a resul of shareholder aciviy (ne cash flow). I is his laer case ha disinguishes he muual fund or oher commingled vehicles from separae 2 Legislaion permiing he pass hrough reamen of long-erm capial gains hrough a muual fund was enaced in The legislaive hisory provides no indicaion as o why shor-erm gains also were no provided wih his pass hrough reamen. This omission appears o have been more of an oversigh han a conscious effor o rea shorerm gains differenly for muual funds. 3 This argumen assumes ha capial gain ax raes remain consan. If capial gains axes were o increase significanly, his relaionship could reverse because losses could be used o offse a higher poenial fuure ax liabiliy. 2

4 accouns. 4 As such, a muual fund invesmen is subjec o a classic exernaliy because he acions of oher exising and poenial invesors can affec he axable disribuions o all shareholders. In addiion, muual fund shareholders also may face an addiional ax liabiliy upon he sale of such asses o he exen he marke value upon sale is greaer or less han heir accumulaed cos basis (which is he sum of he value of all purchases, including reinvesed disribuions). Obviously, hese wo forms of shareholder axaion are no muually exclusive. If during he invesmen horizon, fewer axable disribuions were received, hen he ax liabiliy due upon liquidaion would almos always be greaer relaive o an invesmen wih he same pre-ax reurn (assuming such reurn is posiive) which disribued more axable capial gains hroughou he invesmen horizon. This paper explores he posiive and negaive exernaliies resuling from muual fund cash flows and how hese exernaliies can be affeced by he managemen and accouning pracices of he fund. Muual fund cash flows are generally viewed as a negaive relaive o an individually managed accoun because redempions can force capial gains o be realized and disribued o shareholders, acceleraing heir ax liabiliy. Anoher argumen is ha negaive cash flows can make oherwise ax-efficien funds unsable (Warher 1996). An implici assumpion in hese argumens is ha muual funds use average cos accouning. 5 In fac, muual funds have significan flexibiliy in choosing how hey accoun for securiy sales, and we will show how he choice of accouning echnique can eiher exacerbae or reduce he magniude of he muual fund ax exernaliy. We also consider he oher side of he cash flow argumen; namely, ha posiive cash flows benefi muual fund shareholders versus an invesmen vehicle wih no ongoing cash flow (i.e., a separae accoun). 6 The posiive exernaliy associaed wih muual fund cash flows has no been generally discussed and can represen a significan benefi o invesors in muual funds. Such cash flow dilues he unrealized capial gains posiion of he fund and generally makes axsensiive accouning echniques more powerful in reducing he overall ax burden of he invesmen. We will also show ha hese benefis can increase over ime relaive o a porfolio wihou cash flows. The res of he paper is organized around invesigaing he exernaliies associaed wih muual fund invesmens. The nex secion briefly describes he posiive and negaive exernaliies associaed wih muual fund managemen and how managemen pracices can affec hese relaionships. The hird secion is he bulk of he paper and presens a simulaion mehodology 4 This paper will use he erms separae accoun or individually managed accoun inerchangeably o refer o a porfolio of securiies managed for one invesor. These accouns are no subjec o he ax rules of Subchaper M of he Inernal Revenue Code and are exemp from regisraion under he Invesmen Company Ac of Alhough muual funds canno expressly use he average cos basis mehods ha are available o muual fund shareholders in deermining realized gain or loss, a fund could mimic average cos accouning by idenifying upon sale hose ax los closes o he securiy s average cos. 6 Our discussion and simulaions consider a separae accoun o have an iniial invesmen bu no ongoing cash flow (excep dividends from he underlying invesmens). This is, of course, quie sylized because separae accouns will generally have some cash flow posiive or negaive over he invesmen horizon. However, we do no consider hese siuaions because i does no represen an exernaliy as in he muual fund conex. 3

5 ha allows us o invesigae he magniude of he exernaliies. This secion looks a how cerain ax-managemen echniques can affec afer-ax reurns in boh a separae accoun and a muual fund environmen. In addiion, we consider he effecs of accouning echniques and closing funds on he afer-ax reurns for shareholders. The final secion presens a brief conclusion and issues for policymakers o consider in helping invesors undersand alernaive invesmen vehicles. 2. Muual Fund Tax Exernaliy The differences beween muual funds and separaely managed accouns and how muual funds can exacerbae or miigae any poenial negaive ax evens can be illusraed wih a simple example. Assume ha a muual fund currenly has hree axable shareholders whose iniial purchases were compleed a differen imes and were used o buy he same equiy securiy (XYZ Company). 7 There are no oher ransacions in he fund. The following able gives he invesmen posiion of he fund and each of is shareholders: Table 2.1 Illusraion of Tax-Exernaliy Time Shareholder Acion Fund Acion Toal Fund Posiion 1 Invesor A purchases $100 Fund buys $100 of XYZ 1 share of XYZ sock; of fund shares sock a $100/share Marke value = $100; 2 Invesor B purchases $125 of fund shares 3 Invesor C purchases $150 of fund shares Fund buys $125 of XYZ sock a $125/share Fund buys $150 of XYZ sock a $150/share Cos basis = $100 2 shares of XYZ sock; Marke value = $250; Cos basis = $225 3 shares of XYZ sock; Marke value = $450; Cos basis = $375 Now assume ha invesor A redeems her enire invesmen in he nex period, wih XYZ sock rading a $140 per share. If anoher shareholder invess a he same ime, hen invesor A can be paid wih he cash received from he new shareholders wihou requiring any securiies ransacions a he fund level. However, if he redempion is he only shareholder ransacion, hen he fund mus sell some of is holdings o raise he cash o pay he redeeming shareholder. However, he gain or loss realized (and hen disribued o he remaining shareholders would depend on he accouning reamen used. For example, selling he XYZ shares purchased wih invesor A s iniial invesmen which would also correspond o FIFO accouning would resul in a $40 gain ha mus be disribued o he remaining shareholders. 8 However, he exisence of oher shareholders has presened a way o miigae his poenial exernaliy. In paricular, if he fund sells he shares purchased a $150 ha resuled from invesor C s invesmen, hen he fund 7 Technically, a muual fund ha owned jus one securiy would fail cerain diversificaion ess ha mus be me in order o qualify as a muual fund. The example given is obviously for illusraion only. 8 The disribuion of he realized gains (o he exen hey are no reinvesed in addiional fund shares) would also be a negaive cash flow even ha could force furher realizaions. This is described in more deail in Dickson (1994) and Warher (1996). 4

6 would realize a $10 loss ha would resul in no curren axable capial gain disribuion o he remaining shareholders and could be used o offse fuure capial gain realizaions. No maer which ax reamen is used by he fund, invesor A sill pays ax based on he difference beween he marke value of he redempion ($140) and her cos basis ($100). More generally, consider a porfolio of (equiy) securiies. Is marke value (MV) and cos basis (CB) can be represened by he following relaionships: n MV = p S CB = i= 1 n i i= 1 j= 1 i p n = p s ij i ij i= 1 j= 1 s ij where p ij is he price of securiy i a ime j, and S i is he oal number of shares of securiy i held a ime. S i equals he sum of he holdings of he shares s ij, which were iniially purchased a ime j. (Noe he relaionships are a porfolio snapsho a ime. Ne securiy posiions, s ij, may differ a imes and +1 o he exen here are sales or purchases of he fund s securiies.) Also, he difference beween he porfolio s value and is cos basis or he ne unrealized gain (UG) is: n UG = (p p ) s (1) i= 1 j= 1 i ij ij The ne unrealized gain of he porfolio is a combinaion of posiions a a loss and hose a a gain (boh across securiies and wihin an individual securiy s ax los). I is imporan o recognize ha he amoun of gain or loss recognized from a parial sale of he porfolio s asses canno be deermined wihou furher assumpions. Insead, he UG relaionship represens he ne amoun of gain or loss recognized if he porfolio were o be compleely liquidaed a ime. Equaion (1) demonsraes ha he dispersion in unrealized gain liabiliies and, hence, in capial gain realizaions is an imporan deerminae in he abiliy o conrol he capial gain realizaions hrough accouning procedures. In paricular, he larger he sandard deviaion of (p i p ij ) condiional on s ij >0, he more abiliy he manager has o minimize or maximize ax realizaions. In his conex, a separae accoun wih minimal cash flow will have very lile abiliy o conrol gain realizaions. On he oher hand, a muual fund wih posiive cash flow over ime and ha ends o buy small amouns of each securiy a differen poins in ime will end o have much more flexibiliy. The fund has four sources of cash flows. Firs, he socks held in he muual fund pay dividends d a ime. Second, he fund pays fund expenses of x o is fund managers. Third, he fund is required o disribue annually he received dividends ne of expenses and he realized capial gains o is shareholders, if hey are posiive. Realized capial losses are carried forward and subraced from fuure realized capial gains. The oal fund disribuions are denoed by fd. The invesors in he fund mus pay axes on hose disribuions. Dividends and shor-erm capial gains (i.e., gains of asses held for one year or less) are axed a he marginal income ax rae on 5

7 ordinary income and long-erm capial gains (i.e., gains of asses held for more han one year) are axed a he lower capial gains ax rae. Fourh, invesors buy or redeem shares of he muual fund. Those exogenous cash flows are denoed by c. Addiional flows resul from he reinvesmens of disribuions by he fund s shareholders. The proporion α of he dividend disribuions and he proporion β of he capial gains disribuions are auomaically re-invesed. Toal cashflows mus be absorbed by ne asse sales. The oal cash flows a ime are given by: D SCG LCG D SCG LCG ( fd + fd + fd ) + ( c + αfd + β( fd fd ) cf = d x + The res of he paper invesigaes how porfolio managemen decisions, accouning procedures and shareholder cash flow can affec he recogniion of capial gains or losses in he fund. No Cash Flows A separae accoun of direcly held securiies may have lile or no ongoing cash flows afer he iniial invesmen in he porfolio. Alhough dividends o he exen hey are reinvesed may provide some posiive cash flow, he new posiions resuling from reinvesed dividends would likely be relaively small compared wih he iniial invesmens. These porfolios would no be subjec o he ax exernaliy described in he inroducion because he accoun owners decide when o sell he asses, and he associaed ax liabiliy does no depend on he aciviy of any oher shareholders (hough discreionary porfolio managemen decisions could impac he accoun owners). There is a radeoff for conrol over he porfolio s ax liabiliy, however. Wih no new cash flows, he porfolio s ne unrealized gain will increase as securiy prices rise over ime (assuming hey do). This has he poenial o accelerae he ax liabiliy for a shareholder in cerain cases. For example, if posiions are sold o mainain he porfolio s securiy weighings over ime (e.g., o mainain diversificaion of he porfolio s asses), hen gains may be realized insead of being able o direc cash flow o rebalance he porfolio. Also, if a forced realizaion of capial gains occurs (e.g., merger and acquisiion aciviy among he porfolio s holdings), he porfolio may have a higher raio of marke value o cos basis han a muual fund ha has had posiive cash flows. Ne Cash Flows A muual fund or oher commingled invesmen vehicle is subjec o he cash flow paerns of boh exising and new shareholders. Cash flows affec securiy ransacion aciviy wihin he fund. As such, acions of oher shareholders can cause posiive or negaive effecs for all oher shareholders. Firs, consider he case of posiive cash flow. Assuming he fund is in a ne unrealized gain posiion, he exisence of posiive cash flow dilues he overall capial gain posiion of he fund because he marke value and cos basis of any new invesmen are equal, whereas he porfolio s marke value exceeds is basis. An equivalen way of saing his relaionship is ha he new securiies come in, in aggregae, a a cos higher han he average cos basis of he porfolio. This diluion is posiive for he exising shareholders from a number of perspecives. Firs, i spreads any capial gain realizaions across a larger shareholder base (i.e., he per-share value of any disribuion is reduced). Secondly, i provides a means o offse negaive cash flows ha migh (2) 6

8 oherwise require a liquidaion of some equiy posiions. Finally, and mos imporanly, he addiion of new cos los a differen prices hrough securiy purchases increases he power of he fund s accouning echniques o miigae any fuure redempion aciviy by allowing for greaer choice among ax los. Overall, cash flows can represen a posiive exernaliy. Wha abou negaive ne cash flows? Unambiguously, if securiies are sold a heir average cos, hen he porfolio will realize capial gains o he exen he porfolio s basis is less han is marke value. However, he porfolio does no have o realize gains or losses a heir average coss. The decisions of he fund s adviser specifically, he accouning echnique chosen can miigae he poenial ax exernaliy. Tha said, coninuous redempions can cause an acceleraed ax liabiliy over ime even in a ax-efficien porfolio if share prices generally rise and he fund s accouning echniques eliminae much of he gross unrealized loss in he porfolio. A number of sudies have invesigaed he relaionships affecing ne cash flows (Barclay, Pearson, and Weisbach, 1998; Sirri and Tufano, 1998; Bergsresser and Poerba, 1999). However, many of hese relaionships have been performance-based, which can ofen be fleeing. On he oher hand, o he exen cash flows are posiively correlaed wih equiy marke movemens, i could imply ha he ax-efficien accouning echniques described below are even more powerful because he porfolio would be buying when prices are rising and selling when prices are falling (and possibly realizing losses). Oher han performance, are here oher ways ha muual funds could generae posiive cash flows, hereby benefiing exising invesors? The academic sudies sugges ha unrealized capial gains may be a facor in fuure ne cash flow paerns and ha managers migh consciously conrol he ax overhang in order o remain aracive for fuure shareholders (Barclay, Pearson, and Weisbach, 1998). However, a ax efficien invesor would probably prefer a buyand-hold porfolio wih a lower level of ne cash flows han one in which ha ax liabiliy were acceleraed in order o supposedly arac a high level of new cash. In oher words, such a sraegy significanly reduces he benefi of a posiive cash flow. Anoher approach would be o adverise he fund, if his were successful in generaing new cash flow over ime. Mos direcly, he cash flow relaionship can be affeced by a decision o limi new cash o he fund e.g., closing he fund o new invesors. Closing a fund is ofen done for invesmen reasons in order o mainain he fund s characer and invesmen process. However, here is a poenially significan negaive o such an approach: i makes negaive cash flows and heir associaed exernaliies more likely. We invesigae closing a fund in our simulaions in he following secion. Accouning Techniques Muual funds are subjec o he same rules as oher owners of equiy securiies when accouning for securiy sales; namely, specific idenificaion of he ax los sold. 9 Currenly, muual funds are no required o disclose how hey accoun for securiy sales in any prospecus or shareholder repor. As demonsraed in he nex secion, his informaion could be useful o shareholders because differen accouning echniques can have a maerial impac on he afer-ax performance of muual fund invesmens. 9 As menioned in foonoe 5, muual fund shareholders bu no muual funds hemselves are allowed o use average cos basis mehods, which are no forms of specific idenificaion. For boh muual funds and heir shareholders, FIFO is he defaul mehod for deermining gain or loss. 7

9 I is also ineresing o noe ha ax-efficien accouning echniques benefi all curren fund invesors. Tha is, accouning for securiy sales in differen ways does no affec he fund s preax reurn he objecive of a fund s ax-deferred shareholders bu can improve he fund s afer-ax reurn he objecive of hose shareholders holding he fund ouside of a ax-qualified vehicle. Wihin his conex, cerain regulaory pracices could affec he abiliy o use accouning echniques o affec he afer-ax reurn for shareholders. In paricular, a proposal in Presiden Clinon s fiscal year 1998 budge proposal would have required all securiy sales o be effeced using average cos accouning. Alhough his proposal was no included in he final budge for ha year, he simulaions in he nex secion sugges ha such a move could accelerae he ax liabiliy for shareholders in funds ha currenly use more ax-friendly accouning. Alhough a survey of accouning echniques among muual funds is no available, we will consider a range of poenial accouning echniques: firs-in firs-ou (FIFO), las-in firs-ou (LIFO), average cos, and ax-sensiive accouning. Average cos idenifies for sale he securiy posiion ha is closes o he average cos of he overall posiion in he securiy, or equivalenly sells a fixed fracion of all he los purchased a differen poins in ime. Firs-in, firs-ou is simply idenifying for sale he oldes lo for each posiion. FIFO is usually a ax-inefficien sraegy o he exen securiy prices rise over ime. Las-in, firs-ou is selling he mos recenly purchased lo of each posiion. The las echnique we consider is ax-sensiive accouning, which is ofen referred o as highes-in, firs-ou (HIFO) accouning. HIFO accouning idenifies he highes cos lo in each securiy for sale. 10 These echniques and heir abiliy o affec relaive afer-ax performance are invesigaed in he nex secion. The abiliy o use accouning echniques o affec afer-ax performance depends on he managemen and srucure of he invesmen vehicle. In paricular, accouning echniques are more powerful when here is a greaer dispersion of cos los for each securiy. Accouning procedures can miigae he poenial negaive effecs of redeeming invesors on he oher shareholders. On he oher hand, a separae accoun wih a large iniial invesmen relaive o is overall porfolio does no have as much abiliy o leverage accouning echniques because he fund s holdings would be much more concenraed a specific poins in ime (i.e., HIFO, LIFO, FIFO, and average cos are close o equivalen because here is minimal dispersion of cos los). Similarly, acive managemen echniques where securiies may be bough or sold in shor ime frames may be less able o use accouning echniques han passively managed vehicles where small slices of many securiies end o be ransaced. However, for hose porfolios wih more concenraed buying and selling, he abiliy o effec rading sraegies (e.g., harvesing losses) can have a relaively greaer impac on afer-ax reurns. We invesigae hese iner-dependen relaionships in he nex secion. 10 Tax-efficien accouning is more general han HIFO accouning. For example, i migh be preferable o realize a larger dollar amoun of long-erm gains han a smaller amoun of shor-erm gains because of heir differences in marginal ax raes. Also, a fund wih capial loss carry-forwards ha will soon expire migh wan o swich accouning echniques o realize a lo of gain. 8

10 3. Simulaions of Muual Funds We have consruced a muual fund simulaor o help evaluae he imporance of he exernaliies beween shareholders and he effec of accouning and oher policies of muual fund managers. By assumpion, he simulaed muual funds only keep rack of he equiies of he companies which were amongs he fify larges (in erms of marke capializaion) in We used he CRSP daa se o deermine he ideniy of hese fify companies and o rack heir monhly reurns and disribuions from 1984 hrough If a company was merged ino anoher company, we followed he sock of he acquirer. If a company was bough ou for cash, we replaced i wih he larges marke capializaion company (in December 1983) ha is no already in he daa se. A deailed descripion of he daa se is conained in Appendix 1. The muual fund reurns are based on he acual monhly reurns of he componen socks minus an expense charge of five basis poins per monh. We have used his expense raio for all of our simulaions, alhough we recognize ha his is a high charge for a passively managed index fund and a low charge relaive o he expenses of mos acively managed funds. We assume ha niney percen of he fund disribuions of dividends and capial-gains are auomaically reinvesed in he muual fund. The afer-ax reurns are compued for an invesor facing a 39.6 percen marginal income ax rae on dividends and realized shor-erm capial gain disribuions and a 20.0 percen marginal ax rae on realized long-erm capial gain disribuions. These are he curren raes for someone in he op federal income ax bracke. We apply hese raes o he enire period. 11 Furher, we ignore sae and local income axes. 3.1 Descripion of Simulaions This secion discusses he effecs of differen muual fund policies on afer-ax reurns for a buyand-hold muual fund invesor. Firs, muual funds choose he accouning echnique hey use o deermine he cos basis of shares ha hey sell. We evaluae four differen accouning policies: (1) always using he average cos basis for deermining capial gains and losses, (2) using FIFO (using he cos basis of he oldes los of a paricular sock), (3) using LIFO (using he cos of he mos recenly acquired los) 12, and (4) using HIFO (using he cos of he mos expensive los). The cos basis of he remaining shares of a paricular securiy also depends on he choice of accouning echnique. If HIFO is used, for insance, he cos basis of he remaining shares will be lower han if one of he oher echniques is chosen. By choosing accouning echnique, he fund deermines he iming of axes of is shareholders. Second, muual funds follow eiher an acive or a passive (index) invesmen sraegy. Passively managed funds rack eiher an equally- or a value-weighed index of he fify companies in our daase. Acively managed funds are assumed o hold hiry of he fify securiies a all poins in ime. The hiry socks are held in value-weighed proporions. Each monh, he acively 11 We compued as well he reurns wih acual ax-raes over he period beween 1984 and 1998 for high- and medium-income individuals. We did no summarize he resuls wih acual ax raes because hey are very similar o he resuls repored in his secion. 12 We presen he resuls for LIFO in jus he firs simulaions. Generally, he resuls are similar bu slighly less ax efficien o he HIFO case in he generally rising equiy marke over he simulaion period. Also, LIFO is no a widely used mehod among muual funds because of he significan wash-sale resricions ha are encounered in a daily cash flow environmen. 9

11 managed funds compleely dives hemselves of wo of heir hiry posiions and bring in wo randomly seleced companies from he weny ha have been ouside he fund. The porfolio is rebalanced so ha he new holdings are proporional o he marke capializaions of he members. The fac ha he new enrans are randomly chosen probably reflecs our bias owards he efficien marke hypohesis. We examine hree alernaive rules for choosing which wo securiies o kick ou of he muual fund each monh. One rule is o drop he wo firms ha have he larges gains relaive o heir cos bases. A second rule is exacly he opposie o sell he wo firms ha have he lowes price relaive o cos basis. This is a relaively ax efficien sraegy, alhough i is no he ax minimizing sraegy which would keep rack of he difference beween shor and long-erm gains and losses and which would make he number of socks liquidaed dependen on he cos basis. The hird rule chooses he wo socks o be deleed each monh randomly. Under his regime, he acively managed funds are rue noise raders, exchanging randomly chosen posiions for equally randomly chosen replacemens. Third, we also look a he impac of he pace of ne muual fund sales on he afer ax reurns ha he fund offers is long-erm shareholders. The firs ne sales regime applies o a fund ha has a rend of ne sales equal o one percen of asses per monh. The second regime, roughly corresponding o a fund ha is closed o new purchases (or a leas o some classes of poenial buyers), is for a fund wih a rend rae of ne sales of minus one percen of asses per monh. Tha is, on average i experiences ne redempions. 3.2 Passive Managemen Equally-Weighed Fund The firs resuls are shown in Table 3.1 and refer o a passively managed index fund holding all fify socks wih equal weighs. Tha is, wo percen of he fund s asses are invesed in each of he fify securiies. The mainenance of he wo-percen weighs implies a monhly rebalancing of he porfolio selling socks whose relaive price has risen and buying addiional shares in hose whose relaive price has fallen. Table 3.1 displays he before and afer-ax average monhly reurns for he enire period for an equally-weighed index fund experiencing deerminisic ne sales. 10

12 Table 3.1 Average Monhly Reurns for Passively Managed Funds wih Equal Weighs and Deerminisic Sales, A. Average Before-Tax Monhly Reurns Ne Sales/Asses Average Cos FIFO LIFO HIFO -1% % B. Average Afer-Tax Monhly Reurns Ne Sales/Asses Average Cos FIFO LIFO HIFO -1% % Panel A simply reminds us ha he before-ax reurn is exacly he same for he differen accouning echniques and differen paerns of ne sales of he fund. This means ha an invesor holding he fund in a ax-qualified pension accoun (such as an IRA or 401(k) accoun) would be indifferen o he argumens of his sub-secion. On he oher hand, Panel B indicaes ha a axable invesor who was in one of hese funds for he enire period would care a lo abou which cell in he panel his fund has chosen for him. Firs, if he fund is experiencing neiher ne sales nor ne redempions (oher han he assumed en percen of dividend and capial gains disribuions ha are no reinvesed), hen he difference in afer-ax reurns beween a fund ha uses HIFO accouning and one which uses FIFO accouning is 7.72 basis poins per monh. Perhaps more realisically, he difference beween HIFO and average cos accouning is 6.09 basis poins per monh or 73 basis poins per year. This difference is larger han he assumed expenses of he fund. Over long holding periods, such as en or fifeen years, his 73 basis poins per year differenial can be very significan. Second, he individual invesor in he growing fund (wih 1 percen ne sales per monh) experiences a much higher afer-ax reurn han he invesor in he shrinking fund. Comparing he HIFO resul wih +1% ne sales o he one wih 1% ne sales shows a difference of basis poins per monh. This is a difference of slighly more han 121 basis poins per year an enormous amoun considering ha he wo funds hold exacly he same securiies wih he same weighs and use he same accouning echniques. This difference is due o he exernaliy beween exising shareholders and new shareholders ha we discussed in he previous secion of he paper. The fund wih a seady supply of new shareholders is coninuously buying new los of he fify securiies and can accomplish he monhly rebalancing (o reain he wo-percen weighs) wih far less ax consequence han he fund experiencing seady ne redempions. The difference beween owning a ax-sensiive HIFO index fund experiencing ne new sales every monh and an average-cos basis index fund experiencing ne redempions is basis poins per monh or more han 1.78 percen per year. 11

13 Our simulaed passively managed funds begin in 1984 wih newly acquired posiions in all fify socks. Iniially, here is no much advanage o one accouning echnique over he oher because all of he original los carry he same cos basis. The advanage of HIFO and LIFO over FIFO and average cos accouning grows as he number of los of purchases o choose amongs for parial liquidaions grows. To examine his effec, we calculae he difference accouning choices and ne sales makes for he years for our funds begun in The average monhly before-ax reurn for he sample of fify equally weighed socks was percen for he period. This is cerainly a much beer han average period of ime for large capializaion socks such as hose in our sample. The average afer-ax reurns for are shown in Table 3.2. Table 3.2 Average Afer-Tax Monhly Reurns for Passively Managed Funds wih Equal Weighs and Deerminisic Sales, Ne Sales/Asses Average Cos FIFO HIFO -1% % The gain from he relaively ax efficien HIFO policy is larger han before. For example, wih zero exogenous ne sales, he difference beween HIFO and FIFO is basis poins per monh and he difference beween HIFO and average cos accouning is 7.37 basis poins per monh. The difference beween he afer-ax performance of growing and shrinking funds is also wider for he five years han i is for he enire ime period Now, comparing he HIFO resuls for +1% ne sales wih he HIFO resuls wih 1% ne sales, he growing fund offers is high-ax shareholders a basis poins a monh advanage. This is more han hiry percen greaer han he difference over he enire fifeen-year period, a difference ha we already hough was enormous. For he five years , he difference in afer-ax reurn for a HIFO index fund experiencing one percen per monh ne sales and an average cos index fund experiencing one percen ne redempions is basis poins per monh or 2.16 percen per year. Value-Weighed Fund The assumpion ha he passive funds hold heir posiions wih equal weighs causes hem o realize gains and losses in he process of monhly rebalancing. If he fund held posiions wih value or marke capializaion weighs, rebalancing would be grealy reduced. Wih value weighs, rebalancing is necessary only if he companies in he index issue or repurchase shares or if he composiion of he larges fify companies changes due o mergers and acquisiions. Besides, i could be argued ha marke capializaion weighs are more consisen wih he indexing philosophy. We have examined he effec of he same accouning and ne sales assumpions for he case wih value weighs. The resuls are shown in Tables 3.3 and 3.4. For he record, he average monhly before-ax reurn on value-weighed porfolios is percen for and percen for

14 Table 3.3 Average Afer-Tax Monhly Reurns for Passively Managed Funds wih Marke Capializaion Weighs and Deerminisic Sales, Ne Sales/Asses Average Cos FIFO HIFO -1% % Table 3.4 Average Afer-Tax Monhly Reurns for Passively Managed Funds wih Marke Capializaion Weighs and Deerminisic Sales, Ne Sales/Asses Average Cos FIFO HIFO -1% % The resuls confirm our inuiion: he accouning echnique is much less imporan wih value weighs because much less rebalancing is necessary. 13 The choice of accouning echnique is mos imporan when a porion of a posiion is being sold. Here ha happens o a much smaller exen han wih equal weighs. However, i is imporan o noe ha he exernaliy imposed by he presence or absence of new invesors is sill presen and is essenially undiminished. The difference beween HIFO accouning wih +1 percen new sales and 1 percen new sales is 9.01 basis poins per monh over he enire period and is percen per monh for he period. Liquidaion Tax The calculaions in Tables 3.1 and 3.2 (and for 3.3 and 3.4) are for funds operaing on an ongoing basis. Individual invesors who joined he fund a incepion could have experienced he reurns shown in hese ables. If hey do no sell heir muual fund holdings unil hey pass hrough an esae, he gains from ax deferral could ranslae ino permanen gains. The esae or heir could sell he muual fund shares a ne asse value and owe no axes on he difference beween NAV and he cos basis of he muual fund shares (or he cos basis of he underlying shares in he fund for ha maer). However, i is rue ha he funds using HIFO accouning are carrying heir porfolio posiions a significanly lower cos bases han funds using average cos accouning or FIFO. There always is a quesion as o wheher he deferral can be coninued indefiniely and how invesors would fare if he fund liquidaed is posiions a some poin in he fuure. To examine his we have calculaed he fifeen-year hisory of an equally weighed fund (as in Table 3.1) ha liquidaes and disribues all proceeds a he end of The figures in Table 3.5 refer o invesors who were in he funds from he beginning in The average before-ax reurn is sill percen per monh, jus as i was in Table I should be noed, however, ha our index funds have even less urnover han mos index funds ied o a paricular marke benchmark (e.g., S&P 500). As shown in he daa appendix, here was very lile change o he porfolio s underlying holdings over he ime period examined. As he rae of change in an index fund s consiuens changes, accouning echniques would become more imporan. 13

15 Table 3.5 Average Afer-Tax Monhly Reurns ( ) for Passively Managed Funds wih Equal Weighs, Deerminisic Sales, and Liquidaion in 1998 Ne Sales/Asses Average Cos FIFO HIFO -1% % The gains from using HIFO insead of average cos accouning are significanly reduced relaive o he comparable Table 3.1, bu hey sill are subsanial. For insance, wih zero exogenous ne sales, he difference beween HIFO and average cos accouning is 3.37 basis poins per monh over he fifeen year period. Even ignoring compounding, ha means ha afer fifeen years he HIFO fund will leave is holders wih more han six percen more afer-ax wealh han he average cos accouning fund. More srikingly, he exernaliy beween early shareholders and new shareholders is sill presen in undiminished form. Even if a fund is going o be liquidaed a he end of fifeen years, axable holders are far beer off being in a fund ha grows unil he end raher han one ha seadily loses shareholders. Randomness of Fund Sales Of course, funds don experience he kind of seady exogenous supply of new buyers ha we have been examining. The nex quesion we look a is wha is he cos of random ebbs and flows ha funds acually experience. To do his, we examine he afer-ax average reurns of boh equally weighed and marke capializaion-weighed index funds experiencing flucuaing ne sales. We superimpose a sandard deviaion of 4.5 percen per monh on he underlying rend of ne sales and a serial auocorrelaion of These values correspond wih he daa on observed monhly ne sales for a sample of roughly 800 equiy muual funds over he period This simulaion is repeaed 100 imes and he following ables repor he average afer-ax reurns. The resuls for boh flucuaing ne sales and deerminisic ne sales are shown in Tables 3.6 and 3.7. Table 3.6 Average Afer-Tax Monhly Reurns ( ) for Passively Managed Funds wih Equal Weighs; Deerminisic vs. Flucuaing Ne Sales Ne Sales/Asses Average Cos FIFO HIFO +1% Deerminisic %, 4.5% SD Difference

16 Table 3.7 Average Afer-Tax Monhly Reurns ( ) for Passively Managed Funds wih Marke Capializaion Weighs; Deerminisic vs. Flucuaing Ne Sales Ne Sales/Asses Average Cos FIFO HIFO +1% Deerminisic %, 4.5% SD Difference As we saw before, he value-weighed index fund needs o do very lile rebalancing, so he gains from ax-efficien accouning echniques are minimal wih deerminisic cash flows. However, flucuaing cash flows make he choice of accouning echnique very imporan. The reason is ha ebbs force he funds o sell off some of heir posiions and his is jus he circumsance where accouning echniques maer. Table 3.7 indicaes ha mere flucuaions in ne redempions alone reduce he average monhly afer-ax rae of reurn by 5.45 basis poins a monh if he value-weighed fund uses average cos accouning. On he oher hand, HIFO accouning reduces he impac of ne sales flucuaions by more han eighy percen. The HIFO fund wih flucuaing ne sales has an average afer-ax reurn ha is less han one-half basis poin per monh below he average cos accouning firm wihou flucuaing sales. Perhaps more imporanly, he HIFO fund has a five basis poins a monh advanage over he average cos fund in an environmen of flucuaing ne sales. These same paerns are apparen for he equally weighed index funds of Table 3.6, alhough he magniudes differ. The basic lesson ha we ake from Tables 3.6 and 3.7 is ha he exernaliy of flucuaing sales on exising shareholders can be significanly and in some cases grealy reduced by muual fund managers if hey adop he appropriae accouning policies. Under HIFO he ebbs and flows of oher shareholders has only a very sligh impac on he buy and hold fund paricipans. The same canno be said for average cos accouning. 3.3 Acive Managemen We now urn o some sylized versions of acively managed funds. The funds selec randomly hiry of he fify socks a he beginning of he invesmen period. Each monh, hey compleely dives of wo of heir posiions and bring in wo randomly seleced companies from he weny ha have been ouside he fund. The porfolio is rebalanced so ha he holdings are proporional o he marke capializaions of he members. The simulaions are again repeaed 100 imes and he following ables repor he average afer-ax reurns over hose simulaions. Tables 3.8 and 3.9 show afer-ax reurns for he hree differen sraegies of choosing which socks o eliminae from he porfolio each monh. Table 3.8 is for a fund experiencing a rend rae of ne sales of +1 percen (wih a sandard deviaion of 4.5 percen per monh and a coefficien of serial correlaion of 0.25). Table 3.9 is for a fund wih no ne sales (e.g., an individually managed accoun). Table 3.10 shows he same asse sraegies for funds ha are experiencing rend ne redempions of one percen per monh These funds may have resriced access o some classes of invesors, hus creaing his ne wihdrawal siuaion. 15

17 Table 3.8 Average Afer-Tax Monhly Reurns ( ) for Acively Managed Funds wih Marke Capializaion Weighs; 1% Trend Growh Invesmen Policy Average Cos FIFO HIFO Sell Winners Random Sells Sell Losers Difference: Losers-Winners Table 3.9 Average Afer-Tax Monhly Reurns ( ) for Acively Managed Funds wih Marke Capializaion Weighs; Separae Accoun (0% cash flow) Invesmen Policy Average Cos FIFO HIFO Sell Winners Random Sells Sell Losers Difference: Losers-Winners Table 3.10 Average Afer-Tax Monhly Reurns ( ) for Acively Managed Funds wih Marke Capializaion Weighs; -1% Trend Growh Invesmen Policy Average Cos FIFO HIFO Sell Winners Random Sells Sell Losers Difference: Losers-Winners The choice of accouning echnique coninues o play a significan role, wih he difference beween HIFO and average cos accouning varying beween wo and eigh basis poins per monh. The difference in invesmen policy is even larger. For insance, in Table 3.8, he difference in average afer ax reurn of discarding losers and discarding winners is almos 27 basis poins per monh. 14 This is despie he fac ha he before-ax reurn is slighly (hree basis poins) higher for he discarding winners sraegy han he discarding losers one. 15 The overall difference beween choosing a growing fund which is discarding losers and using HIFO and an 14 In he selling winners scenario, he porfolio manager sells he wo posiions wih he highes raios of marke value o cos basis. Similarly, he selling losers case looks a selling he wo posiions wih he lowes raios of marke value o cos basis (which may or may no resul in realized losses). 15 In he case of our acively managed funds, differen accouning echniques and cash flow paerns can resul in differen securiies being sold under he various scenarios. In oher words, because he new purchases and monhly re-balancing can affec he raio of marke value o cos basis for each securiy, he porfolios and hence, heir preax reurns will differ because of differences in he securiies being sold each monh. 16

18 alernaive acively managed fund ha sells winners, uses average cos accouning and is experiencing rend ne redempions is basis poins per monh or 4.0 percen per year. This is an enormous difference for wo funds experiencing he same marke reurns and choosing from he same universe (large cap socks) of securiies. Almos all of he advanage of one fund over he oher is due in some way o he managemen of he fund. I is ineresing ha he muual fund ha uses HIFO and a policy of discarding losers in Table 3.8 has a higher afer-ax reurn han he HIFO value-weighed index fund in Table 3.7. To make he cases comparable, one wans o look a he case of flucuaing ne sales in Table 3.7. This cerainly indicaes ha a ax-sensiive acively managed fund can ouperform a ax-sensiive index fund, alhough a number of our assumpions affec his resul. There are no bid-ask spreads in our model and we charge he same expenses o boh index and acively managed funds. On he oher hand, we have a paricularly rigid acively managed sraegy. A real-world ax-sensiive acively managed fund would no mechanically replace wo posiions each monh. They would opporunisically replace posiions wih large losses as hey occur. Furher, a fund ineresed in opimizing ax efficiency migh choose a differen universe of socks han we have here. Tax minimizaion is easies wih socks ha have high price volailiy. We have no consruced our sample of fify socks wih his in mind. Liquidaion Tax For compleeness, we have examined he cases where acively managed funds are liquidaed a he end of our fifeen-year period. The resuls are shown in Tables 3.11 and Table 3.11 Average Afer-Tax Monhly Reurns ( ) for Acively Managed Funds wih Marke Capializaion Weighs; 1% Trend Growh; Liquidaed in 1998 Invesmen Policy Average Cos FIFO HIFO Sell Winners Random Sells Sell Losers Difference: Losers-Winners Table 3.12 Average Afer-Tax Monhly Reurns ( ) for Acively Managed Funds wih Marke Capializaion Weighs; -1% Trend Growh; Liquidaed in 1998 Invesmen Policy Average Cos FIFO HIFO Sell Winners Random Sells Sell Losers Difference: Losers-Winners While he advanage of he invesmen sraegy of selling he bigges losing posiions in he fund each monh is reduced by beween hree and eigh basis poins a monh, i sill is he sraegy 17

19 wih he highes afer-ax monhly reurn. In fac, he differences across invesmen sraegy are sill exremely large and he differences across accouning policies are significan. The fund wih he bes combinaion of policies (HIFO, selling losers, and a posiive rend of ne sales) beas he fund wih he wors combinaion (average cos accouning, selling winners, and a negaive rend of ne sales) by an afer-ax margin of basis poins per monh. Considering ha all of hese funds are choosing from he same fify socks over he same ime frame and hey all are being liquidaed a he end of he period, his difference in monhly afer-ax reurns has o be considered enormous. Closing he Fund The nex issue we examine is he impac on long-erm holders of closing an acively managed fund o new invesors or o cerain classes of new invesors. Muual funds, paricularly large muual funds such as Vanguard Windsor and Fideliy Magellan, have aken his acion. The saed reason is usually ha he managers of he fund canno find producive invesmens in which o place addiional funds. The fund may also be concerned abou esablishing such large posiions as o lose liquidiy. The quesion ha we are concerned wih is he exernaliy effec on he long-erm holders. Are he long-erm holders harmed by he absence of new buyers of he fund. We assess his issue by reexamining he performance of our acively managed simulaed funds. We compare he funds in wo differen scenarios. In he firs scenario, he fund is lef open o new buyers for he enire fifeen years of our model. The ne sales are random wih a posiive rend of one-percen of asses per monh and he same 4.5 percen per monh sandard deviaion previously assumed. Under he second scenario, he fund is open for he firs en years wih he same sales experience, bu i is hen closed over The closed fund has negaive ne sales. These are generaed from a rend of negaive one-percen of asses per monh and a sandard deviaion of 4.5 percen a monh. The resuling ne sales disribuions are runcaed so ha ne sales are always nonposiive when he fund is closed o new invesors. 16 The average redempions are approximaely wo percen per monh under hese assumpions. Table 3.13 Average Afer-Tax Monhly Reurns ( ) for Acively Managed Funds wih Marke Cap Weighs; 1% Trend Growh; Open o New Invesors Invesmen Policy Average Cos FIFO HIFO Sell Winners Random Sells Sell Losers This is a very exreme and somewha unrealisic form of a fund closing. Usually, a fund is closed o new invesors and remains open for exising invesors (someimes wih annual purchase limis). The example shown, hough, is consisen wih he goal of closing he fund; namely, o ensure ha posiive cash flow is significanly reduced or reversed, so ha i does no aler he fund s invesmen approach or flexibiliy. 18

20 Table 3.14 Average Afer-Tax Monhly Reurns ( ) for Acively Managed Funds wih Marke Cap Weighs; -1% Trend Growh; Closed o New Invesors Invesmen Policy Average Cos FIFO HIFO Sell Winners Random Sells Sell Losers Tables 3.13 and 3.14 conain he resuls. The firs hing o noe is ha closing he fund o new invesors has a large negaive impac on he axable holders of he fund. In all cases, he impac is significan, bu i is he larges for funds ha oherwise were following ax efficien pracices. The funds ha sysemaically dives hemselves of heir larges losers cos heir axable shareholders beween 18 and 25 basis poins per monh in afer-ax reurn by closing he fund. The relaively ax-efficien invesmen policy of selling losers sill offers he highes afer-ax raes of reurn, bu is effeciveness is grealy diminished by he closure of he fund o new invesors. The mos ax efficien sraegy of all remains he combinaion HIFO and selling losers. The fac ha is afer-ax reurn in Table 3.14 is slighly below ha of he FIFO fund wih he same invesmen policy is a resul ha he before ax reurns are no idenical across he cells of hese ables. While i is sill rue ha HIFO is he bes of he accouning policies, is advanage is also significanly diminished by closure of he fund. 4. Conclusions Our overall conclusion is ha he ax-induced exernaliies beween muual fund shareholders are exremely large and imporan and ha hey can be influenced by managemen policies. The coss of random flucuaions in ne sales on he afer-ax performance of he fund are grealy diminished by choosing HIFO, for insance. The advanage of a fund wih posiive ne sales relaive o one wih ne redempions is also exremely large. Ne sales are presumably somewha under he conrol of managemen. The exreme acion of managemen closing he fund o new buyers is found o have a devasaing impac on he abiliy o pursue ax efficien sraegies. Finally, he acive invesmen policy of selling losing posiions relaive o selling off winners offers much beer afer ax reurns. We find ha here is nohing inherenly inconsisen wih ax-efficien acively managed porfolios. Acive managemen echniques (e.g. selling losers vs. selling winners) appear o have a greaer impac on afer-ax reurns han he choice of accouning echnique. Boh are very imporan, however. In oher words, large-capializaion index funds can generally generae good ax efficiency by simply choosing a ax-efficien accouning echnique, whereas he ax efficiency of acively managed funds requires boh a ax-moivaed invesmen sraegy (such as selling losing posiions) and he appropriae ax-efficien accouning policy. Wih an aggressive combinaion of ax-efficien policies, he acively managed funds we simulaed could have provided greaer ax efficiency han similarly consruced indexed funds ha only use axsensiive accouning. 19