Tax Efficient Asset Management: Evidence from Equity Mutual Funds
Clemens Sialm : University of Texas at Austin - McCombs School of Business; Stanford University; National Bureau of Economic Research (NBER)
Hanjiang Zhang :
Nanyang Technological University - Nanyang Business School
December 16, 2013
Abstract: Investment taxes have a substantial impact on the performance of taxable mutual fund investors. Mutual funds can reduce the tax burdens of their shareholders by avoiding securities that are heavily taxed and by avoiding realizing capital gains that trigger higher tax burdens to the fund’s investors. Such tax avoidance strategies constrain the investment opportunities of the mutual funds and might reduce the before-tax performance of the funds.
Our paper empirically investigates the costs and benefits of tax efficient asset management based on U.S. equity mutual funds from 1990-2012. We find that mutual funds that follow tax-efficient asset management strategies generate superior after-tax returns. Surprisingly, mutual funds that generate lower taxable distributions do not underperform other funds before taxes, indicating that the constraints imposed by tax efficient asset management do in practice not have significant performance consequences.
We came across this study from the following discussion @ Bogleheads:
Bogleheads:
As a former IRS Revenue Officer, I am acutely aware of the impact that taxes have on our investments, and the fact that knowledgeable investors can do something about it.
Below are excerpts from a recent study:
Investment taxes have a substantial impact on the performance of taxable mutual fund investors.
The average tax burden is similar in magnitude to the average expense ratio.
A $10,000 investment in 1990 in the most tax-efficient domestic equity mutual fund over our sample period would have accumulated to $91,200 in 2012 after taking into account taxes on dividend and capital gains distributions. On the other hand, an equal investment in the least tax-efficient domestic equity fund would have accumulated to only $40,800 after taxes, although both funds exhibited very similar performance before taxes.
Unrealized capital gains remain untaxed until the securities are liquidated and can completely be avoided due to the “step-up of the cost basis at death”
Tax burdens on mutual funds tend to be higher for funds that focus on small-capitalization and
value portfolios, as these investment styles trigger relatively high capital gains distributions. Tax burdens also increase with the turnover, the age, and the capital gains overhang of the fund. Finally, the tax burden also increases as funds experience outflows or volatile flows.
Passively-managed funds tend to exhibit lower tax burdens than actively-managed funds, despite their higher dividend yields.
Many mutual funds attempt to create value for their investors through stock selection or
market timing strategies. However, such active strategies often cause substantial expenses and
trading costs that make it difficult for actively managed mutual funds to persistently generate superior performance for their investors.
We selected two growth funds with extreme average tax burdens over the whole sample period. The tax-efficient fund has an average tax burden of 0.44% per year, whereas the tax-inefficient fund has an average tax burden of 3.77% per year.
Tax Efficient Asset Management
Best wishes.
Taylor
My taxable account consists of Vanguard Total Stock Market, Vanguard Total International, and Prime Money Market. Keep it simple, with international able to benefit from the foreign tax credit.
Everything else, including REITS and separate Index 500 and Extended Market funds (so I can re-allocate large and small), as well as a few actively-managed funds (including long-held Health Care, Cap Opp, and Selected Value) are in tax-sheltered accounts. Re-balancing takes place in the tax-sheltered space except when I add more to international.
Every December I enjoy seeing all the capital gains generated on which I don't pay taxes.
Thank you Taylor and Bogleheads.
by Taylor Larimore » Fri Jan 31, 2014 2:00 pm
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