Tax‐Efficient Asset Management: Evidence from Equity Mutual Funds

• Published date: 01 April 2020
• Date: 01 April 2020
• Author: CLEMENS SIALM,HANJIANG ZHANG
• DOI: http://doi.org/10.1111/jofi.12843

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 2 •APRIL 2020

Tax-Efficient Asset Management: Evidence from

Equity Mutual Funds

CLEMENS SIALM and HANJIANG ZHANG∗

ABSTRACT

We investigate the relation between tax burdens and mutual fund performance from

both a theoretical and an empirical perspective. The theoretical model introduces

heterogeneous tax clienteles in an environment with decreasing returns to scale and

shows that the equilibrium performance of mutual funds depends on the size of the

tax clienteles. Our empirical results show that the performance of U.S. equity mutual

funds is related to their tax burdens. We find that tax-efficient funds exhibit not only

superior after-tax performance, but also superior before-tax performance due to lower

trading costs, favorable style exposures, and better selectivity.

INVESTMENT TAXES HAVE A SUBSTANTIAL impact on the long-term performance

of taxable mutual fund investors. Mutual funds in the United States are re-

quired to distribute their dividend income and their realized capital gains to

their shareholders. These distributions are taxed at the fund investor level at

different rates. In particular, short-term capital gains distributions, generated

by the liquidation of fund positions held for less than one year, are typically

taxed at substantially higher rates than long-term capital gains distributions.

Unrealized capital gains, meanwhile, remain untaxed until the securities are

∗Clemens Sialm is at the McCombs School of Business, University of Texas at Austin, and

at the National Bureau of Economic Research. Hanjiang Zhang is at Washington State Univer-

sity. We thank Stefan Nagel (the Editor); an Associate Editor; two referees; Dan Bergstresser;

Jonathan Cohn; Magnus Dahlquist; Joel Dickson; Steve Dimmock; Rich Evans; Daniel Feen-

berg; Will Gerken; Greg Kadlec; Xiang Kang; Inmoo Lee; Marlena Lee; David Lesmond; Tobias

Moskowitz; Tim Park; Jim Poterba; John Shoven; Nathan Sosner; Juan Sotes-Paladino; Laura

Starks; Sheridan Titman; Scott Weisbenner; participants at the 2015 American Finance Associa-

tion Meetings in Boston, the 2015 Asian Bureau of Finance and Economic Research Conference

in Singapore, the 2018 Conference of Swiss Economists Abroad in Zurich, the 2018 European

Symposium in Financial Markets in Gerzensee, and the 2018 Finance Down Under Conference

in Melbourne; and seminar participants at AQR Capital Management, Georgetown University,

Georgia State University, McGill University, Monash University, Northeastern University, Notre

Dame University, Stanford University, Tulane University, University of California at Riverside,

University of Delaware, University of Illinois at Chicago, University of Kentucky, University of

Massachusetts at Amherst, University of New South Wales, University of Sydney, the University

of Texas at Austin, University of Texas at San Antonio, and YorkUniversity for helpful comments.

We also thank Daniel Sialm for research assistance. Clemens Sialm is an independent consultant

with AQR Capital Management and thanks the Stanford Institute for Economic Policy Research for

financial support during his Sabbatical leave. We are grateful to the Geneva Institute for Wealth

Management for their research award.

DOI: 10.1111/jofi.12843

C2019 the American Finance Association

735

736 The Journal of Finance R

liquidated. In this paper, we shed light on the costs and benefits of tax-efficient

asset management by investigating the before- and after-tax performance of

U.S. equity mutual funds with different tax management strategies.

Mutual funds can reduce the tax burdens of their shareholders by defer-

ring the realization of capital gains, by accelerating the realization of capital

losses, and by avoiding securities with high dividend yields, as discussed by

Bergstresser and Poterba (2002). Such tax management strategies, however,

constrain funds’ investment choices and may reduce their before-tax perfor-

mance. On the other hand, fund managers who are sufficiently savvy to avoid

taxes may exhibit superior investment abilities in other dimensions as well.

For instance, tax-efficient fund managers may generate lower trading costs,

take on favorable factor exposures, and demonstrate superior stock selection

and timing abilities.

To better understand the equilibrium relation between before- and after-

tax returns across mutual funds, we develop a stylized model with different

investment strategies and heterogeneous tax clienteles. Investors have access

to investment opportunities that face different tax burdens and that are subject

to decreasing returns to scale, as suggested by Berk and Green (2004). The

model shows that the returns of the different investment strategies depend

on the distribution of tax clienteles. If the proportion of tax-exempt investors

is relatively high, then tax-exempt investors are the dominant investors and

before-tax returns are equalized across the strategies. Conversely, if taxable

investors are dominant, then after-tax returns are equalized. At intermediate

distribution levels, neither before-tax nor after-tax returns are equalized, in

contrast to the predictions by Berk and Green (2004).

To empirically estimate the relation between tax efficiency and fund perfor-

mance, we use data on a comprehensive sample of U.S. equity mutual funds

between 1990 and 2016. We find that taxes have a significant effect on the

performance of taxable fund investors. On average, fund shareholders in the

highest tax bracket are estimated to pay investment taxes that amount to

1.08% of their investment value per year. This tax burden is similar in size

to fund expenses, which have received substantial attention in the literature

(e.g., French (2008)).

We find that the tax burden of mutual funds can be predicted by their invest-

ment styles, by the flows of fund investors, and by the capital gains overhang.

Tax burdens tend to be higher for funds that focus on small-capitalization and

value portfolios, as these investment styles trigger relatively high realizations

of capital gains. In addition, tax burdens increase as funds experience redemp-

tions by fund investors or volatile investor flows. Finally, funds’ tax burdens

are positively related to turnover, fund age, and the capital gains overhang.

We further find that the tax efficiency of mutual funds is highly persistent,

as mutual funds tend to maintain consistent styles and investment strategies

over time. A one-standard-deviation increase in prior tax burden is associated

with a significant increase in the tax burden of a fund over the next year of

between 0.44 and 0.47 percentage points.

Tax-Efficient Asset Management 737

Turning to our main analysis, we find that the before- and after-tax perfor-

mance of U.S. equity mutual funds is related to their prior tax burdens. We

find that tax-efficient funds generate not only superior after-tax performance,

but also superior before-tax performance over the next year. A one-standard-

deviation decrease in the tax burden over the prior three years (which is equal to

1.18 percentage points) is associated with a significant increase in the before-tax

return of a fund of between 0.39 and 0.55 percentage points over the next year.

Tax-efficient funds generate superior after-tax returns in the future due both

to higher before-tax returns and lower tax burdens. Thus, our results indicate

that tax-efficient asset management strategies, as practiced by U.S. equity

mutual funds between 1990 and 2016, exhibit favorable returns after as well

as before taxes. The superior pre-tax performance of tax-efficient funds is not

eliminated by fund flows, as would be expected from the stylized benchmark

model with decreasing returns to scale. This puzzling result indicates that fund

investors are not fully aware of the benefits of tax efficiency.

To further investigate the pre-tax performance differences across funds with

differential tax efficiency, we study the trading costs, style exposures, and

investment abilities of mutual funds. The superior pre-tax performance of tax-

efficient funds can be explained by lower trading costs, favorable style expo-

sures, and superior investment ability. These results indicate that the invest-

ment ability of fund managers is correlated across different dimensions: fund

managers who avoided taxable distributions in prior years face lower trad-

ing costs, exhibit superior selectivity, and take on favorable style exposures in

future years.

Mutual funds might be tax efficient not because these funds deliberately

minimize their tax burden, but rather because these funds’ strategies gener-

ate relatively low tax burdens as a byproduct. For example, a low-turnover

fund that invests in large capitalization stocks should be relatively tax effi-

cient because this fund liquidates stock positions infrequently and any such

liquidations are concentrated among poorly performing stocks that are ex-

cluded from large-capitalization benchmarks. To address this possibility, we

study the performance of mutual funds that explicitly classify themselves as

tax-managed funds. We find that after taxes, self-designated tax-efficient funds

outperform matched funds in the same families with similar investment styles.

Furthermore, the self-designated tax-efficient funds do not significantly under-

perform other funds before taxes, indicating that the constraints imposed by

tax-efficient asset management do not appear to have negative performance

consequences. Since these matched funds exhibit similar investment styles and

have similar management teams, these matching results are consistent with

our main results, which indicate that performance differences can be explained

by trading costs, style exposures, and investment abilities.

Our paper is related to a small literature that investigates the tax impli-

cations of mutual fund management. Jeffrey and Arnott (1993), Dickson and

Shoven (1995), and Arnott, Kalesnik, and Schuesler (2018) show that invest-

ment taxes play an important role for mutual fund investors. Barclay,Pearson,

and Weisbach (1998) discuss the conflict that mutual fund managers face in