Tax Externalities of Equity Mutual Funds

Investors holding mutual funds in taxable accounts face a classic externality. The after-tax return of their investment depends on the behavior of others. In particular, redemptions may force the mutual fund to sell some of its equity positions in order to pay off the liquidating investors. As a result, the mutual fund may be forced to distribute realized capital gains to its shareholders. The taxes of investors staying with the fund are accelerated by the actions of those leaving the fund. On the other hand, new investors convey a positive externality upon existing investors by diluting the unrealized capital gain position of the fund. The simulations presented in this paper show that these externalities are important determinants of the after-tax performance of equity mutual funds. Mutual fund managers can significantly influence the magnitude of these externalities by choosing tax-efficient accounting techniques and investment policies. The authors would like to thank Olivia Lau of Stanford for superb assistance with this research. We also have benefited from discussions, information and ideas from Fred Grauer, Keith Lawson, Davide Lombardo, Jim Poterba, John Rea, Douglas Shackelford, and conference participants at the NBERÕs "The Economic Effects of Taxation." Research support from the Smith-Richardson Foundation and the NBER are gratefully acknowledged. The opinions expressed in this paper are those of the authors and do not necessarily reflect the views of The Vanguard Group Inc., its affiliates, or its Board of Directors.