Explaining After-Tax Mutual Fund Performance

Abstract

Published research on the topic of mutual fund performance focuses almost exclusively on pretax returns. For U.S. mutual fund investors holding positions in taxable accounts, however, what matters is the after-tax performance of their portfolios. We analyzed after-tax returns on a large sample of diversified U.S. equity mutual funds for the 1981–98 period. We found the variables that determined after-tax performance for this period to be past pretax performance, expenses, risk, style, past tax efficiency, and the recent occurrence of large net redemptions.

U.S. equity fund investors in high tax brackets lost an average of about 2.2 percentage points annually to taxes in the 1981–98 period. But despite the important impact of taxes on investor returns, published research on the topic of mutual fund performance focuses almost exclusively on pretax returns. We identify a concise set of publicly available variables that are useful for explaining the subsequent after-tax performance of U.S. equity funds. With this information, investors and their advisors are better equipped to make fund selections for taxable accounts.

The study consisted of an analysis of the returns on a large sample of diversified U.S. equity mutual funds for the 1981–98 period. The main findings from our analysis of after-tax returns are as follows: After we controlled for other factors, we found that

• funds that were historically tax efficient subsequently outperformed comparable funds on an after-tax basis,

• funds that recently experienced large net redemptions, particularly large-capitalization value funds, subsequently underperformed comparable funds on an after-tax basis,

• risk, investment style, past pretax performance, and expenses were important determinants of after-tax returns (and of pretax returns), and

• turnover in stock holdings was apparently not related to future after-tax returns.

To isolate the tax effects associated with the characteristics studied, we also analyzed mutual fund tax efficiency in the 1981–98 period. This analysis revealed that, after other factors were controlled for, funds that did not experience recent large cash redemptions, did experience recent large cash inflows, were historically tax efficient, were classified as small cap, or had high expense ratios subsequently tended to be more tax efficient. However, although funds with large cash inflows, high expense ratios, or an emphasis on small-cap stocks tended to be more tax efficient, they also tended to have lower pretax returns. In fact, the negative influence of these traits on pretax returns was at least as great as their positive influence on tax efficiency, which implies a neutral or negative net effect of the three traits on after-tax returns. These results suggest that taxable investors and their advisors should not make investment decisions with tax efficiency as their sole consideration. The focus should be on after-tax returns. We recommend, as would be the recommendation for investors holding funds in nontaxable accounts, that taxable investors diversify among investment styles (large–small, value–growth) and focus on funds with good past pretax performance and low expenses. In addition, when selecting U.S. equity funds for taxable accounts, investors should further focus on funds with high past tax efficiency that have not recently experienced large net redemptions.