PSU ACCTG 550 - Dynamic Tax Planning at Mutual Funds

Unformatted text preview:

Smeal College of Business Taxation and Management Decisions: ACCTG 550Pennsylvania State University Professor HuddartDynamic Tax Planning at Mutual Funds1. IntroductionTaxation has an important effect on investor returns. Some estimatesindicate the after-tax proceeds to a taxable mutual fund investor over a ten-year period is as much as 39% less than the pretax proceeds implied by theraw (tax-free) returns published in newspaper advertisements.1The tax costassociated with holding stock can be reduced by reducing the turnover ofappreciated securities in a portfolio. Slowing the turnover of appreciatedstockholdings has the effect of deferring the payment of capital gains.Despite the broad acceptance of the importance of taxes to investmenttrading strategies, there is little systematic documentation of the effects oftaxation on the stock trading decisions of institutional investors. Anecdotalevidence is inconsistent. One mutual fund manager we consulted stated thatalthough tax effects existed, they did not greatly affect the trading decisionsof his investment advisory practice because (i) the investment adviser’scompensation is based on pretax performance relative to an index that isnot tax-adjusted, (ii) the clients who invested in the mutual funds managedby the adviser undoubtedly faced different marginal rates of tax, and (iii)the marginal rates of tax were in any case unknown to the adviser.2On the other hand, promotional literature for one mutual fund containsthe following statement:Mutual funds generate positive returns by sellingstocks when their prices are high and reinvesting theproceeds. Shareholders, however, must pay capital gainstaxes on the gains produced by this practice, regardless of1Barbara Donnelly (February 20, 1992) “Beware Tax Consequences of Mutual Funds”Wall Street Journal p. C1. A 28% rate of tax is assumed in Donnelly’s analysis. Publishedperformance numbers for mutual funds do not take into account the effect of taxes thatinvestors must pay.2It may be that mechanisms are at work which cause some fund managers to payattention to taxes and others to ignore them. For instance, investors may sort themselvesinto tax clienteles according to the trading reputation of the fund. Low turnover funds(e.g., some growth funds) may attract high marginal tax rate taxpayers because thosefunds are most likely to postpone the recognition of capital gains. Similarly, funds withhigh turnover may be more attractive to taxpayers who face low marginal rates of tax.cSteven Huddart, 1995–2005. All rights reserved. www.smeal.psu.edu/faculty/huddartACCTG 550 Mutual Fundsthe overall value of the fund’s shares. The Schwab 1000Fund’s portfolio managers will attempt to offset taxablegains with losses realized on underperforming stocks. Thegoal of this strategy is to minimize the capital gainstax liability to shareholders and increase their after-taxreturns.32. Taxes versus information: the tradeoff• The Investment Advisers Act of 1940 regulates the contracts that deter-mine the compensation paid to investment advisers, including mutualfund managers. Commonly, these contracts provide for compensationthat is (i) a percentage of the average net assets under management,plus (ii) an incentive fee or penalty that is tied to the difference betweenthe performance of the fund and the performance of a benchmark suchas the S&P 500 index. In the compensation package, neither the per-formance of the fund nor the performance of the benchmark is adjustedfor tax effects. Consequently, mutual fund managers may face little orno incentive to consider the impact of taxation on unitholders.• Mutual fund managers constantly revise the composition of portfoliosthey manage. Capital gains triggered by the sale of appreciated securi-ties are passed through to the unitholders of the fund. Rapid portfolioturnover by fund managers accelerates the recognition of capital gainsfor fund investors.• Taxes are only one of many factors a fund manager should considerin arriving at the trading decisions of the institution he manages. Forexample,–amutual fund may be obliged to liquidate its position in manysecurities because unitholders have chosen to sell their mutual fundunits.–amutual fund may, on average, be buying securities because manyinvestors have chosen to increase their holding of the fund’s units.• Institutional fund managers may receive information about the expectedreturns of securities in coming periods. Trading on the basis of this3Pamphlet “Schwab 100 Fund” Charles Schwab & Co. Inc.Page 2Mutual Funds ACCTG 550information depends upon the rate of tax that applies to any gain orloss triggered in the portfolio. The higher the tax rate, the less desirableis a trade involving the sale of an appreciated security. Also, the tax costof an information-based trade is decreasing in the basis of the securityto be sold.• Conditional on being sold, stocks with large unrealized gains are morelikely to be sold in the first quarter than the fourth quarter, sincepostponing the sale by one quarter may postpone taxes by one year.• It is doubtful whether managers’ compensation contracts cause them toproperly internalize the tax consequences of their trading behavior onmutual fund investors.2.1 Illustration of tax and information interaction in tradingSuppose stocks A and B offer capital gains but pay no dividends. Forsimplicity, assume they offer sure returns. An investment is made in A. Aftern years, B becomes available. Stock B offers an annual return, RB, thatis greater than the annual return offered by stock A, RA. The investor’sremaining investment horizon is m years at which time he must sell hisposition. The current market value of the investor’s holding in A is $1. Thecost for tax purposes of his investment in A is c. Let the tax rate on capitalgains be t.If he holds A for his entire investment horizon, he will have(1 + RA)m(1 − t)+tc (1)dollars after tax at the end of m years. The tc term in this expression reflectsthe fact that the first c dollars of proceeds from the sale are considered to bea return of capital not subject to tax. If he sells A to buy B,hewill receive(1 − t + tc)(1 + RB)m(1 − t)+t(2)dollars after tax at the end of m years. As the holding period grows longer,the annualized return from continuing to hold A approaches RAafter tax,while the annualized return from selling A to hold B approaches RBaftertax. Thus for very long


View Full Document

PSU ACCTG 550 - Dynamic Tax Planning at Mutual Funds

Download Dynamic Tax Planning at Mutual Funds
Our administrator received your request to download this document. We will send you the file to your email shortly.
Loading Unlocking...
Login

Join to view Dynamic Tax Planning at Mutual Funds and access 3M+ class-specific study document.

or
We will never post anything without your permission.
Don't have an account?
Sign Up

Join to view Dynamic Tax Planning at Mutual Funds 2 2 and access 3M+ class-specific study document.

or

By creating an account you agree to our Privacy Policy and Terms Of Use

Already a member?