Tax-efficient mutual funds reduce an investor’s tax burden. Analysts have often also assumed that tax-efficient funds are costly because they constrain investment opportunities of mutual fund investors, thus negatively offsetting tax savings by resulting in lower returns overall.
New research from McCombs Professor Clemens Sialm and his co-author looks at the common belief that tax-efficient mutual funds constrain investment opportunities. Their data covers 414,393 monthly U.S. equity mutual fund observations recorded for the period between 1990 and 2012.
“In our research, we find that tax-efficient asset managers exhibit superior after-tax returns, as expected,” says Sialm. “What was surprising is that those same mutual funds regularly outperformed the market before taxes as well. The reason comes down to the asset managers themselves.
“Tax-efficient managers are more skilled in many different dimensions. They not only know how to reduce taxes, they also know how to lower trading costs and are also often better at picking stocks, which is notoriously difficult to do,” says Sialm.
In order to reduce taxes, tax-efficient asset managers hold on to stocks for a longer duration to avoid short-term capital gains, which are taxed at a very high rate. The managers’ patience, says Sialm, means investors save money by avoiding excessive taxes and trading fees that go along with frequent portfolio churn. Their ability to pick better stocks at the outset – even with the added requirement that those stocks not be subject to high taxes – means they generate better returns all around.
In fact, during the 23-year period studied, the mutual funds with the lowest taxes generated 5.6 percent higher returns before taxes and 21.1 percent higher returns after taxes and liquidation than mutual funds with the highest taxes.
Tax-efficiency offers a certain amount of predictability. Fund investors can increase their future after-tax performance by avoiding funds with high prior tax burdens.
“A good way to determine the tax-efficiency of a mutual fund is to look at their prior distribution behavior,” says Sialm. “Funds that made large dividend and capital gains distributions will often continue to make such distributions in the future and impose a larger tax burden on their investors.
“All things being equal,” says Sialm “by selecting mutual funds with low tax burdens, individual investors are not only reducing the amount of taxes they will pay, but are also choosing funds that are often better managed overall.”
The co-author of the study is Hanjiang Zhang of Nanyang Technological University in Singapore.
The full paper can be found online here.