Mutual Fund Tax Clienteles

Mutual Fund Tax Clienteles By Clemens Sialm Department of Finance University of Texas Austin, TX 78712 and Laura Starks Department of Finance University of Texas Austin, TX 78712

Preliminary draft April 2008

Mutual Fund Tax Clienteles Clemens Sialm and Laura Starks

Abstract Due to the growth of defined contribution assets in mutual funds, fund managers face potential heterogeneity in their shareholder tax clienteles. We hypothesize that the managers consider their particular clienteles in decisions about the fund. Consistent with this hypothesis, we find significant differences across funds according to the proportion of defined contribution assets under management. Specifically, funds differ in their characteristics and investment strategies. Despite these differences, we find no evidence that any investment constraints that may arise from the funds that pursue tax efficient management strategies result in return performance differences.

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I. Introduction The preferences of portfolio managers’ clientele should be an important part of the managers’ investment strategies. For example, portfolio managers with high net worth or trust clients commonly consider tax effects in making investment decisions. On the other hand, some managers (e.g., managers of defined benefit pension plans) have no need to consider tax effects because the portfolio is not taxed on capital gains or dividends. The decisions of both of these groups of portfolio managers are straightforward as they can focus on the tax consequences (or no tax consequences) of their portfolio decisions. Mutual fund portfolio managers, however, face a more complicated task.

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complication is caused in part because mutual funds are subject to special tax rules that require them to pass through all dividends and realized capital gains to their shareholders, in part because they are pooled investment vehicles with potentially diverse tax clienteles, and in part because their incentives may encourage them to ignore their investors’ tax situations. For many years mutual funds had primarily taxable investors, which would encourage them to include some consideration of their investors’ tax situations in their decisions despite the complexity. In line with this supposition, previous research has provided evidence that mutual fund managers consider taxes in their investment decisions (e.g., Barclay, Pearson and Weisbach, 1998; Gibson, Safieddiene, and Titman, 2000; Huddart and Narayanan, 2002; and Christoffersen, Geczy, Musto, and Reed, 2005). Further, evidence suggests that the tax efficiency of mutual funds is important for shareholders’ mutual fund choice. Morningstar provides mutual fund investors with

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information on funds’ embedded capital gains (termed “capital gains overhang”) and these tax burdens appear to affect investor inflows as documented by Bergstresser and Poterba (2002). However, mutual fund managers’ decisions have become even more complicated in recent years because the diversity of mutual fund clients’ tax status has increased with the large growth in tax-deferred assets that are being invested in mutual funds from retirement accounts that have deferred taxation. Investment in 401(k) and other defined contribution retirement plan accounts has grown significantly since the plans were first given special tax treatment by a 1978 change in tax code, and has grown even more so over the last two decades from about $1 trillion in 1991 to over $4 trillion by 2007, with more than half now invested in mutual funds. The growth of tax-deferred accounts with their investment in mutual funds implies that the mutual fund shareholders are increasingly diverse in terms of being taxable or tax-deferred. For example, the proportion of defined contribution assets in equity mutual funds has grown to 25% by 2007.1 Further the tax situation of a shareholder affects the shareholder’s preferences with respect to the fund’s investment strategy, yet there has to date been little research on whether mutual fund managers vary their investment strategies according to their tax clienteles.2 In this paper we examine whether the presence of large amounts of tax-deferred assets has affected the strategies of the mutual funds in which they are primarily invested. Using information on the amount of defined contribution assets in a broad range of funds, we address several fundamental questions. The first question is whether there exist 1

ICI, Research Fundamentals: The U.S. Retirement Market, 2nd Quarter 2007 An exception to this is Christoffersen, Geczy, Musto and Reed (2005) who document that a fund’s crossborder dividend policy varies with the level of defined contribution assets in the fund. 2

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systematic differences in mutual funds that attract retirement assets to their funds. We hypothesize that such differences should exist and that certain fund characteristics would be expected to affect the determinants of defined contribution assets in funds. The second question we address is whether the mutual fund managers’ investment strategies are related to the composition of their shareholder base. We hypothesize that if managers consider the tax preferences of their shareholders, such a relation should be found. That is, we should find differences in the investment strategies of mutual funds with high defined contribution assets as compared to those funds with low defined contribution assets and that these differences should reflect the preferences of taxable versus taxdeferred shareholders. With regard to this question, we examine two aspects of the fund managers’ investment decisions.

We examine the decisions as reflected by the

distributions of the funds (dividend distributions and capital gain distributions) and we use the disclosed mutual fund equity holdings to determine whether the tax status of the funds’ shareholders is related to the time horizon of the holdings. Finally, we address the question of whether the fund’s performance is related to the tax status of its participants. We hypothesize that maintaining the tax efficiency of a mutual fund may constrain the managers’ investment strategies, resulting in their having to give up return to achieve tax efficiency. We test whether there exist performance differences in funds according to the tax status of their shareholders. Mutual funds included in defined contribution plans are typically chosen to be included on a menu by plan sponsors and then chosen to be included in individual plans by the individuals. Although we find that the principal characteristics of mutual funds chosen by the plan sponsors and participants are similar to those chosen by mutual fund

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investors in general (e.g., lower expense ratios, low load or no load fees, higher previous returns), we also find some significant differences in the magnitudes of those characteristics with the funds with the highest amount of defined contribution assets (more than 50% of their assets) tending to have lower expense ratios and lower or no load fees, be newer funds, have greater assets under management, be part of larger families of funds, have less industry concentration, and have a larger number of stocks in the portfolio as compared to the funds with the lowest amount of defined contribution assets (less than 25% of their assets). We also find differences in investment strategies between funds with high amounts of defined contribution assets and those with low amounts. Examining both distributions and mutual fund holdings, we find that mutual funds held primarily by retirement accounts tend to be less tax-efficient than funds held primarily by taxable investors as would be expected if the mutual fund managers were considering the tax status of their shareholders. In particular, we find that long-term capital gain distributions are increasing in the proportion of defined contribution assets in the fund and that mutual funds held primarily by non-taxable investors have lower propensities to realize capital gains. Finally, we address the question of whether constraints imposed by tax efficiency needs are costly to the portfolio managers by examining whether performance differences exist between funds held primarily by retirement accounts versus those held primarily by taxable investors. We find that any such constraints do not appear to have costs in terms of lower risk-adjusted returns. Our paper is somewhat related to the literature on whether mutual fund investors take tax effects into account (Dickson, Shoven and Sialm, 2000; Bergstresser and Poterba,

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2002; Barber and Odean, 2003; Ivkovic, Poterba and Weisbenner, 2005; Ivkovic and Weisbenner, 2008; and Johnson and Poterba, 2008) in that we examine whether mutual funds differ across the taxability of the investors (reflected in the proportion of defined contribution assets in the funds’ total assets). Our paper is most closely related to the literature on mutual fund managers’ investment decisions in light of the tax consequences which provides evidence that the managers consider taxes in their decisions, but that the decision is complex (Barclay, Pearson and Weisbach, 1998; Gibson, Safieddiene, and Titman, 2000; Huddart and Narayanan, 2002; Christoffersen, Geczy, Musto, and Reed, 2005).3 For example, Barclay, Pearson and Weisbach discuss the conflict that mutual fund managers face in choosing their capital gains distribution policy. Current fund investors prefer that capital gains be deferred as long as possible, but prospective investors prefer that capital gains be realized so that they do not face premature realization of capital gains after they come on board. Barclay, Pearson and Weisbach argue that managers have an incentive to realize some capital gains (reduce the capital gain overhang) in order to attract new investors. They provide empirical evidence to back up their argument using fund flows and net asset value changes. Two other papers employ the actual trading of mutual fund managers to examine whether they consider the tax consequences of their decisions.

Gibson, Safieddine, and Titman (2000) find

evidence of tax loss selling just before a year end. Huddart and Narayanan (2002) find differences in stock sales related to tax clienteles and that these differences are persistent over time. The results of both of these papers suggest that the mutual fund managers pay attention to the tax consequences of their investment decisions. The paper closest to ours 3

In addition, the tax burden can have an effect on other decisions by mutual fund managers. Khorana and Servaes (1999) provide evidence that the level of capital gain tax overhang is associated with the decision to open a new fund in the same category.

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is that of Christoffersen, Geczy, Musto and Reed (2005) who find that in 2003 managers’ decisions with respect to cross-border dividend policy differs according to the proportion of defined contribution assets in their funds. We examine the issue from a different perspective by examining differences in manager behavior according to the proportion of defined contribution assets in their funds over the 1997 through 2006 time period. Our paper differs from the preceding papers in that we examine the differences in characteristics and performance of the mutual funds most used in defined contribution plans versus others. In addition, rather than examining the investment decision itself as is done in Gibson, Safieddiene, and Titman (2000) or Huddart and Narayanan (2002), we examine the tax outcome of the investment decisions in terms of the dividend and capital gain distributions. Christoffersen, Geczy, Musto and Reed (2005) also examine the dividend distribution, but from a different perspective. In the next section we describe our data, followed Section III in which we present our empirical results on the determinants of defined contribution assets across mutual funds. In Section IV we examine whether differences in investment strategies exist and in Section V we examine whether differences in performance exist. We conclude in Section VI.

II. Data The main data source for the size of mutual fund assets in Defined Contribution (DC) retirement accounts is based on the annual survey of mutual fund families by the publication Pensions & Investments.4 Since 1997, Pensions & Investments has conducted

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We thank David Klein from Pensions & Investments for providing us with the survey data. Additional information about the survey can be obtained from the website at http://www.pionline.com.

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an annual survey of mutual fund families that manage DC contribution plans. The surveys ask the mutual fund families to report the total assets managed in DC accounts for the mutual funds most used by DC plans in different investment categories (Domestic Equity Funds, Domestic Fixed Income Funds, International Equity Funds, Balanced Funds, Money Market Funds). We obtained data for the surveys between 1997 and 2006, covering the assets managed in DC plans as of December 31st of the year prior to the survey date. Fund families are instructed to list the dollar amount of DC plans excluding assets in IRAs, Keoghs and SARSEPs, sponsoring company stock, and assets under administration. Generally, mutual fund families are only asked in the survey to list the DC plan assets for the twelve funds in each category with the largest DC assets. Therefore, we do not have DC assets for all funds in large families. However, we know that the funds in these families that are not listed tend to have relatively low DC assets. We focus our analysis on domestic and international equity funds held by families that participate in the annual surveys. For example, in 2006, 63 mutual fund families participated in the survey. The fund families include the three largest mutual fund DC providers: Fidelity, Capital Research & Management, and Vanguard. In 2006, the survey also lists the DC plan assets of 550 equity mutual funds.5 We merge the survey data with the CRSP Survivorship Bias Free Mutual Fund database using ticker symbol and name. In addition, we merge the CRSP database with the Thompson Financial CDA/Spectrum holdings database and the CRSP stock price database using the MFLINKS file based on Wermers (2000) and available through the Wharton Research Data Services. The CRSP mutual fund database includes information 5

Out of the top 15 funds according to the DC assets, 8 are listed in the top 25 directly distributed fund share classes in Bergstresser, Chalmers and Tufano (2007) and 4 are listed in the top 25 broker distributed fund share classes.

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on fund returns, total assets under management, different types of fees, investment objectives, and other fund characteristics. The Thompson Financial database provides long positions in domestic common stock holdings of mutual funds.

The data are

collected both from reports filed by mutual funds with the SEC and from voluntary reports generated by the funds. The majority of the mutual funds in our sample disclose their holdings at a quarterly frequency over the sample period. To focus our analysis on equity mutual funds, we eliminate balanced, bond, and money market funds, as well as funds not invested primarily in equity securities.6 To avoid the incubation bias described by Evans (2004), we exclude funds which in the previous month manage less than $10 million, funds with missing fund names in the CRSP database, and funds where the year for the observation is in the same year or in an earlier year than the reported fund starting year. For funds with multiple share classes, we eliminate the duplicated funds and compute the fund-level variables by aggregating across the different share classes. Finally, we only include mutual funds from fund families that participate in the Pensions & Investments surveys. Table 1 reports summary statistics on the fund attributes in our sample of 2,008 distinct equity funds and 125,387 fund-month observations between 1997 and 2006. Since mutual funds are only asked to give the DC assets for their largest funds, we have DC values for 57,564 fund-month observations. However, the funds with the available DC values account for 82.7 percent of the assets under management.

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We select funds according to their S&P objectives: Domestic Equity Funds (AGG, GMC, GRI, GRO, ING, SCG), Sector Funds (ENV, FIN, GLD, HLT, NTR, RLE, SEC, TEC, UTI), and International Equity Funds (ECH, ECN, EGG, EGS, EGT, EGX, EID, EIG, EIS, EIT, EJP, ELT, EPC, EPX, EPR, ESC, GLE, JPN, PAC). Mutual funds that, on average, hold less than 80 percent of common stocks are also classified as non-equity funds.

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Figure 1 shows the distribution of the proportions of mutual fund assets held in DC plans according to the Pensions & Investments survey.

The proportion ranges

between zero and 100 percent and averages 24.23 percent. Around 11.7 percent of these mutual funds have a majority of their assets held in DC plans. The proportion of assets held in DC plans underestimates the proportion of assets held in tax-qualified accounts because mutual funds can be held in Individual Retirement Accounts (IRAs), Keoghs, and other tax-qualified investment vehicles. Investment Companies that are registered under the Investment Company Act of 1940 can avoid taxation at the corporate level if they pass-through 98% of their dividend and capital gains income to the fund shareholders on an annual basis.

Thus, an

investment company distributing all its income to its shareholders would have no tax liability.

However, these distributions are taxable to the mutual fund shareholder,

whether or not that shareholder had been holding the stock when the gain was received. Thus, when funds realize capital gains, they accelerate the payment of taxes on those gains for their current shareholders. Alternatively if the funds have price appreciation on their shares, but have not sold them, they have a capital gain tax “overhang” that is faced by current shareholders as well as future shareholders.7 Before distributing dividends and capital gains, mutual funds usually subtract the fund expenses from the income. We obtain the distributions of dividends and short- and long-term capital gains from the CRSP mutual fund database. In a small number of cases representing only 2.9 percent of the total value of capital gains distribution, the CRSP

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The Audit and Accounting Guide for Investment Companies issued by the American Institute of Certified Public Accountants (AICPA) includes a detailed description of the tax treatment of mutual funds.

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mutual fund database does not classify the term of the capital gains, In these cases, we assume that unclassified gains correspond to long-term capital gains. Table 1 gives the summary statistics for the funds’ dividend and capital gains distribution yields over the prior year. The distribution yields are computed by adding the dollar value of the dividends and capital gains distributions per mutual fund share over the prior 12 months and dividing it by the net asset value (NAV) at the beginning of the 12-month period. Mutual funds distributed on average 0.58 percent of the initial value as dividends, 1.07 percent as short-term capital gains, and 3.10 percent as longterm capital gains. The dividend distributions are relatively small because mutual funds distribute dividend income after subtracting their expenses. Figure 2 depicts the time series variation in the average dividend and capital gains distributions over our sample period. To obtain a measure of the overall tax costs of an equity mutual fund, we define the tax burden (TB) as: TBf ,t = τ tDIV y fDIV + τ tSCG y fSCG + τ tLCG y fLCG , ,t ,t ,t

(1)

where τDIV, τSCG, and τLCG are the marginal income tax rates on dividends and short- and long-term capital gains, respectively and yDIV, ySCG, and yLCG are the dividend and shortand long-term capital gains yields, respectively. We use the top federal marginal income tax rates as described in Sialm (2007) as the relevant tax rates. Thus, the tax burden captures the total tax costs as a percentage of the assets under management from dividend and capital gains taxation However, the tax burden captures only the direct tax costs based on mutual fund distributions. It ignores any tax costs that occur if an investor liquidates a mutual fund and realizes additional capital gains on the mutual fund trades.

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Figure 3 summarizes the time-series variation of dividend and capital gains taxes since 1997. The most significant change in tax laws over our sample period was the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003, which reduced the marginal tax rate on qualified dividends and long-term capital gains to 15 percent. The tax burden averages 1.15 percent per year and exhibits significant cross-sectional variation.

Whereas around one-quarter of mutual funds do not make any taxable

distributions, one-quarter of funds have tax burdens exceeding 1.5 percent per year. It is notable that the tax costs of mutual funds are of a similar order of magnitude as the expense ratios of the mutual funds. Using the periodical equity holdings from Thompson Financial, we obtain a measure of the short- and long-term capital gains overhang of a mutual fund. Specifically, at the end of every quarter we compute for each position the unrealized capital gain as the percentage difference between the current price of the position and the price of the position on the last trading day in the quarter the position was acquired. If the current position was acquired during multiple quarters, then we compute the weighted average capital gain of the different lots. An unrealized capital gain is classified as shortterm if the position has been held for less than four quarters. The unrealized short-term and long-term capital gains are then aggregated over all stock positions of a fund. As Table 1 shows, the short-and long-term capital gain overhangs equal 0.72 and 6.16 percent, respectively. The large standard deviations of these capital gain overhangs indicate that there are significant cross-sectional differences in tax overhangs. Table 1 reports additional summary statistics for fund characteristics used in our paper. The average investor return of mutual funds in our sample equals 0.73 percent per

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month with a standard deviation of 5.22 percent. We compute the gross holdings return based on the most recently disclosed quarter-end Thompson equity holdings and the asset allocation weights from CRSP. The holdings database includes only long positions in domestic common stocks and excludes other non-equity holdings.

To adjust fund

holdings returns for various asset classes, we proxy for these asset returns using published indices. For bonds and preferred stocks we use the total return of the Lehman Brothers Aggregate Bond Index, while for cash holdings and other assets we use the Treasury bill rate. The mean gross holdings return equals 0.81 percent per month and has a correlation of 92.7 percent with the net investor return across the mutual funds in our sample. The mean assets under management per fund equals $2.06 billion and the average fund family in our sample manages $85.30 billion in aggregate. The average age of a fund is about 12 years with a standard deviation of 8 years. The mean expense ratio is 1.29 percent per year and the mean turnover ratio is about 88 percent per year. Since we focus our analysis on equity funds, the vast majority of the assets are invested in common stocks (94.70 percent) and cash (3.93 percent).

Bonds, preferred stocks, and other

securities comprise a relatively small proportion of the total holdings. Based on the CRSP data we compute the new money growth (NMG), which is defined as the growth rate of the assets under management after adjusting for the appreciation of the mutual fund’s assets (RFt), assuming that all the cash flows are invested at the end of the period: NMGf ,t =

TNAf ,t − TNAf ,t −1 (1 + RFf ,t ) TNAf ,t −1

(2)

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Since estimated fund flows are very volatile, we winsorize both the top and the bottom parts of the distribution at the 1 percent level. The winsorized new money growth rate has a mean of 1.73 percent per month and a standard deviation of 6.06 percent over the prior year. The number of stocks is computed based on the holdings information from Thompson Financial and the Industry Concentration Index (ICI) is computed following Kacperczyk, Sialm, and Zheng (2005) as the concentration of the stock portfolio in ten broadly defined industries.8

The average fund holds approximately 135 stocks and

exhibits an ICI of 14.60 percent. Table 1 summarizes holdings-based style characteristics for the mutual funds in our sample.

We group fund holdings according to their size, book-to-market, and

momentum characteristics as proposed by Daniel, Grinblatt, Titman, and Wermers (1997). Each stock listed in CRSP is grouped into respective quintiles according to its market value (using NYSE cutoff levels), its industry-adjusted book-to-market ratio, and its lagged one-year return.

Using the quintile information, we compute the value-

weighted size, value, and momentum scores for each mutual fund in each period. For example, a mutual fund that invests only in stocks in the smallest size quintile has a size score of one, whereas a mutual fund that invests only in the largest size quintile has a size score of five. Mutual funds in our sample tend to hold stocks in the largest size quintile and have a slight bias towards growth and momentum stocks.

The Industry Concentration Index of fund f at time t is defined as ICIf,t = Σj (wf,t,j – wm,t,j)2, where wf,t,j is the value weight of the stocks held by the mutual fund in the j-th industry and wm,t,j is the weight of the CRSP total market portfolio corresponding to the j-th industry. 8

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The last four rows of Table 1 indicate that 5.97 percent of all funds in our sample are index funds, 1.54 percent are tax-efficient funds, 13.63 percent are sector funds, and 15.91 percent are international funds.9

III. Determinants of Defined Contribution Assets in Mutual Funds Typically the plan sponsors of defined contribution plans offer the participants a menu of investment opportunities and the participants choose their investments from these menus. According to a 2005/2006 survey of plan sponsors by Deloitte Consulting (2006), 17 percent of the responding plans had fewer than 10 investment options, while 19 percent of plans had at least 20 investment options, with most of the options being mutual funds. Thus, the presence of defined contribution assets in a mutual fund depends on both the plan sponsor’s choice and the individual participant’s choice.10 The first question we address is whether certain mutual fund characteristics attract plan sponsors and participants to a particular fund. We divide the mutual funds in our sample into three groups according to the ratio of defined contribution assets to total assets invested in the fund.

For each group we calculate average mutual fund

characteristics using annual data and we test for differences across the low and high DC ratio groups, where we cluster the standard errors by fund. We present the results of this analysis in Table 2. Since we do not have data for all of the funds, in the first column we include average characteristics for a fourth group, the funds with missing data (which by definition should be funds with very low or no 9

The classification of index funds and tax-efficient funds is made according to the fund names. We identify sector and international funds by their S&P objective classifications. 10 In some defined contribution plans, the participants are offered the choice of a brokerage account window which widens the mutual fund choices to thousands of funds, making the mutual fund choice a decision of just the participant and not the plan sponsor.

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amounts of defined contribution assets because they were not reported as one of the funds with a significant amount of such assets). In the remaining three columns of the table we show the average characteristics for the three defined contribution groups.

Overall the

results show that defined contribution assets are a significant portion of many funds’ assets under management. The first group has a low ratio of DC assets (defined as less than 25%), but these assets still average 11.45% of total assets. The second group is defined as those with between 25% and 50% of DC assets. Their average is 35.04% of DC assets. Finally, the highest DC group is defined as those funds with at least 50% of their assets being DC assets, averaging 71.28%. It should also be noted that there exist differing numbers of funds in the three DC groups with the lowest DC ratio group having the greatest number of fund observations and the highest DC ratio group having the least. Thus, most funds still do not have a significant amount of DC assets. Table 2 also shows that many of the mutual fund characteristics differ significantly across the groups. The funds in the highest DC ratio group have lower average expenses, lower average loads, are relatively newer, have greater assets under management, are part of larger families of funds, have less industry concentration, and have a larger number of stocks in the portfolio. Although one might expect high DC ratio funds to have a steady flow of new money continually coming into the fund, we find no significant differences across the funds in their mean growth rate in new money nor in the variability of that growth rate. The table also shows that a significant difference exists in the proportion of funds in the groups that are index funds with a large clustering of index funds in the highest DC ratio group. Over 16% are index funds as compared to under 5% for the other two

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groups. This is consistent with the findings of the Investment Company Institute that about 45-47% of all index fund assets are either defined contribution accounts or individual retirement accounts.

The high level of index funds in the highest DC ratio

group may also explain some of the differences across the characteristics between the highest and lowest DC asset groups, in particular, the lower expenses, lower turnover and higher number of stocks held in the highest group would be influenced by the presence of index funds. When we remove the index funds (not shown), we find that the highest DC ratio funds are still cheaper (in terms of both expenses and loads), relatively newer and have less industry concentration in their portfolios. There exist many reasons for mutual fund managers to trade securities other than for tax purposes. To capture some of these reasons we examine other characteristics of the mutual fund holdings for differences across the DC asset groups. We calculate the average percentage stock and cash allocations in each group as well as the size score, book-to-market score, and momentum score (described in the last section) and find no significant differences across any of these characteristics. Finally we examine the shortterm and long-term capital gain overhangs for each fund and find no significant differences for these characteristics either. Table 2 provides a univariate perspective of which individual mutual fund characteristics are associated with assets held in defined contribution plans.

In a

multivariate test of these factors, we regress the logarithm of the size of fund assets invested by defined contribution participants against the characteristics of the mutual funds. Because we do not have information on the individual retirement accounts or all of the defined contribution assets in funds, we run a censored normal regression. For

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comparison purposes we also run a regression of the log of funds’ total assets against the characteristics of the funds. The results are provided in Table 3 with the regression results for the determinants of the funds’ DC assets in the first column and the regression for the determinants of the funds’ total assets in the second column. Comparing the coefficients from the first column with those of the second, it appears that the size of the defined contribution assets in a fund depend on many of the same characteristics that attract all mutual fund investors, taxable and tax-deferred alike, to the funds: larger size of the fund family, older funds, lower expenses, lower turnover, higher previous abnormal returns and higher risk. It also appears that differences exist across these characteristics in terms of the magnitude of their coefficients. In particular, it appears that defined contribution participants are especially attracted to larger fund families. This should not be surprising since some of the largest fund families (e.g., Vanguard, T. Rowe Price, Fidelity) provide recordkeeping services to defined contribution plans and their funds are typically included in the choices for these plans.11 Comparisons of the regression results also suggest that defined contribution plan participants are more attracted to older funds and to lower expense funds. The attraction to abnormal returns is consistent with the results of Del Guercio and Tkac (2002) particularly considering that the choices of plan sponsors would resemble those of institutional investors more than individual investors. While the total assets in a fund are larger for funds with load fees, this is not the case for defined contribution assets – they are more likely to be in funds without load fees.

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See, for example, “Vanguard, T. Rowe Win Highest Rankings from 401(k) Plan Sponsors,” Managing 401(k) Plans, April 2005.

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IV. Differences in Investment Strategies A. Evidence from Mutual Fund Distributions In this section we consider hypotheses related to the investment strategies of funds with taxable versus nontaxable investors.

Portfolio managers with primarily

taxable investors would be interested in improving the tax-efficiency of their funds. Since taxable investors have to pay tax on the fund’s dividend and capital gains distributions, the portfolio manager can take several actions that would lower the taxes faced by the investors in a given year. First, they can tilt their portfolios toward stocks with low dividend yields, lowering the dividend distributions. Second, the managers can defer the realization of capital gains (by not selling stocks with appreciated prices). Third the managers can accelerate the realization of capital losses (by selling stocks with depreciated prices). These potential activities imply that if managers consider the tax profiles of their shareholders (as suggested by the previous work of Barclay, Pearson and Weisbach, 1998; Gibson, Safieddiene, and Titman, 2000; Huddart and Narayanan, 2002; and Christoffersen, Geczy, Musto, and Reed, 2005), funds with low proportions of defined contribution assets should have different distribution patterns than those with high proportions of such assets. That is, we should expect to see, controlling for other differences, significant differences across dividend yields and capital gain distributions for these funds.

1. Determinants of Mutual Fund Distributions We first employ a univariate analysis to test the hypothesis that the distribution characteristics of mutual funds should vary according to the proportion of defined

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contribution assets. We divide the sample funds into three groups according to the mutual fund’s ratio of DC assets and include a fourth group for funds for which the DC asset information is missing. The results, shown in Table 4, indicate that there are no economically or statistically significant differences between funds held primarily by DC plans and the other funds. It is interesting that funds that are held primarily by taxable investors tend to distribute relatively large dividends and capital gains, indicating that these funds do not take full advantage of opportunities to defer capital gains for their investors. Investors holding index funds would have been burdened by significantly smaller taxes than a taxable investor in a typical actively-managed mutual fund. For example, investors holding the Vanguard 500 Index fund would have received dividend distributions of 1.48 percent, and short- and long-term capital gains distributions of just 0.05 and 0.15 percent over our sample period. These results are consistent with those of Barber and Odean (2003) who examine the differences in distribution characteristics for mutual funds held by individual investors in taxable versus nontaxable accounts over the 1991-1996 time period. Although they find statistically significant differences in distributions, they did not find economically significant differences. They find the difference in dividend yield to be only 4 basis points and the differences in capital gains distributions to range from 23 to 42 basis points. Although the results in Table 4 as well as the Barber and Odean (2003) results suggest that distributions do not differ across funds with different proportions of DC assets, it may be the case that other variations across the mutual funds mask systematic

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differences in distributions that exist. Thus, to more completely test our hypothesis we examine the determinants of mutual fund distributions in a multivariate framework that includes the proportion of defined contribution assets in the mutual fund as an independent variable. Our major control variables are the return and risk of the fund over the previous 36 months, the flows and variation in flows to the fund over the previous year, the funds’ expenses, load, turnover, size, size of family, age, and type of fund. We also control for time fixed effects and cluster the standard errors by fund. Table 5 shows the results of these regressions where our dependent variables are the fund’s distributions normalized by net asset value: the dividend yield, short term capital gains distribution yield, long term capital gains distribution yield, and total capital gains distribution yield. Our independent variable of interest is the ratio of defined contribution assets to total assets (DC ratio). We also include an additional control variable by interacting the DC ratio with an indicator variable for whether the fund is an index fund. The first column of Table 5 shows the results when the fund’s dividend yield is the dependent variable. Contrary to our hypothesis, the coefficient on the ratio of DC assets is negative, indicating that funds with more DC assets have smaller distributions. Although this may seem counter to a tax management stance on the part of fund managers, it is more likely a reflection that DC plan participants tend to choose capital appreciation over current income to fund their future retirement. However, the economic significance of this dividend yield effect is relatively small. The coefficient estimate indicates that a 10 percentage point increase in the DC ratio decreases the dividend distributions by 0.02 percentage points.

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Since expenses are deducted from the dividend distribution before it is declared, dividend yield is naturally decreasing in expenses. The significantly positive coefficients on sector funds and international funds are due to the proliferation of utility sector funds and UK and European firms, respectively. The second column presents the results when the short-term capital gains distribution is the dependent variable.

We find no significant differences in the

proportion of defined contribution assets for these distributions. As would be expected, there exists a positive relation between the short-term capital gains overhang at the end of the prior quarter and the short-term capital gain distribution. Consistent with that result, we find that the short-term capital gain distribution is decreasing in the new money invested in the fund over the previous 12 months and in the funds’ turnover. Since stock returns, redemptions and turnover each increase the likelihood of having to realize capital gains, these results are not surprising. For the long term capital gains distribution and the total capital gains distribution (shown in columns 3 and 4), we find, as hypothesized, that the distributions are increasing in the proportion of defined contribution assets. We find that a ten percentage point increase in the DC ratio increases total short- and long-term capital gains distributions by 0.24 percentage points. Consistent with Dickson, Shoven, and Sialm (2000), we find that funds that experience negative or highly volatile new money growth over the prior year tend to distribute higher capital gains since these funds are more likely that the fund will have to sell off shares and recognize capital gains.

We find that short-term capital gains

distributions tend to increase and long-term capital gains distributions tend to decrease

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with a fund’s turnover. Not surprisingly, index funds tend to distribute significantly lower capital gains than actively managed funds.

2. Changes in Distributions around the 2003 Tax Law Reforms During our sample period the tax code was reformed in 2003. As described previously, Figure 3 shows the levels of the highest marginal tax rates throughout our sample period and the effects of the 2003 tax law reforms.

The tax rate on dividends

reduced from a high of 38.6 to 15 percent for qualified dividends, short-term capital gains rates reduced from 38.6 to 35 percent, and long-term capital gains rates reduced from 20% to 15%. Given the 2003 tax law changes, one would expect that if portfolio managers are considering taxes in their decisions, there would be changes in the ways in which taxes affect investment strategies. In fact, Gibson, Safieddine, and Titman (2000) find this to be the case in the tax law changes of 1986. Consequently in Table 6 we repeat the analysis in Table 5, adding an indicator variable to capture differences in the fund distributions around 2003. To capture the time effects in fund distributions we control for a linear time trend instead of for annual fixed effects. Consistent with Chetty and Saez (2005) and Brown, Liang, and Weisbenner (2007), which find that companies tend to increase dividend payouts after the 2003 tax reform, we find that the dividend yield increases after 2002.12 However, the change in the dividend yield around 2003 does not differ between funds held primarily in taxable accounts and funds held in employersponsored retirement accounts. Similarly, we show that short- and long-term capital

12

Perez-Gonzales (2003) shows that dividend payouts increase in years when dividends are less taxdisadvantaged relative to capital gains for firms whose large shareholders are affected by these tax reforms.

23

gains distributions increased after 2002.

However, the increase in capital gains

realizations after 2002 is slightly more pronounced for funds with high DC ratios.

B. Evidence from Mutual Fund Holdings Beyond examining distributions to infer the effect of taxes on managers’ investment decisions, we also examine the funds’ holdings and changes in those holdings. Figure 4 shows the hazard rate of mutual fund liquidations by the duration of the holdings. As the figure shows, funds with a high level of defined contribution assets (greater than 50%) are less likely to liquidate a position at every holding period than are funds with a low level of defined contribution assets. In Figure 5, we examine the hazard rate by capital gains amount. We show the hazard rate for all capital gains in Panel A, for short-term capital gains (those that have been held less than four quarters) in Panel B and for long-term capital gains (those that have been held for four quarters or more) in Panel B. Panel A shows that for all capital gains the low DC funds appear to engage in tax efficient strategies relative to the high DC funds. There exists a wider spread in the hazard rate between the high and low DC funds for firms with capital losses than for firms with capital gains. This is even more the case when one examines the short-term holdings in Panel B. We employ a linear probability model to determine whether differences in liquidation decisions vary between funds with large amounts of DC assets and those without such large amounts. We present the results from the model in Table 7 where the dependent variable in the first three columns is an indicator variable if the fund liquidates a position and the dependent variable in the last three columns is the proportion of the

24

fund position liquidated. We first examine the unconditional trading in the funds. As Table 7 shows, the longer a position is held, the less likely the fund is to liquidate that position, but that relation is convex as the duration squared measure is positive. Not surprisingly, index funds are less likely to liquidate a position. The high DC ratio funds are less likely to liquidate a position unconditionally, which would be the case if the low DC ratio funds were employing a tax management strategy. We find that the interaction terms between the length of the position (short-term or long-term) and the magnitude of the capital loss or gain are generally positive. The first column indicates that mutual funds are more likely to liquidate a position if the capital loss or the capital gain is relatively large. The coefficients tend to be significantly larger for capital losses indicating that mutual funds are more likely to sell a stock with a capital loss than a stock with a similar capital gain. This behavior is consistent with momentum strategies followed by funds (Grinblatt, Titman, and Wermers, 1995) or with tax sensitive investment strategies, which require funds to realize short-term capital losses. For example, the propensity for a mutual fund to liquidate a position held for less than four quarters increases by 3.52 percent if a position exhibits a ten percentage point larger capital loss. On the other hand, the propensity for a mutual fund to liquidate a position held for less than four quarters increases by 0.21 percent if a position exhibits a ten percentage point larger capital gain. The impact of capital gains or losses on longterm positions on fund liquidations is smaller than on short-term positions. For example, if a fund holds a position for at least four quarters, then the probability of liquidation does not depend significantly on the size of the gain. Column 4 indicates that the results are

25

very similar if we use the proportion of a position sold in a given quarter as the dependent variable. The second column tests whether the propensities to liquidate positions with certain capital gains or losses depend on the DC ratio of a fund. We find that funds that are held primarily in DC accounts are significantly less likely to realize short-term capital losses and they are significantly more likely to realize short-term capital gains than funds with low DC assets. This behavior is consistent with our hypothesis that funds held in DC plans are less sensitive to tax considerations than funds held primarily outside DC plans. The third column includes additional interaction effects with index funds. Controlling separately for index funds tends to magnify the effects reported in the second column. This result is plausible because index funds tend to be less sensitive to past performance than actively managed mutual funds. The results based on the portfolio holdings confirm our results based on fund distributions. Mutual funds held in retirement accounts tend to be less tax-efficient than funds held primarily by taxable investors. However, mutual funds held primarily by taxable investors still have relatively high propensities to realize capital gains.

IV. Differences in Performance Mutual fund managers who consider tax efficiency in their investment decisions face a more constrained investment opportunity set than those mutual fund managers who do not consider tax efficiency. The issue that we address in this section is whether such tax efficiency activities cause the manager to give up return and consequently lead to lower before-tax performance. If this is the case, we would expect to find systematic

26

differences in returns between funds with substantial levels of DC assets versus those without as the former do not need to be as concerned with the tax efficiency of their portfolio. To evaluate these differences, we employ seven different measures of mutual fund return performance.

We again divide the mutual funds into three different groups

according to their lagged DC ratio and include also the group of mutual funds with missing DC data, giving us four different groups in which we employ each model over the sample period to obtain average performance for the group. The results, based on monthly returns, are shown in Table 8 with the first column showing the return performance measures for the missing DC data group followed by the three DC asset groups from lowest to highest. The last column shows the results from tests of the differences in performance between the lowest and highest DC ratio groups. Our first return measure is simple raw return. Although the missing DC data group has a marginally significantly positive raw return, the remaining groups do not and there are no significant differences in returns between the lowest and highest DC group. We also examine several risk-adjusted measures of return.

We first employ the

alpha from the capital asset pricing model: Ri,t–RF,t = αi + βi,M(RM,t–RF,t) + εi,t

(3)

where Ri,t–RF,t and RM,t–RF,t are the monthly excess returns on the fund portfolio and the market portfolio respectively. We also estimate alphas from the Fama-French model (Fama and French, 1993): Ri,t–RF,t = αi + βi,M(RM,t–RF,t) + βi,SMBSMBt + βi,HMLHMLt + εi,t

(4)

and the Carhart model (Carhart, 1997):

27

Ri,t–RF,t = αi + βi,M(RM,t–RF,t) + βi,SMBSMBt + βi,HMLHMLt + βi,UMDUMDt + εi,t where SMBt

,

(5)

HMLt and UMDt are the monthly size, value and momentum factor

portfolios. Using these models, we find that the funds show little significant outperformance on average over the sample period. We also find that the funds with reported DC assets tend to have significantly negative future alphas when employing the Fama-French or FamaFrench-Carhart models. However, we find no significant differences in these alphas across the levels of DC assets. To this point our performance measures are based on the monthly returns of the funds and the benchmark portfolios. Alternatively we employ two measures to evaluate the return performance of the funds using their actual holdings. We first use the DGTW selectivity model (Daniels, Grinblatt, Titman, and Wermers, 1997) DGTWi,t = Σk wi,k,t-1 Rk,t – Σk wi,k,t-1 BRk,t

(6)

where wi,k,t-1 is the weight of stock k in fund i’s portfolio for period t-1, Rk,t is the return on stock k for period t and BRk,t is the characteristic-based benchmark return for stock k for period t.

Finally we estimate the return gap as developed by Kacperczyk, Sialm, and

Zheng (2007): RGi,t = Ri,t – Σk wi,k,t-1 Rk,t .

(7)

Again when employing performance evaluations based on the funds’ holdings rather than their returns, we find no significant difference between the high and low DC ratio funds in any of the return measures. It is interesting that funds with very small amounts invested in DC accounts, i.e., funds with missing DC ratios, tend to exhibit slightly superior performance measures than funds with low DC ratios.

28

In Table 9 we take our analysis further by conducting a more comprehensive test of the hypothesis that engaging in tax efficient strategies constrains a manager’s choices and can lead to lower investment returns. If we assume that funds with fewer DC assets have more constrained investment strategies because of the need to engage in tax efficient strategies, then we should examine whether the funds’ performance is related to lagged characteristics of the fund, including whether the ratio of DC assets to total assets affects the performance. We find that while some fund characteristics affect the performance of the funds, the presence of a large amount of DC assets does not improve the future performance of a fund as one would presume if tax efficient strategies affect the managers’ opportunity sets.

The presence of DC assets actually lowers the future

performance of the fund using the CAPM alpha, whereas the DC ratio has no significant impact on future fund performance using the other performance measures. We find that an indicator for index funds has a negative coefficient for the performance of funds under the CAPM, Fama-French, Carhart and DGTW models and an interaction term between DC assets and the index fund indicator variable for whether the fund is an index fund has a significantly positive relation with the Fama-French and Carhart alphas. This result is most likely due to the result shown in Table 8 that the funds in our sample in general underperformed according to these measures.

V. Conclusions In this paper we examine whether the preferences of portfolio managers’ clientele are an important part of the managers’ investment strategies as reflected in differences across mutual funds with primarily tax-deferred accounts as compared to other mutual

29

funds. Using information on the amount of defined contribution assets in a sample of mutual funds that covers the largest fund families, we develop and test several hypotheses regarding differences across mutual funds. We first hypothesize that plan sponsors and their participants would be attracted to certain fund characteristics.

Consistent with this hypothesis we find significant

differences in the characteristics of funds with the highest amount of defined contribution assets (more than 50% of their assets) as compared to funds with the lowest amount of defined contribution assets (less than 25% of their assets). The high DC funds tend to have lower expense ratios, lower or no load fees, be newer funds, have greater assets under management, be part of larger families of funds, have less industry concentration, and have a larger number of stocks in the portfolio as compared to the funds. Some of these differences imply that plan sponsors are selective in their choice of funds to include on the plan platform. Our second hypothesis addresses differences in mutual fund investment strategies across funds with different proportions of defined contribution assets.

That is, we

hypothesize that if managers consider the tax preferences of their shareholders, we should find differences in the investment strategies of mutual funds with high defined contribution assets as compared to those funds with low defined contribution assets and that these differences should reflect the preferences of tax-deferred versus taxable shareholders. Using two types of empirical tests, tests on mutual fund distributions and tests on mutual fund holdings, we document that such differences exist. We find that mutual funds held primarily taxable investors tend to be more tax-efficient than funds held primarily by retirement account holders. In particular, we find that long-term capital

30

gain distributions are increasing in the proportion of defined contribution assets in the fund and that mutual funds held primarily by non-taxable investors have lower propensities to realize capital gains. These results suggest that mutual fund managers of funds held primarily by taxable investors consider the tax consequences of their investment decisions. Finally, we hypothesize that maintaining the tax efficiency of a mutual fund may constrain the managers’ investment strategies, resulting in lower returns for the tax efficient funds. We do not find significant performance differences between funds held primarily by retirement accounts versus those held primarily by taxable investors, suggesting that any constraints faced by tax efficient fund managers do not appear to have costs in terms of lower risk-adjusted returns or the fund managers are not practicing tax efficiency to the extent it is affecting their performance. Overall, our evidence shows that mutual fund managers appear to consider the tax consequences of their actions when they have a smaller component of defined contribution plan shareholders. However, even in this case the tax considerations do not appear to be of first-order importance as one would expect with a diverse clientele. The question that arises is how the tax considerations will evolve as defined contribution plans become the dominant shareholders of mutual funds.

31

References Barber, B. and T. Odean, 2004, Are Individual Investors Tax Savvy? Asset Location Evidence from Retail and Discount Brokerage Accounts, Journal of Public Economics 88, 419-442. Barclay, M., N. Pearson, and M. Weisbach, 1998, Open End Mutual Funds and Capital Gains Taxes, Journal of Financial Economics 49, 3-43. Bergstresser, D., J. Chalmers, and P. Tufano, 2007, Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry, working paper. Bergstresser, D. and J. Poterba, 2002, Do After-Tax Returns Affect Mutual Fund Inflows? Journal of Financial Economics 63, 381-414. Brown, J., N. Liang, and S. Weisbenner, 2007, Executive Financial Incentives and Payout Policy: Firm Responses to the 2003 Dividend Tax Cut, Journal of Finance 62, 19351965. Carhart, M., 1997, On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57–82. Chay, J. B., Dosoung Choi, and J. Pontiff, 2006, Market Valuation of Tax-Timing Options: Evidence from Capital Gains Distributions, Journal of Finance 61, 837865. Chetty, R. and E. Saez, 2005, Dividend Taxes and Corporate Behavior: Evidence from the 2003 Dividend Tax Cut, Quarterly Journal of Economics 120, 791-833. Christoffersen, S., C. Geczy, D. Musto, and A. Reed, 2005, Cross-border Dividend Taxation and the Preferences of Taxable and Non-taxable Investors: Evidence from Canada, Journal of Financial Economics 78, 121-144. Daniel, K., M. Grinblatt, S. Titman, and R. Wermers, 1997, Measuring Mutual Fund Performance with Characteristic-Based Benchmarks, Journal of Finance 52, 10351058. Del Guercio, D., and P. Tkac, 2002, The Determinants of the Flow of Funds of Managed Portfolios: Mutual Funds versus Pension Funds,” Journal of Financial and Quantitative Analysis 37, 523-557. Deloitte Consulting, 2006, Annual 401(k) Benchmarking Survey: 2005/2006 Edition. Dickson, J., and J. Shoven, 1995, Taxation and Mutual Funds: An Investor Perspective, Tax Policy and the Economy 9, 151-180. Dickson, J., J. Shoven, and C. Sialm, 2000, Tax Externalities of Equity Mutual Funds, National Tax Journal 53, 607-628. Elton, E., Martin Gruber, and Christopher Blake, 2006, The Adequacy of Investment Choices Offered By 401K Plans, Journal of Public Economics 90, 1299-1314. Elton, E., Martin Gruber, and Christopher Blake, 2007, Participant Reaction and the Performance of Funds Offered by 401(k) Plans, Journal of Financial Intermediation 16, 240-271. 32

Evans, R., 2007, Does Alpha Really Matter? Evidence from Mutual Fund Incubation, Termination and Manager Change, working paper, Boston College. Fama, E., and K. French, 1993, Common Risk Factors in the Returns on Stocks and Bonds, Journal of Financial Economics 33, 3–56. Ferson, W., Schadt, R., 1996. Measuring Fund Strategy and Performance in Changing Economic Conditions, Journal of Finance 51, 425–461. Gibson, S., A. Safieddine and S. Titman, 2000, Tax Motivated Trading and Price Pressure: An Analysis of Mutual Fund Holdings, Journal of Financial and Quantitative Analysis 35, 369–386. Graham, J., and A. Kumar, 2006, Do Dividend Clienteles Exist? Evidence on Dividend Preferences of Retail Investors, Journal of Finance 61, 1305-1336. Grinblatt, M., S. Titman, and R. Wermers, 1995, Momentum Investment Strategies, Portfolio Performance, and Herding: A Study of Mutual Fund Behavior, American Economic Review, 1088-1105. Huddart, S., and V. Narayanan, 2002, An Empirical Examination of Tax Factors and Mutual Funds' Stock Sales Decisions, Review of Accounting Studies 7, 319–341. Investment Company Institute, 2007, Trends in the Ownership of Mutual Funds in the United States. Ivković, Z., J. Poterba, and S. Weisbenner, 2005, Tax Loss Trading by Individual Investors, American Economic Review 95, 1605-1630. Ivković, Z. and S. Weisbenner, 2007, ‘Old Money Matters: The Sensitivity of Mutual Fund Redemption Decisions to Fund Characteristics, working paper, Michigan State University and University of Illinois at Urbana-Champaign. Johnson, W., 2004, Predictable Investment Horizons and Wealth Transfers Among Mutual Fund Shareholders, Journal of Finance 59, 1979-2012. Johnson, W., and J. Poterba, 2008, Taxes and Mutual Fund Inflows around Distribution Dates, working paper, University of Oregon and MIT. Kacperczyk, M., C. Sialm, and L. Zheng, 2007, Unobserved Actions of Mutual Funds, Review of Financial Studies, forthcoming. Kacperczyk, M., C. Sialm, and L. Zheng, 2005, On the Industry Concentration of Actively Managed Equity Mutual Funds, Journal of Finance 60, 1982-2012. Khorana, A. and H. Servaes, 1999, The Determinants of Mutual Fund Starts, Review of Financial Studies 12, 1043-1074. Perez-Gonzalez, F., 2003, Large Shareholders and Dividends: Evidence from U.S. Tax Reforms, working paper, Columbia University. Plancich, S., 2003, Mutual Fund Capital Gain Distributions and the Tax Reform Act of 1997, National Tax Journal 56, 271-296. Sialm, C., 2007, Tax Changes and Asset Pricing, working paper, University of Texas at Austin.

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Wermers, R., 2000, Mutual Fund Performance: An Empirical Decomposition into StockPicking Talent, Style, Transaction Costs, and Expenses, Journal of Finance 55, 1655-1702

34

Table 1: Summary Statistics This table presents the summary statistics for the sample of equity mutual funds over the period 1997 to 2006. Mean DC Ratio (Proportion of Assets held in Defined Contribution Plans) (in %) Dividend Yield over Prior Year (in % per year) Short-Term Capital Gains Yield over Prior Year (in % per year) Long-Term Capital Gains Yield over Prior Year (in % per year) Total Distribution Yield over Prior Year (in % per year) Tax Burden (in % per year) Short Term Capital Gains Overhang (in %) Long Term Capital Gains Overhang (in %) Investor Return (in % per month) Standard Deviation of Investor Returns over Prior Year (in % per month) Holdings Return (in % per month) TNA (Total Net Assets) (in Billions) Family TNA (in Billions) Age Expense Ratio (in %) Total Maximum Load (in %) Proportion Invested in Stocks (in %) Proportion Invested in Cash (in %) Turnover Ratio (in %) Mean of Prior-Year New Money Growth (in % per month; 1% winsorized) Standard Deviation of Prior-Year New Money Growth (in % per month; 1% winsorized) Industry Concentration Index (in %) Number of Stock Held Size Score (Score between 1-5 using Size Quintiles) Value Score (Score between 1-5 using Book-to-Market Quintiles) Momentum Score (Score between 1-5 using Momentum Quintiles) Proportion of Index Funds (in %) Proportion of Tax-Efficient Funds (in %) Proportion of Sector Funds (in %) Proportion of International Funds (in %)

Median

24.23 0.58 1.07 3.10 4.75 1.15 0.72 6.16 0.73 5.22 0.81 2.06 85.30 12.35 1.29 2.46 94.70 3.93 87.96 1.73 6.06

18.54 0.16 0.00 0.00 1.47 0.31 0.61 5.97 1.01 4.68 1.07 0.37 24.35 8.00 1.25 2.00 96.27 2.72 69.00 0.03 2.01

Standard Deviation 24.23 1.17 3.42 6.30 7.88 2.20 7.51 15.30 5.79 2.63 6.16 6.62 144.13 12.63 0.52 2.32 5.87 4.69 78.63 8.62 22.62

14.60 134.94 4.24 2.87 3.11 5.97 1.54 13.63 15.91

4.87 75.00 4.58 2.80 3.07

21.71 267.16 0.83 0.56 0.61

35

Table 2: Characteristics of Mutual Funds by DC-Ratio This table summarizes the main characteristics of mutual funds by the proportion of assets held in defined contribution retirement accounts in the prior year. The dependent variable is measured at an annual frequency and the standard errors are clustered by fund number.

DC-Ratio (in %)

Ratio of Assets Held in DC Retirement Accounts Missing Low Medium High H-L [0,0.25) [0.25,0.5) [0.5,1] 11.45 35.04 71.28 59.82

Expenses (in %)

1.34

1.33

1.13

0.97

Total Maximum Load (in %)

2.54

2.76

2.09

0.89

Age (in Years)

9.53

16.02

17.21

11.84

Turnover (in %)

93.34

85.81

78.78

65.45

0.62

2.59

5.43

5.36

Family TNA (in Billions)

105.77

35.77

87.17

105.33

Industry Concentration Index

19.08

11.26

6.99

5.78

Number of Stocks

125.85

132.51

140.77

237.52

2.59

1.73

0.84

1.79

8.18

5.48

3.71

6.78

5.74

4.80

4.92

16.73

Stock Allocation (in %)

94.65

94.47

94.71

94.72

Cash Allocation (in %)

3.99

3.96

4.05

4.13

Size Score

4.19

4.27

4.33

4.33

Book-to-Market Score

2.88

2.84

2.86

2.80

Momentum Score

3.12

3.15

3.11

3.09

Short Term Capital Gains Overhang (in %) Long Term Capital Gains Overhang (in %) Number of Annual Observations

1.67

1.65

1.54

1.33

6.42

7.86

8.82

9.07

TNA (in Billions)

Mean Monthly New Money Growth (in %) Standard Deviation of Monthly New Money Growth (in %) Proportion Index Funds (in %)

5627

3082

1178

-0.36*** (0.04) -1.86*** (0.17) -4.18*** (1.08) -20.36*** (5.33) 2.77* (1.49) 69.55*** (18.37) -5.48*** (0.93) 105.01*** (32.11) 0.06 (0.44) 1.29 (1.23) 11.92*** (3.83) 0.28 (0.38) 0.17 (0.32) 0.06 (0.07) -0.04 (0.04) -0.06* (0.04) -0.32 (0.23) 1.21 (1.02)

351

36

Table 3: Censored Regression for Assets Held in DC Plans This table summarizes the results of a censored normal regression of the logarithm of the size of mutual funds assets invested in DC retirement accounts. The assets held in DC plans are censored since the P&I survey only includes the assets for the largest DC holdings. Therefore, the censoring differs between the various fund families in the different years. The dependent variable is measured at an annual frequency and the standard errors are clustered by fund number. The regressions include year-fixed effects.

Log of Family Total Assets Age Expenses (in %) Total Load (in %) Turnover (in %) Prior 36-Month Abnormal Return Prior 36-Month Standard Deviation Index Funds Sector Funds International Funds Number of Observations Left-Censored Observations

Log of Assets Held in DC 0.545*** (0.041) 0.044*** (0.006) -107.907*** (20.082) 0.739 (3.535) -0.363*** (0.078) 31.607*** (7.617) 6.603** (2.887) -0.305 (0.329) -2.284*** (0.237) -0.214 (0.206) 8,277 3,824

Log of Total Assets 0.350*** (0.023) 0.038*** (0.003) -93.703*** (9.347) 8.388*** (1.828) -0.285*** (0.040) 39.978*** (3.449) 4.116*** (1.401) -0.180 (0.155) -1.037*** (0.118) -0.045 (0.103) 8,277 0

37

Table 4: Distribution Characteristics of Mutual Funds by DC-Ratio This table summarizes the main characteristics of mutual funds by the proportion of assets held in defined contribution retirement accounts in the prior year. The dependent variable is measured at an annual frequency and the standard errors are clustered by fund number.

Dividends (in %) ST Capital Gains (in %) LT Capital Gains (in %) All Capital Gains (in %) Total Distributions (in %) Tax Burden (in %) Number of Annual Observations

Ratio of Assets Held in DC Retirement Accounts Missing Low Medium High H-L [0,0.25) [0.25,0.5) [0.5,1] 0.58 0.53 0.53 0.58 0.05 (0.06) 1.06 0.99 0.89 0.93 -0.06 (0.19) 3.19 3.29 3.46 3.59 0.30 (0.42) 4.25 4.28 4.35 4.52 0.24 (0.51) 4.83 4.80 4.88 5.10 0.29 (0.51) 1.17 1.13 1.15 1.14 0.01 (0.12) 5595 3067 1175 561

38

Table 5: Determinants of Mutual Fund Distributions This table summarizes the coefficients of linear regressions of the determinants of mutual fund distributions. The dependent variable is measured at an annual frequency. The regressions include timefixed effects and the standard errors are clustered by fund number.

DC-Ratio DC-Ratio x Index Short Term Capital Gains Overhang Long Term Capital Gains Overhang Prior 12-Month Mean New Money Prior 12-Month Std Dev. of New Money Expenses Total Load Turnover Log of Total Assets Log of Family Total Assets Age Index Funds Sector Funds International Funds Number of Observations R-Squared

Dividend Yield (in %) -0.002*** (0.001) 0.005*** (0.001) -0.476 (0.456) -0.236* (0.145) 0.007 (0.007) -0.002 (0.002) -0.645*** (0.078) 0.011 (0.013) -0.001*** (0.000) -0.027 (0.021) 0.014 (0.017) 0.001 (0.001) 0.037 (0.094) 1.064*** (0.246) 0.529*** (0.063) 4,336 0.244

ST Capital Gains LT Capital Gains Total Capital Gains Yield (in %) Yield (in %) Distributions (in %) 0.005 0.019** 0.024*** (0.004) (0.008) (0.009) -0.008** -0.048*** -0.056*** (0.004) (0.011) (0.012) 0.067*** 0.080*** 0.147*** (0.016) (0.023) (0.032) -0.018 0.072*** 0.054*** (0.036) (0.013) (0.013) -0.038* -0.316*** -0.354*** (0.023) (0.052) (0.066) 0.012 0.098*** 0.110*** (0.008) (0.018) (0.023) 0.098 -0.657** -0.559* (0.174) (0.322) (0.384) -0.040 0.118* 0.078 (0.026) (0.066) (0.074) 0.005*** -0.004*** 0.001 (0.001) (0.001) (0.001) -0.006 -0.115 -0.120 (0.046) (0.143) (0.160) 0.006 -0.198* -0.192 (0.050) (0.105) (0.129) 0.002 -0.001 0.001 (0.004) (0.007) (0.008) -0.131 -1.411** -1.542** (0.193) (0.560) (0.618) -0.373** 0.131 -0.242 (0.168) (0.429) (0.491) -0.513*** -0.337 -0.850** (0.123) (0.335) (0.374) 4,336 4,336 4,336 0.203 0.256 0.293

39

Table 6: Distributions Around 2003 Tax Reforms This table summarizes the coefficients of linear regressions of the determinants of mutual fund distributions. The standard errors are clustered by fund number.

DC-Ratio After 2002 DC-Ratio x After 2002 DC-Ratio x Index Short Term Capital Gains Overhang Long Term Capital Gains Overhang Prior 12-Month Mean New Money Prior 12-Month Standard Deviation of New Money Expenses Total Load Turnover Log of Total Assets Log of Family Total Assets Age Index Funds Sector Funds International Funds Time Trend (in Months) Number of Observations R-Squared

Dividend Yield (in %) -0.003** (0.001) 0.189*** (0.058) 0.001 (0.001) 0.005*** (0.001) -0.002 (0.004) 0.000 (0.001) 0.008 (0.007) -0.002 (0.002) -0.651*** (0.078) 0.013 (0.013) -0.001*** (0.000) -0.028 (0.021) 0.014 (0.017) 0.001 (0.002) 0.037 (0.093) 1.076*** (0.245) 0.540*** (0.064 ) -0.003*** (0.001 ) 4336 0.236

ST Capital Gains Yield (in %) 0.003 (0.006) 0.795*** (0.181) 0.003 (0.006) -0.009** (0.004) 0.098*** (0.017) 0.002 (0.002) -0.035 (0.023) 0.010 (0.009) 0.059 (0.172) -0.025 (0.027) 0.004*** (0.001) -0.007 (0.046) 0.009 (0.049) 0.001 (0.004) -0.121 (0.181) -0.239 (0.164) -0.429*** (0.122) -0.032*** (0.003) 4336 0.122

LT Capital Gains Total Capital Gains Yield (in %) Yield (in %) 0.007 0.010 (0.007) (0.009) 0.668* 1.463*** (0.372) (0.438) 0.022* 0.025* (0.013) (0.015) -0.047*** -0.056*** (0.012) (0.013) 0.160*** 0.258*** (0.024) (0.036) 0.116*** 0.118*** (0.012) (0.012) -0.335*** -0.369*** (0.054) (0.068) 0.106*** 0.116*** (0.019) (0.024) -0.858*** -0.800** (0.329) (0.396) 0.140** 0.115 (0.066) (0.076) -0.005*** -0.001 (0.001) (0.002) -0.137 -0.144 (0.146) (0.164) -0.133 -0.124 (0.107) (0.131) -0.007 -0.006 (0.007) (0.010) -1.671*** -1.792** (0.571) (0.624) 0.341 0.101 (0.437) (0.493) -0.149 -0.578 (0.354) (0.398) -0.050*** -0.082*** (0.005) (0.006) 4336 4336 0.176 0.191

40

Table 7: Propensity to Liquidate Positions This table summarizes the coefficients of a linear probability model. The regressions include time-fixed effects and the standard errors are clustered by fund number. Dependent Variable Duration/100 Duration Squared/100 Short Term Position Index Fund High DC Ratio Short Term x Loss Short Term x Gain Long Term x Loss Long Term x Gain Short Term x Loss x High DC Short Term x Gain x High DC Long Term x Loss x High DC Long Term x Gain x High DC Short Term x Loss x Index Short Term x Gain x Index Long Term x Loss x Index Long Term x Gain x Index Short Term x Loss x High DC x Index Short Term x Gain x High DC x Index Long Term x Loss x High DC x Index Long Term x Gain x High DC x Index Short Term x High DC Short Term x Index High DC x Index Short Term x High DC x Index Number of Observations R-Squared

Indicator Variable if Fund Liquidates a Position -0.417*** -0.419*** -0.444*** (0.056) (0.057) (0.054) 0.005*** 0.005*** 0.005*** (0.001) (0.001) (0.001) 0.008* 0.009** 0.019*** (0.004) (0.004) (0.005) -0.096*** -0.096*** -0.071*** (0.006) (0.006) (0.004) -0.023*** -0.018** -0.027*** (0.008) (0.009) (0.010) 0.352*** 0.368*** 0.436*** (0.021) (0.024) (0.014) 0.021*** 0.017*** 0.021*** (0.004) (0.005) (0.005) 0.147*** 0.154*** 0.272*** (0.016) (0.020) (0.015) 0.001 0.001 0.000 (0.001) (0.001) (0.001) -0.098*** -0.122*** (0.039) (0.040) 0.027** 0.026* (0.012) (0.014) -0.032 -0.077*** (0.022) (0.024) 0.003 0.004 (0.002) (0.002) -0.391*** (0.033) -0.009 (0.011) -0.208*** (0.017) 0.010*** (0.002) 0.136** (0.054) -0.005*** (0.020) 0.071*** (0.026) -0.002 (0.004) -0.011 -0.000 (0.009) (0.008) -0.046*** (0.008) 0.017 (0.013) -0.009 (0.015) 2,001,569 2,001,569 2,001,569 0.064 0.065 0.071

Proportion of Fund Position Liquidated -0.443*** -0.445*** -0.464*** (0.061) (0.061) (0.060) 0.005*** 0.005*** 0.005*** (0.001) (0.001) (0.001) -0.013*** -0.011** -0.004 (0.005) (0.005) (0.006) -0.132*** -0.132*** -0.111*** (0.010) (0.009) (0.009) -0.026*** -0.020** -0.031*** (0.009) (0.009) (0.011) 0.354*** 0.370*** 0.435*** (0.021) (0.023) (0.014) 0.058*** 0.054*** 0.060*** (0.006) (0.007) (0.007) 0.135*** 0.141*** 0.255*** (0.016) (0.020) (0.016) 0.005*** 0.005*** 0.004** (0.002) (0.002) (0.002) -0.101*** -0.121*** (0.040) (0.042) 0.028* 0.027 (0.017) (0.019) -0.027 -0.078*** (0.024) (0.025) 0.002 0.003 (0.003) (0.003) -0.385*** (0.039) -0.039*** (0.013) -0.200*** (0.018) 0.010*** (0.003) 0.123** (0.059) 0.001 (0.026) 0.083*** (0.029) -0.001 (0.006) -0.012 -0.001 (0.009) (0.008) -0.027*** (0.009) 0.018 (0.016) -0.015 (0.017) 2,001,569 2,001,569 2,001,569 0.079 0.080 0.084

41

Table 8: Performance of Mutual Funds by DC-Ratio This table summarizes the performance of mutual funds by the proportion of assets held in defined contribution retirement accounts in the prior year. The explanatory variables are taken at a monthly frequency and the standard errors are clustered by time.

Return CAPM Alpha Fama-French Alpha Carhart Alpha Ferson-Schadt Alpha DGTW-Selectivity Return Gap Expense Ratio (Monthly) Number of Annual Observations

Ratio of Assets Held in DC Retirement Accounts Missing Low Medium High H-L [0,0.25) [0.25,0.5) [0.5,1] 0.786* 0.682 0.628 0.669 -0.013 (0.413) (0.430) (0.446) (0.409) (0.074) 0.042 -0.036 -0.055 -0.024 0.011 (0.088) (0.081) (0.078) (0.066) (0.046) -0.085 -0.134** -0.162** -0.107** 0.028 (0.064) (0.059) (0.063) (0.051) (0.034) -0.074 -0.172*** -0.170** -0.138** 0.034 (0.067) (0.061) (0.066) (0.055) (0.037) -0.021 -0.103 -0.100 -0.078 0.025 (0.080) (0.073) (0.082) (0.076) (0.046) 0.061 0.057 0.053 0.020 -0.036 (0.049) (0.053) (0.054) (0.051) (0.044) 0.077** 0.011 -0.011 0.027 0.017 (0.030) (0.027) (0.026) (0.039) (0.024) 0.112 0.111 0.094 0.081 -0.030*** (0.001) 67,654 36,578 14,038 4,195

42

Table 9: Performance of Mutual Funds This table summarizes the determinants for the performance of mutual funds. The regressions include timefixed effects and the standard errors are clustered by time. CAPM Alpha (in bp per month) DC Ratio (in %) -0.118* (0.067) DC Ratio x Index 0.220 (0.145) Log of Total Assets -6.559*** (2.134) Log of Family Total 4.325*** Assets (1.228) Age -0.212* (0.125) Expenses -1.836 (in bp per month) (1.250) Total Load 0.370 (in %) (0.956) Turnover -0.022 (in %) (0.079) Prior 12-Month Mean 0.452 New Money (1.875) Prior 12-Month Std. Dev. -0.227 New Money (0.556) Index Funds -26.138*** (6.597) Sector Funds -7.692 (15.447) International Funds 15.888 (18.370) Number of Observations 53,520 R-Squared 0.080

Fama-French Alpha (in bp per month) -0.084 (0.054) 0.281*** (0.091) -0.228 (1.547) 1.928 (1.100) -0.106 (0.086) -1.125* (0.616) -0.040 (0.665) 0.013 (0.053) 1.217 (1.122) -0.452 (0.350) -14.441*** (5.123) 7.476 (13.873) 9.626 (18.220) 53,520 0.074

Carhart Alpha (in bp per month) -0.076 (0.054) 0.264*** (0.096) -1.613 (1.587) 1.766* (1.063) -0.080 (0.076) -1.643** (0.647) 0.172 (0.759) -0.052 (0.043) 0.551 (0.801) -0.272 (0.265) -17.333*** (5.165) 7.322 (14.386) 10.494 (18.471) 53,520 0.082

DGTW Selectivity (in bp per month) -0.025 (0.069) 0.154 (0.117) -1.476 (2.241) 0.692 (1.400) -0.061 (0.070) -0.757 (0.719) 1.086 (0.746) -0.001 (0.052) 1.810* (0.746) -0.704** (0.338) -16.758** (7.145) -6.818 (16.849) 27.702* (14.834) 51,907 0.085

Return Gap (in bp per month) -0.056 (0.047) 0.092 (0.065) -2.627*** (0.910) 2.821*** (0.898) 0.001 (0.051) 0.246 (0.502) -1.020* (0.528) -0.011 (0.016) -0.185 (0.437) 0.139 (0.162) -2.950 (4.350) 3.815 (3.033) -13.470 (16.468) 51,815 0.041

43

Figure 1: Distribution of Proportion of Mutual Fund Assets held in DC Retirement Accounts These figures summarize the histogram for the proportion of mutual fund assets held in DC retirement accounts. 0.08

Proportion of Observations

0.07 0.06 0.05 0.04 0.03 0.02 0.01 0 0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

Proportion of DC Assets

44

Figure 2: Time-Series Variation of Dividend and Capital Gains Distributions This figure summarizes the percentage of dividend, short- and long-term capital gains distributions relative to the net asset values of mutual funds over the sample between 1997 and 2006.

8

7

Distribution Yields

6 Long-Term Capital Gains

5

4

3

Short-Term Capital Gains

2

1 Dividends 0 1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

45

Figure 3: Time-Series Variation of Dividend and Capital Gains Tax Rates This figure summarizes the top marginal federal dividend, short- and long-term capital gains tax rates over the sample between 1997 and 2005. 0.5 0.45 0.4

Short-Term Capital Gains

Marginal Tax Rate

0.35 0.3

Dividends

0.25 0.2 0.15 Long-Term Capital Gains

0.1 0.05 0 1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

46

Figure 4: Hazard Rate of Mutual Fund Liquidations by Duration This figure summarizes the proportion of equity positions that are liquidated at different holdings periods for funds with DC ratios above 50 percent and funds with DC ratios below 50 percent. 0.2

0.18

Propensity to Liquidiate a Position

0.16

0.14

0.12

0.1

0.08

Low DC

0.06

0.04

High DC Funds

0.02

0 1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

Holdings Period (in Quarters)

47

Figure 5: Hazard Rate of Mutual Fund Liquidations by Capital Gains Amount This figure summarizes the proportions of equity positions that are liquidated at different holdings periods for funds with DC ratios above 50 percent and funds with DC ratios below 50 percent. Panel A summarizes the proportions of holdings held for less than four quarters and Panel B summarizes the proportions of holdings held for four quarters or more. Panel A: All Capital Gains 0.35

0.3

Propensity to Liquidate

0.25

0.2

0.15

0.1

Low DC

0.05

High DC Funds

0 -1

-0.75

-0.5

-0.25

0

0.25

0.5

0.75

1

1.25

1.5

1.75

2

Capital Gain

48

Panel B: Short-Term Capital Gains 0.6

Propensity to Liquidate Short Term Position

0.5

0.4 Low DC 0.3

0.2 High DC Funds

0.1

0 -1

-0.75

-0.5

-0.25

0

0.25

0.5

0.75

1

1.25

1.5

1.75

2

1

1.25

1.5

1.75

2

Short Term Capital Gain

Panel C: Long-Term Capital Gains 0.35

Propensity to Liquidate Long Term Position

0.3

0.25

0.2

0.15

0.1 Low DC

0.05 High DC Funds

0 -1

-0.75

-0.5

-0.25

0

0.25

0.5

0.75

Long Term Capital Gain

49