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

September 28, 2008

The authors thank Federico Belo, Li Jin, and seminar participants at the College of William and Mary, SMU, Texas A&M University, the University of Texas at Austin, the European Summer Symposium on Financial Markets in Gerzensee, the ISCTE Business School – Nova Annual Finance Conference on Mutual Funds and Investment Management in Lisbon, and the University of Oregon Institutional Investor Conference for helpful comments.

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Mutual Fund Tax Clienteles

September 28, 2008

Abstract Mutual funds are pooled investment vehicles with potentially diverse tax clienteles. Whereas many mutual funds are held primarily by taxable investors, a significant fraction of mutual fund assets are held in tax-qualified retirement accounts. Our paper investigates whether the characteristics and the investment strategies of mutual funds held by diverse tax clienteles differ. Examining both mutual fund income distributions and mutual fund holdings, we find that funds held primarily by retirement accounts tend to be less taxefficient than funds held primarily by taxable investors. 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 between funds held by different tax clienteles.

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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 lack of tax consequences) in their portfolio decisions. Mutual fund portfolio managers, however, face a more complicated task. The 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 exists that institutional investors appear to have some preferences regarding a firm’s dividend policy, which would also be consistent with managers

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considering tax effects on their investors (e.g., Del Guercio, 1996; Gompers and Metrick, 2001; Bennett, Sias and Starks, 2003; Grinstein and Michaely, 2005; Desai and Jin, 2008).1 Evidence also suggests that the tax efficiency of mutual funds is important for shareholders’ mutual fund choice. Morningstar provides mutual fund investors with 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 of the increase in the diversity of shareholders’ tax status. The increased diversity is a result of the large growth in tax-deferred assets being invested in mutual funds from retirement accounts with 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 percent by 2007.2 Further the tax situation of a shareholder affects the shareholder’s preferences with respect to the fund’s investment

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Further, Bennett, Sias and Starks (2003) find that institutions’ aversion to high dividend paying stocks has increased over time, suggesting changes in these preferences, which could be due to changes in tax laws or their clients’ preferences. 2 ICI, Research Fundamentals: The U.S. Retirement Market, 2nd Quarter 2007

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strategy, yet there has to date been little research on whether the investment strategies of mutual funds differ according to their tax clienteles. 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 questions.

The first question is whether there exist 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 attract defined contribution assets. The second question we address is whether the mutual fund managers’ investment strategies are related to the composition of their shareholder base. 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 these differences should reflect the preferences of taxable versus tax-deferred shareholders. With regard to this question, we examine two aspects of the fund managers’ investment decisions. We investigate 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

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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 plan participants. We find significant differences in the characteristics of mutual funds chosen by the plan sponsors and participants in contrast to those chosen by mutual fund investors in general. For example, funds held extensively in DC plans tend to have lower expense ratios and lower or no load fees, have greater assets under management, be part of larger families of funds, and be better diversified as compared to the funds with the lowest amount of defined contribution assets. These results support the hypothesis that plan sponsors effectively screen the mutual funds included in DC plans. 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 capital gain distributions are increasing in the proportion of defined contribution assets in the fund and that mutual funds held primarily by taxable investors have higher propensities to realize capital losses. Finally, we address the question of whether constraints imposed by tax efficiency needs are costly to the portfolio managers. That is, we examine whether performance differences exist between funds held primarily by retirement accounts versus those held

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primarily by taxable investors. We find no significant differences in returns according to the tax clientele, suggesting that any tax efficiency constraints do not appear to have costs in terms of lower risk-adjusted returns. Our paper is related to the literature on whether mutual fund investors take tax effects into account (Bergstresser and Poterba, 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 also related to the finding by Jin (2006) of differences in selling decisions by institutional investors who serve tax sensitive clients versus tax-exempt clients. The former are sensitive to cumulative capital gains taxes, but the latter are not. Jin does not include mutual funds in his institutional investor sample. Our paper is most closely related to the literature on mutual fund managers’ investment decisions in light of the tax consequences. This literature has provided evidence that the managers consider taxes in their decisions, but that the decision is complex (Barclay, Pearson and Weisbach, 1998; Dickson, Shoven and Sialm, 2000; Gibson, Safieddiene, and Titman, 2000; Huddart and Narayanan, 2002; Christoffersen, Geczy, Musto, and Reed, 2005).4 For example, Barclay, Pearson and Weisbach discuss the conflict that mutual fund managers face in choosing their capital gains distribution policy. Current taxable fund investors prefer that capital gains be deferred as long as possible, but prospective taxable investors prefer that capital gains be realized so that they do not face premature realization of capital gains after they come on board. Barclay, 4

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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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. Dickson, Shoven, and Sialm (2000) simulate the impact of tax externalities on the after-tax performance of mutual funds. They show that redemptions may force a mutual fund to sell some of its appreciated equity positions, resulting in a distribution of taxable capital gains to its remaining shareholders. On the other hand, new investors convey a positive externality upon existing investors by diluting the unrealized capital gain position of the fund. These tax externalities are important determinants of the aftertax performance of equity mutual funds. Three 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. Christoffersen, Geczy, Musto and Reed (2005) find that in 2003 managers’ decisions with respect to cross-border dividend payments differ according to the proportion of defined contribution assets in their funds. We examine this issue from a different perspective by examining whether manager behavior varies systematically with the proportion of defined contribution assets in their funds over the 1997 through 2006 time period. Another distinction of our paper is that we examine whether mutual funds most used in defined contribution plans differ in

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their characteristics and performance from other funds. A final distinction is that rather than examining the investment decision itself, we examine the tax outcome of the investment decisions in terms of the dividend and capital gain distributions. 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 the mutual fund assets in the Defined Contribution (DC) retirement accounts is based on the annual survey of mutual fund families by the publication Pensions & Investments.5

Since 1997, Pensions &

Investments has conducted 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

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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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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 can surmise from our data that the unlisted funds in these families 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 lists the DC plan assets of 550 equity mutual funds.6 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 Thomson 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 on fund returns, total assets under management, different types of fees, investment objectives, and other fund characteristics. The Thomson 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 actively-managed domestic equity mutual funds, we eliminate balanced, bond, index, international, sector, and money market funds, as well as 6

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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funds not invested primarily in equity securities.7 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 6,828 fund-year 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 3,577 fund-year observations. However, the funds with the available DC values account for 87.1 percent of the assets under management. 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 24.29 percent. 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 their dividend and 7

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. The classification of index funds is made according to the fund names.

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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.8 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 few cases representing only 2.4 percent of the total value of capital gains distributions, the CRSP 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 0.42 percent of the initial value as dividends, 1.24 percent as short-term capital gains, and 3.60 percent as longterm capital gains.

The dividend distributions are relatively small because of the

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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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subtraction of expenses before the distribution. 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: SCG SCG TB f ,t = τ tDIV y DIV y f ,t + τ tLCG y LCG f ,t + τ t f ,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 (2008) as the relevant tax rates. Thus, the tax burden captures the total tax costs from dividend and capital gains taxation as a percentage of the assets under management. 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. 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 1.30 percent per year and exhibits significant crosssectional variation.

Around one-quarter of mutual funds do not make any taxable

distributions and one-quarter of funds have tax burdens exceeding 1.7 percent per year. It is notable that the tax costs of mutual funds are of a similar order of magnitude as their expense ratios. However, the tax burden is significantly more volatile than the expense

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ratio. Whereas fund expenses have received a lot of attention in the literature (e.g., French 2008), the tax burden of mutual funds has not obtained nearly as much attention. Using the periodical equity holdings from Thomson 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 equity 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 short-term 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 2.65 and 10.71 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 based on the CRSP database equals 0.71 percent per month with a standard deviation of 5.54 percent. We compute the gross holdings return based on the most recently disclosed quarter-end Thomson equity holdings and the asset allocation weights from CRSP. The holdings database includes 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

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Lehman Brothers Aggregate Bond Index, while for cash holdings and other assets we use the Treasury bill rate. The mean gross holdings return equals 0.82 percent per month and has a correlation of 96.4 percent with the net investor return across the mutual funds in our sample. The mean of Total Net Assets (TNA) equals $2.13 billion and the average fund family in our sample manages $63.58 billion in aggregate. The average age of a fund is about 13.7 years with a standard deviation of 14.5 years. The mean expense ratio is 1.26 percent per year and the mean turnover ratio is about 92 percent per year. Since we focus our analysis on equity funds, the vast majority of the assets are invested in common stocks (94.84 percent) and cash (4.02 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: NMG f ,t =

TNA f ,t − TNA f ,t −1 (1 + RF f ,t ) TNA f ,t −1

(2)

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 2.24 percent per month and a standard deviation of 7.03 percent over the prior year. The number of stocks is computed based on the holdings information from Thomson Financial and the Industry Concentration Index (ICI) is computed following Kacperczyk, Sialm, and Zheng (2005) as the concentration of the stock portfolio in ten 15

broadly defined industries.9

The average fund holds approximately 121 stocks and

exhibits an ICI of 0.049. The industry concentration ratio can be considered as a marketadjusted Herfindahl index. It measures the deviation of a mutual fund portfolio from the market portfolio. Thus, an ICI of 0 indicates that the mutual fund has the same industry composition as the market portfolio. The ICI increases as a mutual fund becomes more concentrated in a few industries.

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.

III. Determinants of Defined Contribution Assets in Mutual Funds As mentioned earlier, 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 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. 9

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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 the choices of both the plan sponsor and the individual participant.10 The first question we address is whether certain mutual fund characteristics attract plan sponsors and participants to a particular fund. We divide in every year the mutual funds in our sample into quartiles 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 the funds, in the first column we include average characteristics for a fifth group, the funds with missing data (which by definition should be funds with very low or no 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 four columns of the table we show the average characteristics for the defined contribution quartiles. Overall the results show that defined contribution assets are a significant portion of many funds’ assets under management. The bottom quartile has an average DC ratio of 4.50 percent and the top quartile has a DC ratio of 53.61 percent of total assets. Table 2 also shows that many of the mutual fund characteristics differ significantly across the groups. The funds in the highest DC ratio quartile have lower 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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average expenses, lower average loads, have greater assets under management, are part of larger families of funds, have a larger number of stocks in the portfolio, and have less industry concentration. Funds with relatively high DC assets tend to have a lower mean growth rate of new money, probably because they tend to be significantly larger. Furthermore, the standard deviation of the new money growth rate is also slightly lower for funds with above median DC assets, since retirement contributions are more predictable than other investments in mutual funds. 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 based on the holdings and find only a significant difference for the momentum score. Funds held in DC accounts tend to hold stocks with lower momentum scores. Finally we examine the short-term and long-term capital gain overhangs for each fund and find that high DC ratio funds tend to have lower short-term capital gains overhangs and higher long-term capital gains overhangs. This result is driven by the fact that high DC ratio funds have lower turnovers and tend to hold a larger proportion of stocks for longer than a year. 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. Besides running an OLS specification, we also run a Heckman Selection model

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because we do not have information on the defined contribution assets in all funds. The Heckman Selection model uses the size of a fund, the size of the family, and the number of funds in a family as instruments. The results are provided in Table 3. The coefficient on log TNA is larger than one, indicating that larger funds are more likely to be held in DC accounts. We also have some evidence that funds from large families are over-represented in DC accounts. 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

Consistent with the univariate results, we find that funds with

significant DC investments tend to have significantly lower expense ratios.

The

coefficient on the return over the prior 36 months is significantly negative, indicating that funds held extensively in DC plans tend to chase performance less aggressively than funds held outside DC plans. The results using the OLS estimation are very similar to the results using the Heckman Selection model.

IV. Differences in Investment Strategies A. Evidence from Mutual Fund Distributions In this section we consider hypotheses related to differences in the investment strategies of funds with taxable versus nontaxable investors. Portfolio managers with primarily taxable investors presumably would be interested in improving the taxefficiency 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

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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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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 appreciated stocks). Third the managers can accelerate the realization of capital losses (by selling depreciated stocks). 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 contribution assets. As in the previous tests, we divide the sample funds into quartiles according to the mutual fund’s ratio of DC assets and include a fifth group for funds for which the DC asset information is missing. The results, shown in Table 4, indicate that on an univariate basis before controlling for other factors, there is no significant difference in dividend or short-term capital gain distributions between funds in the top quartile of DC assets and those in the bottom. On the other hand, the table shows that significant differences do exist for long-term capital gains, total distributions and the tax

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burden. The funds in the top quartile tend to distribute larger capital gains than funds in the bottom quartile. For example, funds in the top DC quartile distribute 5.32 percent of capital gains annually whereas funds in the bottom DC quartile distribute only 4.28 percent of capital gains. 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 broadly consistent with Barber and Odean (2003) who examine the differences in distribution characteristics for mutual funds held by individual investors in their taxable versus nontaxable brokerage accounts over the 1991-1996 time period. 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. 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 short- and long-term capital gains overhangs, 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

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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). The first column of Table 5 shows the results when the dependent variable is the fund’s dividend yield. Contrary to our hypothesis, the coefficient on the ratio of DC assets is negative, indicating that funds with more DC assets have smaller dividend 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. It should also be noted that the economic significance of this dividend yield effect is relatively small. The coefficient estimate indicates that a ten percentage point increase in the DC ratio decreases the dividend distributions over the subsequent 12 months by 0.02 percentage points. The dividend yield is also decreasing in the short and long term capital gain overhangs, the expenses, and the turnover of the fund. Since expenses are deducted from the dividend distribution before it is declared, dividend yield is naturally decreasing in expenses. The last three columns present the results when the short-term, the long-term, and the total capital gains distributions are used as the dependent variable. Consistent with the univariate results from Table 4, we find a positive relation between the DC ratio and the capital gains distribution. Moreover, this relation is economically meaningful. We

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find that a ten percentage point increase in the DC ratio increases total capital gains distributions over the subsequent 12 months by 0.20 percentage points. As would be expected, there exists a positive relation between the current capital gains overhang at the subsequent capital gain distribution. Consistent with Dickson, Shoven, and Sialm (2000), we also find that funds that experience negative or highly volatile new money growth over the prior year tend to distribute higher capital gains over the subsequent year since these funds are more likely to sell off shares and recognize capital gains. Thus, these flow externalities have a significant impact on the tax burden of taxable investors. We find that short-term capital gains distributions tend to increase and dividend and long-term capital gains distributions tend to decrease with a fund’s turnover. None of the distributions are related to whether a fund has a load fee, the size of the fund or its family, or to the age of the fund.

2. Changes in Distributions around the 2003 Tax Law Reforms During our sample period the tax code was reformed in 2003 by the JGTRRA. 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, shortterm capital gains rates reduced from 38.6 to 35 percent, and long-term capital gains rates reduced from 20 to 15 percent. 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

23

affect investment strategies. In Table 6 we repeat the analysis from Table 5, adding an indicator variable to capture differences in the fund distributions around 2003. The change in the dividend yield around 2003 does not differ between funds held primarily in taxable accounts and funds held in employer-sponsored retirement accounts. Similarly, the 2003 tax reform did not have a significant impact on the capital gains distribution behavior of mutual funds held by different tax clienteles. These results indicate that fund managers did not adjust their distribution policies significantly after the 2003 tax reforms. One explanation for these results could be the poor market returns in the years preceding the tax changes. If funds did not have large capital gains, the incentive to take advantage of the tax law changes could be weak.

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. Our sample of mutual funds with available DC ratios have 1,568,114 position-quarters. Figure 4 shows the hazard rate of mutual fund liquidations by the duration of the holdings. Funds with a high level of defined contribution assets (top quartile) are less likely to liquidate a position at every holding period than are funds with a medium level (middle two quartiles) or a low level (bottom quartile) of defined contribution assets. For example, funds in the bottom DC quartile liquidate 20.5 percent of their positions after one quarter and funds in the top DC quartile liquidate 16.4 percent of their positions after one quarter.

24

In Figure 5, we examine the hazard rate by capital gains amount. We show the hazard rate for short-term capital gains (those that have been held less than four quarters) in Panel A and for long-term capital gains (those that have been held for four quarters or more) in Panel B. Panel A shows that low DC funds are more likely to liquidate a shortterm loss than high DC funds as would be expected if managers are attempting to be tax efficient. Furthermore, the propensity to liquidate a short-term gain is roughly identical for the various groups of mutual funds. Thus, low DC funds appear to engage in tax efficient strategies relative to the high DC funds. We also find similar results for longterm positions, which are reported in Panel B. Figure 5 indicates that differences in liquidation decisions vary between funds with large amounts of DC assets as compared to those with small amounts. To test whether these differences are statistically significant, we employ a linear probability model. We present the results from the model in Table 7 where the dependent variable in the first two columns is an indicator variable if the fund liquidates a position and the dependent variable in the last two columns is the proportion of the fund position liquidated. We first examine the unconditional trading in the funds. As the first two columns of Table 7 show, the longer a position is held, the less likely the fund is to liquidate that position. However, that relation is convex as the duration squared measure is positive. We find that the interaction terms between the length of the position (short-term or longterm) 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.

Moreover, the coefficients tend to be

25

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 our hypothesis of tax sensitive strategies, which require funds to realize short-term capital losses, but is also consistent with the momentum strategies followed by funds documented by Grinblatt, Titman, and Wermers (1995). For example, the propensity for a mutual fund to liquidate a position held for less than four quarters increases by 3.96 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 0.31 percent if a position exhibits a ten percentage point larger capital gain. The impact of capital gains or losses on long-term positions on fund liquidations is less sensitive than on short-term positions. Column 3 indicates that the results are 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 with low DC ratios are significantly more likely to realize short- and long-term capital losses than funds with medium DC ratios and that high DC ratio funds are significantly less likely to realize short- and long-term capital losses than funds with medium DC assets. This behavior is consistent with our hypothesis that funds held primarily by participants in DC plans are less sensitive to tax considerations than funds held primarily outside DC plans. The results based on the portfolio holdings confirm our results based on fund distributions. Mutual funds held widely in retirement accounts tend to be less tax-

26

efficient than funds held primarily by taxable investors. However, mutual funds held primarily by taxable investors are not completely tax-efficient. They still have relatively high propensities to realize capital gains, which would be consistent with the tradeoffs suggested by Barclay, Pearson and Weisbach (1998).

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 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

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 eight different measures of mutual fund return performance. We again divide the mutual funds into quartiles according to their lagged DC ratio and include also the group of mutual funds with missing DC data, giving us five 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 DC asset quartiles. The last column shows the results from tests of the differences in performance between the lowest and highest DC ratio groups.

27

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 (1993) model: Ri,t–RF,t = αi + βi,M(RM,t–RF,t) + βi,SMBSMBt + βi,HMLHMLt + εi,t

(4)

and the Carhart model (1997): 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 no significant difference in abnormal performance over the sample period. We also find that the all fund groups tend to have significantly negative future alphas when employing the Fama-French or FamaFrench-Carhart models. 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 and style timing models (Daniel, Grinblatt, Titman, and Wermers, 1997) CSi,t = Σk wi,k,t-1 Rk,t – Σk wi,k,t-1 BRk,t(t-1)

(6)

28

CTi,t = Σk wi,k,t-1 BRk,t(t-1) - Σk wi,k,t-5 BRk,t(t-5)

(7)

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(t-s) is the characteristic-based benchmark return for stock k for period t to which stock j was allocated during quarter t-s according to its size, value, and momentum characteristics. 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 .

(8)

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. 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.

29

V. Conclusions In this paper we examine whether the preferences of portfolio managers’ clientele are an important influence on the managers’ investment strategies as reflected in differences across mutual funds with primarily tax-deferred accounts as compared to other mutual 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 as compared to funds with the lowest amount of defined contribution assets. The high DC funds tend to have lower expense ratios, lower or no load fees, 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 low DC 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

30

tests on mutual fund holdings, we document that such differences exist. We find that mutual funds held primarily by retirement account holders tend to be more tax-efficient than other types of funds, presumably held primarily by taxable investors. 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 nontaxable investors have lower propensities to realize capital gains. These results suggest that the managers of mutual 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. Bennett, J., R. Sias, and L. Starks, 2003, Greener Pastures and the Impact of Dynamic Institutional Preferences, Review of Financial Studies 16, 1203-1238. 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. Brav, A., J. Graham, C. Harvey, and R. Michaely. 2005. Payout Policy in the 21st Century. Journal of Financial Economics 77(3): 483-527. Carhart, M., 1997, On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57–82. 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., 1996, The Distorting Effect of the Prudent-Man Laws on Institutional Equity Investments, Journal of Financial Economics 40, 31-62. Deloitte Consulting, 2006, Annual 401(k) Benchmarking Survey: 2005/2006 Edition. Desai, M., and L. Jin, 2008, Institutional Tax Clienteles and Payout Policy, working paper, Harvard University. 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. 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.

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French, K., 2008, Presidential Address: The Cost of Active Investing, Journal of Finance 63, 1537-1573. 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. Gompers, P., and A. Metrick, 2001, Institutional Investors and Equity Prices, Quarterly Journal of Economics 116, 229–259. 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. Jin, L., 2006, Capital Gains Tax Overhang and Price Pressure, Journal of Finance 61, 1399-1431. 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. Sialm, C., 2008, Tax Changes and Asset Pricing, Forthcoming: American Economic Review. Wermers, R., 2000, Mutual Fund Performance: An Empirical Decomposition into StockPicking Talent, Style, Transaction Costs, and Expenses, Journal of Finance 55, 1655-1702

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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) 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 Tax-Efficient Funds (in %) Number of Observations Number of Observations with Valid DC Ratio

Median

24.29 0.42 1.24 3.60 5.27 1.30 2.65 10.71 0.71 0.82 2.13 63.58 13.68 1.26 2.32 94.84 4.02 91.99 2.24 7.03

19.33 0.04 0.00 0.24 1.53 0.35 1.64 7.72 0.97 1.10 0.40 20.73 9.00 1.23 1.27 96.54 2.72 72.00 0.09 1.92

Standard Deviation 20.87 0.95 3.87 7.28 8.98 2.33 6.45 17.80 5.55 5.91 6.40 119.06 14.51 0.44 2.37 6.02 4.96 80.42 10.78 31.59

4.91 121.44 4.26 2.76 3.14 2.18 6,828 3,577

3.55 87.00 4.69 2.75 3.11

5.55 147.05 0.88 0.41 0.55

34

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 %)

Quartiles by Ratio of Assets Held in DC Retirement Accounts Missing Low Q2 Q3 High High-Low 4.50 13.97 25.32 53.61 49.11

Expenses (in %)

1.30

1.33

1.32

1.19

1.06

Total Maximum Load (in %)

2.34

2.46

2.96

2.51

1.29

TNA (in Billions)

0.58

1.34

3.17

4.34

5.33

75.71

21.69

31.98

70.95

85.87

Age (in Years)

9.65

15.61

19.34

19.05

15.11

Turnover (in %)

96.95

91.94

93.64

88.16

76.53

Number of Stocks

121.34

100.22

113.09

113.27

159.54

Industry Concentration Index

4.93

5.21

4.87

4.93

4.55

Mean Monthly New Money Growth (in %) Standard Deviation of Monthly New Money Growth (in %) Stock Allocation (in %)

3.03

2.46

1.47

1.01

1.34

8.89

7.63

4.88

3.53

5.71

94.98

94.59

95.21

95.30

94.80

Cash Allocation (in %)

3.94

4.14

3.74

4.26

4.18

Size Score

4.23

4.24

4.32

4.34

4.22

Book-to-Market Score

2.77

2.77

2.74

2.76

2.76

Momentum Score

3.14

3.17

3.14

3.14

3.08

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

2.80

2.65

2.81

2.54

2.07

9.91

9.79

11.70

12.06

12.04

897

889

Family TNA (in Billions)

3,226

898

893

-0.27*** (0.03) -1.18*** (0.20) 3.99*** (1.08) 64.18*** (13.03) -0.50 (1.50) -15.41*** (5.81) 59.33*** (17.17) -0.66* (0.38) -1.12** (0.52) -1.92 (1.53) 0.22 (0.40) 0.04 (0.32) -0.02 (0.08) -0.02 (0.04) -0.08** (0.04) -0.58** (0.27) 2.24** (0.99)

35

Table 3: Determinants for Assets Held in DC Plans This table summarizes the determinants 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. All specifications include time-fixed effects.

Log of TNA Log of Family Total Assets Expenses (in %) Total Load (in %) Turnover Age Prior 36-Month Return (in %) Prior 36-Month Standard Deviation (in %) Short-Term Capital Gains Overhang (in %) Long-Term Capital Gains Overhang (in %) Number of Observations

Dependent Variable: Log of Assets in DC Accounts OLS Heckman Selection Model 1.084*** 1.132*** (0.035) (0.034) 0.078** 0.043 (0.031) (0.032) -0.580*** -0.577*** (0.115) (0.115) -0.024 -0.022 (0.019) (0.019) -0.036 -0.036 (0.029) (0.028) -0.008*** -0.008*** (0.002) (0.002) -0.106*** -0.106*** (0.027) (0.027) 0.022 0.023 (0.018) (0.018) -0.001 -0.001 (0.004) (0.004) 0.004* 0.004* (0.002) (0.002) 3,209 5,607

36

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

Quartiles by Ratio of Assets Held in DC Retirement Accounts Missing Low Q2 Q3 High High-Low 0.40 0.36 0.39 0.37 0.43 0.07 (0.07) 1.17 1.07 1.17 0.99 1.27 0.20 (0.22) 3.62 3.21 3.60 3.74 4.05 0.84** (0.37) 4.79 4.28 4.78 4.73 5.32 1.04** (0.47) 5.19 4.64 5.17 5.10 5.75 1.11** (0.48) 1.24 1.10 1.23 1.19 1.36 0.26** (0.13) 3,216 893 886 895 887

37

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 (in %) Short Term Capital Gains Overhang (in %) Long Term Capital Gains Overhang (in %) Prior 12-Month Mean New Money (in %) Prior 12-Month Std Dev. of New Money (in %) Expenses (in %) Total Load (in %) Turnover (in %) Log of Total Assets Log of Family Total Assets Age Number of Observations R-Squared

Dividend Yield (in %) -0.002** (0.001) -0.009*** (0.002) -0.004*** (0.001) 0.004 (0.005) -0.001 (0.001) -0.524*** (0.076) 0.019 (0.010) -0.001*** (0.000) 0.013 (0.015) -0.002 (0.015) 0.001 (0.001) 3,239 0.162

ST Capital Gains LT Capital Gains Total Capital Gains Yield (in %) Yield (in %) Distributions (in %) 0.008* 0.012* 0.020** (0.005) (0.006) (0.008) 0.104*** 0.081*** 0.185*** (0.024) (0.029) (0.041) -0.028*** 0.077*** 0.050*** (0.005) (0.014) (0.015) -0.058** -0.361*** -0.419*** (0.027) (0.063) (0.080) 0.016* 0.102*** 0.118*** (0.009) (0.019) (0.025) 0.136 -0.500 -0.364 (0.247) (0.410) (0.505) -0.041 0.055 0.014 (0.033) (0.077) (0.088) 0.005*** -0.004*** 0.000 (0.001) (0.001) (0.002) -0.007 -0.158 -0.166 (0.061) (0.179) (0.204) 0.006 -0.201 -0.195 (0.065) (0.132) (0.165) 0.005 -0.002 0.002 (0.004) (0.007) (0.009) 3,239 3,239 3,239 0.236 0.276 0.313

38

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

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

Dividend Yield (in %) -0.001 (0.001) -0.005 (0.013) -0.009*** (0.002) -0.004*** (0.001) 0.004 (0.005) -0.001 (0.001) -0.524*** (0.076) 0.019* (0.010) -0.001*** (0.000) 0.013 (0.015) -0.001 (0.014) 0.000 (0.001) 3239 0.162

ST Capital Gains LT Capital Gains Total Capital Gains Yield (in %) Yield (in %) Yield (in %) 0.009 0.009 0.019* (0.008) (0.008) (0.012) -0.003 0.004 0.002 (0.008) (0.011) (0.015) 0.104*** 0.081*** 0.185*** (0.024) (0.029) (0.041) -0.028*** 0.077*** 0.050*** (0.005) (0.014) (0.015) -0.058** -0.361*** -0.419*** (0.027) (0.063) (0.080) 0.016* 0.102*** 0.118*** (0.009) (0.019) (0.025) 0.134 -0.496 -0.362 (0.242) (0.409) (0.503) -0.041 0.055 0.014 (0.033) (0.077) (0.088) 0.005*** -0.004*** 0.000 (0.001) (0.001) (0.002) -0.008 -0.157 -0.165 (0.061) (0.179) (0.204) -0.008 -0.203 -0.196 (0.065) (0.132) (0.166) 0.004 -0.002 0.002 (0.004) (0.007) (0.009) 3239 3239 3239 0.236 0.276 0.313

39

Table 7: Propensity to Liquidate Positions This table summarizes the coefficients of a linear probability model. The standard errors are clustered by fund number. Dependent Variable Intercept Duration (Divided by 100) Duration Squared (Divided by 100) Short Term Short Term x Low DC Long Term x Low DC Short Term x High DC Long Term x High DC Short Term Loss Short Term Gain Long Term Loss Long Term Gain Short Term Loss x Low DC Short Term Gain x Low DC Long Term Loss x Low DC Long Term Gain x Low DC Short Term Loss x High DC Short Term Gain x High DC Long Term Loss x High DC Long Term Gain x High DC Number of Observations R-Squared

Indicator Variable if Fund Liquidates a Position 0.184*** 0.191*** (0.005) (0.005) -0.782*** -0.748*** (0.038) (0.037) 0.008*** 0.008*** (0.001) (0.001) -0.009** -0.005 (0.004) (0.005) -0.015* (0.008) -0.011** (0.005) -0.028*** (0.009) -0.023*** (0.007) 0.396*** 0.417*** (0.017) (0.019) 0.031*** 0.028*** (0.005) (0.007) 0.235*** 0.260*** (0.014) (0.018) 0.005*** 0.004*** (0.001) (0.001) 0.061** (0.030) 0.001 (0.010) 0.058** (0.029) 0.003 (0.003) -0.107*** (0.033) 0.012 (0.010) -0.075*** (0.021) 0.002 (0.002) 1,568,114 1,568,114 0.036 0.038

Proportion of Fund Position Liquidated 0.250*** 0.260*** (0.006) (0.006) -0.810*** -0.772*** (0.045) (0.043) 0.008*** 0.007*** (0.001) (0.001) -0.033*** -0.029*** (0.004) (0.006) -0.020** (0.010) -0.019** (0.007) -0.037*** (0.010) -0.029*** (0.008) 0.389*** 0.405*** (0.017) (0.020) 0.068*** 0.064*** (0.006) (0.009) 0.216*** 0.239*** (0.015) (0.019) 0.010*** 0.009*** (0.002) (0.002) 0.069** (0.032) 0.001 (0.012) 0.065** (0.030) 0.004 (0.004) -0.096*** (0.033) 0.016 (0.012) -0.074*** (0.022) 0.001 (0.003) 1,568,114 1,568,114 0.030 0.033

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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 DGTW-Timing Return Gap Expense Ratio (Monthly) Number of Annual Observations

Quartiles by Ratio of Assets Held in DC Retirement Accounts Missing Low Q2 Q3 High High-Low 0.752* 0.712 0.639 0.596 0.712 0.000 (0.413) (0.433) (0.441) (0.440) (0.432) (0.044) -0.069 -0.006 -0.079 -0.106 -0.028 -0.022 (0.073) (0.087) (0.079) (0.082) (0.084) (0.040) -0.145*** -0.133** -0.162** -0.176*** -0.148** -0.015 (0.051) (0.061) (0.065) (0.065) (0.062) (0.032) -0.166*** -0.173*** -0.211*** -0.203*** -0.162** 0.010 (0.053) (0.062) (0.066) (0.066) (0.063) (0.032) -0.112* -0.076 -0.161** -0.117 -0.085 -0.009 (0.064) (0.076) (0.080) (0.077) (0.081) (0.040) 0.019 0.033 0.034 0.001 0.018 -0.014 (0.043) (0.053) (0.052) (0.058) (0.052) (0.028) 0.061 0.073 0.081 0.099 0.058 -0.015 (0.057) (0.076) (0.090) (0.088) (0.075) (0.013) 0.044*** 0.042** 0.020 0.004 0.029** -0.012 (0.013) (0.016) (0.019) (0.016) (0.013) (0.017) 0.108 0.110 0.110 0.099 0.088 -0.022*** (0.000) 39,216 10,692 10,641 10.643 10,574

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Table 9: Performance of Mutual Funds This table summarizes the determinants for the performance of mutual funds. The regressions include time fixed effects and the standard errors are clustered by time.

DC Ratio (in %) Log of Total Assets Log of Family Total Assets Age Expenses (in bp per month) Total Load (in %) Turnover (in %) Number of Observations R-Squared

CAPM Alpha (in bp per month) -0.016 (0.103) -7.931*** (1.666) 5.209*** (1.543) -0.073 (0.102) -0.786 (0.735) -1.199 (0.845) -0.020 (0.023) 39,597 0.092

Fama-French Alpha (in bp per month) -0.076 (0.073) -0.600 (1.211) 2.477** (1.215) -0.078 (0.074) -1.048* (0.548) -1.001 (0.684) -0.007 (0.018) 39,597 0.098

Carhart Alpha (in bp per month) -0.061 (0.069) -2.928** (1.165) 2.703** (1.118) -0.043 (0.063) -1.859*** (0.567) -0.381 (0.667) -0.072*** (0.023) 39,597 0.109

DGTW Selectivity (in bp per month) -0.044 (0.054) -0.744 (0.998) 0.329 (0.946) -0.092 (0.061) -0.667 (0.467) 0.781 (0.584 -0.019 (0.018) 38,792 0.071

Return Gap (in bp per month) 0.007 (0.052) -2.875*** (0.691) 2.801*** (0.709) 0.038 (0.045) 0.687* (0.377) -1.039*** (0.371) -0.003 (0.011) 38,659 0.013

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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

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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.

10 Long-Term Capital Gains

Distribution Yields

8

6

Short-Term Capital Gains

4

2

Dividends 0 1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

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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

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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 in the top and bottom quintile (High DC and Low DC) and funds in the two middle quintiles (Medium DC). 0.25

Propensity to Liquidate Position

0.2

0.15

Low DC

0.1

Medium DC

0.05

High DC

0 0

4

8

12

16

20

Duration in Quarters

46

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 in the top and bottom quintile (High DC and Low DC) and funds in the two middle quintiles (Medium DC). 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: Short-Term Capital Gains 0.7

Propensity to Liquidate Short-Term Position

0.6

Low DC

0.5

Medium DC

0.4

High DC

0.3

0.2

0.1

0 -1

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

Capital Gain

47

Panel B: Long-Term Capital Gains 0.6

Propensity to Liquidate Long-Term Position

0.5

Low DC 0.4

Medium DC

0.3

High DC

0.2

0.1

0 -1

-0.8

-0.6

-0.4

-0.2

0 Capital Gain

0.2

0.4

0.6

0.8

1

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