Study from the McCombs School of Business at The University of Texas finds taxable capital gains are an important factor
Investors looking to rebalance their portfolios due to the market volatility since the COVID-19 pandemic began should consider an often-overlooked factor when choosing mutual funds.
That’s according to a study from the McCombs School of Business at The University of Texas in Austin, which shows that those funds that are tax-managed perform better.
The study is published in the April 2020 edition of The Journal of Finance and analyzes the performance of mutual funds and their tax burdens.
McCombs professor Clemens Sialm found that tax-efficient funds provide higher returns for investors and more income for fund shareholders.
"The average equity mutual fund generates quite a bit of tax burden. Most investors don't consider taxes as much as they should. So, in the coming months, as many investors make many portfolio adjustments meant to maximize their long-term objectives, they would be wise to rethink this issue," Sialm said.
Sialm together with Hanjiang Zhang of Washington State University looked at US equity mutual funds with more than US$10 million in assets from 1990 to 2016.
Over those sixteen years, tax rates fluctuated from 15% to 43% and a low of 15%. To calculate the bite taken by capital gains, the researchers used the rates in effect when a fund sold a stock.
Considering the average fund, a 1.18% drop in tax burden meant a 0.55% higher return before taxes and a 0.99% boost after taxes.
Better management
But the correlation was not simply one of numbers; the authors found that tax-managed funds were more likely to be better managed overall.
They also tended to have lower trading costs because they traded less often.
The study suggests that investors should seek out funds that hold onto stocks in the most tax-efficient way, for example by holding onto stocks for longer than a year to cut capital gains tax.
The funds that are likely to produce better returns according to the study are:
- Tax-managed funds, which reduce capital gains by balancing them against losses. Their after-tax returns were 0.81% better than similar funds that weren't tax managed.
- Momentum funds, which buy stocks while they're rising and sell when they start to fall. "If you have a winning stock, you hold on to it longer," Sialm said. "If it's a losing stock, you sell it and take the capital loss."
- Index funds, which try to match indexes like the Standard & Poor's 500. They hang onto a stock for as long as it's part of the index.
The full study is available in the Journal of Finance.
