Tax-sensitive Investors Research Articles

The Agency Tax Costs of Mutual Funds

In the intermediated economy of the twenty-first century, retail mutual fund investors cede investment and voting decisions to institutional investors who manage the funds. As a result, actions undertaken unilaterally by financial intermediaries dictate the tax liability of passive individual investors. This Article argues that the tax decisions of institutional investors are guided by their own tax considerations rather than by the tax considerations of those beneficiaries who own mutual funds through conventional taxable accounts. Because these beneficiaries, unlike the institutional investors, are tax-sensitive, the diverging incentives give rise to agency tax costs. These agency tax costs arise from the institutional investors’ trading decisions and stewardship activities, as well as their voting behavior. Because these investors regularly vote on corporate mergers and acquisitions (M&A), voting outcomes on these transactions are distorted. The structure of M&A deals, the method of payment used in such deals, and even premiums paid to sellers are skewed because the votes of passive tax-sensitive investors are cast by tax-insensitive institutional investors. As a result, institutional investors not only fail to replicate the tax outcomes that tax-sensitive investors could have achieved had they owned stock directly, but they also fail to achieve the same corporate voting outcomes. This Article proposes several options for mitigating agency tax costs. These options include mandatory separation of funds based on the tax profile of the beneficiaries, heightened tax disclosure by mutual funds, decentralization of votes in mutual fund sponsors and pass-through voting systems. These alternatives would reduce the agency tax costs of mutual funds without imposing new agency costs on tax-insensitive shareholders who also rely on institutional investors for portfolio management.

Mutual funds' capital gains lock-in and earnings management

Capital gains taxation creates a lock-in effect, increasing investors' incentives to monitor and decreasing portfolio firms' incentives to cater to short-term investors. We show a negative relation between lock-in and portfolio firms' earnings management, and this relation is stronger for capital gains held by tax-sensitive investors. Further, the relation between lock-in and earnings management is stronger when the capital gains tax rate is higher. We show that locked-in funds vote against management and against audit committee members' reappointment following earnings management. Locked-in funds are less likely to exit a position following disappointing earnings announcements, reducing firms' incentive to manage earnings.

Summaries of Papers In This Issue

Summaries of Papers In This Issue

Investor Taxes and Option Prices

ABSTRACT We examine whether tax-sensitive investors play a significant role in options markets by examining whether option prices reflect investor taxes. Existing empirical option pricing literature ignores taxes. We exploit a unique setting where “index” options on the S&P 500 Index (SPX) and nearly identical “non-index” options on the exchange traded fund (ETF) tracking the S&P 500 Index (SPY) face different tax treatments. We find that higher investor taxes reduce option prices, indicating tax capitalization in options. We find consistent results when analyzing options around the investor tax changes enacted by the American Taxpayer Relief Act (ATRA) of 2012, and for options on stock indices other than the S&P 500 (e.g., Russell 2000). Altogether, our findings provide new evidence of an additional item—investor taxes—influencing option prices, suggesting that tax-sensitive investors play a non-trivial role in options markets and that taxes warrant consideration in broader options research. Data Availability: Data used in this study are available from public sources identified in the paper. JEL Classifications: H24; G12.

ETF Heartbeat Trades, Tax Efficiencies, and Clienteles: The Role of Taxes in the Flow Migration from Active Mutual Funds to ETFs

We study the use of “heartbeat trades” by ETFs in explaining their superior tax efficiency. By relying on the in-kind-redemption exemption rule, authorized participants help ETFs avoid distributing realized capital gains and reduce their tax overhang. In recent years, ETFs end up with 0.92% lower tax burden per year than active mutual funds, partly due to heartbeat trades. Challenged by ETFs’ tax efficiencies, mutual funds exhibit higher flow-tax sensitivity than flow-fee sensitivity. Active mutual funds with relatively higher tax burdens had more outflows from tax-sensitive investors at the same time when ETFs with similar investment styles experienced stronger inflows. Using holdings data of institutions with high-net-worth clients, we find that investment advisors with tax-sensitive investors allocate four times more assets to ETFs than other institutions, representing an important driver behind the overall surge in ETF flows, especially after the increase of capital gains tax rate in 2013. We conclude that the migration of flows from active mutual funds to ETFs is driven primarily by tax considerations.

Investor Taxes and Option Prices

We examine whether tax-sensitive investors play a significant role in options markets by examining whether option prices reflect investor taxes. Existing empirical option pricing literature ignores taxes. We exploit a unique setting where “index” options on the S&P 500 Index (SPX) and nearly identical “non-index” options on the exchange traded fund (ETF) tracking the S&P 500 Index (SPY) face different tax treatments. We find that higher investor taxes reduce option prices, indicating tax capitalization in options. We find consistent results when analyzing options around the investor tax changes enacted by the American Taxpayer Relief Act (ATRA) of 2012, and for options on stock indices other than the S&P 500 (e.g., Russell 2000). Altogether, our findings provide new evidence of an additional item – investor taxes – influencing option prices, suggesting that tax-sensitive investors play a non-trivial role in options markets and that taxes warrant consideration in broader options research.

The Effect of Shareholder-Level Taxes on Organizational Form and Stock Ownership: Evidence from Equity Carve-Outs of Master Limited Partnerships

ABSTRACT I examine the role of heterogeneous shareholder-level taxes in organizational form decisions and in subsequent changes in investor stock ownership. Specifically, I investigate the decision to form a master limited partnership (MLP), which is a tax-advantaged entity for tax-sensitive shareholders, but a tax-disadvantaged entity for tax-exempt shareholders. Consistent with shareholder-level taxes influencing organizational form decisions, I find that firms owned by more tax-exempt shareholders are less likely to carve-out MLPs. Consistent with shareholder-level taxes influencing stock ownership, I find that tax-sensitive investors, on average, decrease their ownership in the parent and hold a relatively larger ownership share in the MLP than in the parent after the carve-out. In contrast, tax-exempt investors own less of the MLP than of the parent. These results provide evidence that firms cater to investors' shareholder-level taxes in making organizational form decisions and that investors sort on tax characteristics inherent to organizational form. JEL Classifications: G32; H24; H25. Data Availability: Data used in this study are available from public sources identified in the paper.

Capital gains lock-in and governance choices

Differences in accrued gains and investors’ tax-sensitivity induce variation in a capital gains lock-in effect across mutual funds even for the same stock at the same time. Exploiting this variation, we show this effect influences funds’ governance decisions: higher capital gains decrease the likelihood a fund exits prior to contentious votes and increase the likelihood a fund votes against management. Consistent with tax motivation, these findings are concentrated among funds with tax-sensitive investors. Further, high aggregate capital gains across funds holding a stock predict a higher likelihood management loses a vote and a lower likelihood a contentious vote is proposed.

Actively managed ETFs vs actively managed mutual funds

PurposeThe purpose of this paper is to study if actively managed exchange-traded funds (AMETFs) and actively managed mutual funds (AMMFs) are complements or substitutes. It also tests if there are tax or liquidity clientele effects.Design/methodology/approachThe study investigates the relation between individual AMMF flows and aggregate AMETF flows as well as individual AMETF flows and aggregate AMMF flows. A 2013 tax change is used to analyze if a tax clientele effect exists between the AMETF and AMMF markets. The authors use differences in investor groups for institutional vs retail fund share classes to test for liquidity clientele effects.FindingsThe authors find that equity and mixed AMETFs and AMMFs are substitutes, although not perfect substitutes. Taxation-related differences between the two products create a clientele effect for fixed income and mixed funds where tax-sensitive investors are more likely to substitute AMETFs for AMMFs surrounding tax increases. There is weak evidence that institutional investors may prefer AMETFs more than retail investors because of their enhanced liquidity.Originality/valueThis is the first study to investigate the flow relation between AMETFs and AMMFs. The fast-paced growth of the AMETF area coupled with the substitutability between the two products and tax advantages of AMETFs has the capability to gain significant market share from AMMFs in the future.

Actively Managed ETF versus Actively Managed Mutual Funds

Purpose: The purpose of this paper is to study if actively managed exchange-traded funds (AMETFs) and actively manager mutual funds (AMMFs) are complements or substitutes. It also tests if there are tax or liquidity clientele effects. Design/methodology/approach: The study investigates the relation between individual AMMF flows and aggregate AMETF flows as well as individual AMETF flows and aggregate AMMF flows. A 2013 tax change is used to analyze if a tax clientele effect exists between the AMETF and AMMF markets. The authors use differences in investor groups for institutional versus retail fund share classes to test for liquidity clientele effects. Findings: The authors find that equity and mixed AMETFs and AMMFs are substitutes, although not perfect substitutes. Taxation related differences between the two products creates a clientele effect for fixed income and mixed funds where tax-sensitive investors are more likely to substitute AMETFs for AMMFs surrounding tax increases. There is weak evidence that institutional investors may prefer AMETFs more than retail investors because of their enhanced liquidity. Originality/value: This is the first study to investigate the flow relation between AMETFs and AMMFs. The fast-paced growth of the AMETF area coupled with the substitutability between the two products and tax advantages of AMETFs has the capability to gain significant market share from AMMFs in the future.

Measuring Tax-Sensitive Institutional Investor Ownership

ABSTRACTWe classify all institutional investors that file Form 13-F over the period 1995–2013 as either “tax-sensitive” or “tax-insensitive” based on their trading behavior and portfolio characteristics. We examine tests of the effects of investor tax-sensitivity on portfolio rebalancing, price pressure, and fund performance, and compare our measure of tax-sensitive institutional investor ownership to three measures used in prior studies. We show that our measure of tax-sensitive investors dominates other measures in the portfolio rebalancing and price pressure tests. In the fund performance test, our measure of tax-sensitivity is the only one that finds that tax-sensitive investors have significantly lower returns on their portfolio stocks, which is a new result in the literature.JEL Classifications: G11; G20; H24.

Mutual Fund Portfolio Holding Performance and Voting Decisions

Differences in accrued gains and investors’ tax-sensitivity induce variation in capital gains “lock-in” across mutual funds even for the same stock at the same time. Exploiting this variation, we show capital gains lock-in affects funds’ governance decisions: higher gains in a stock decrease the likelihood a fund exits prior to contentious votes and increase the likelihood a fund votes against management. Consistent with tax motivation, these findings are concentrated among funds with tax-sensitive investors. Further, high aggregate capital gains across funds holding a stock predict a higher likelihood management loses a vote and a lower likelihood a contentious vote is proposed.

The Effect of Shareholder-Level Taxes on Organizational Form and Stock Ownership: Evidence from Equity Carve-Outs of Master Limited Partnerships

I examine the role of heterogeneous shareholder-level taxes in organizational form decisions and in subsequent changes in investor stock ownership. Specifically, I investigate the decision to form a master limited partnership (MLP), which is a tax-advantaged entity for some shareholders (tax-sensitive investors) and tax-disadvantaged for others (tax-exempt investors). Consistent with shareholder-level taxes influencing organizational form decisions, I find that firms owned by more tax-exempt shareholders are less likely to carve-out MLPs. Consistent with shareholder-level taxes influencing stock ownership, I find that tax-sensitive investors, on average, decrease their ownership in the parent and hold a relatively larger ownership share in the MLP than in the parent after the carve-out. In contrast, tax-exempt investors own less of the MLP than of the parent. These results provide the first evidence that firms cater to investors’ shareholder-level taxes in making organizational form decisions and that investors sort on tax characteristics inherent to organizational form.

Capital Gains Lock-In and Governance Choices

Because of differences in accrued gains and investors' tax-sensitivity, capital gains varies across mutual funds even for the same stock at the same time. Using this variation, we show that tax lock-in affects funds' governance decisions. Higher tax lock-in decreases the likelihood a fund sells a stock prior to contentious votes, and increases the likelihood the fund votes against management. Consistent with tax motivations, these findings are concentrated among funds with tax-sensitive investors. High aggregate capital gains across funds holding a stock predicts a higher likelihood management loses a vote and a lower likelihood a contentious vote is proposed.

Capital Gains Taxes and Liquidity

I predict that tax-sensitive investors’ reluctance to realize capital gains in a particular stock reduces noise trading in the stock and thus decreases the stock’s liquidity. After controlling for information asymmetry, I find that over the period 1988-2008, a one standard deviation increase in the unrealized gains of institutional investors who are unambiguously tax-sensitive results in a 0.44 percent increase in Ahimud’s measure of illiquidity, a 1.8 percent increase in the quoted bid-ask spread, and a 1.2 percent increase in the effective bid-ask spread for the mean firm each quarter. I find that a hedge portfolio that goes long in firms with a relatively large difference between the unrealized gains of tax-sensitive investors and those of institutional investors that are unambiguously tax-insensitive and short in firms with a relatively small difference earns on average a positive and significant risk-adjusted return equal to 0.016 percent per quarter and 0.049 percent per year.

Capital Gains Tax Overhang and Payout Policy

Jin (2006) documents that tax-sensitive institutional investors with large embedded capital gains are reluctant to sell their shares, creating upward stock price pressure. This price pressure should reduce a firm's incentive to repurchase its shares. Consistent with this argument, we find that embedded capital gains of tax-sensitive institutional investors in a firm's stock reduce the probability that the firm repurchases shares and, conditional on repurchasing, the number of shares that it repurchases. Controlling for the holdings of these tax-sensitive investors and the embedded gains of a combined set of tax-sensitive and tax-insensitive institutional investors allows us to account for selection- or performance-based alternative explanations. We provide further evidence by examining how the sensitivity of repurchases to embedded capital gains of tax-sensitive institutional investors changes around the time of capital gains tax rate cuts in 1997 and 2003. We find that, in both cases, the negative response of repurchases to these embedded gains decreases after a tax cut, consistent with these embedded gains creating a tax overhang. In fact, after the larger 1997 tax cut, this response briefly becomes positive. We interpret this as the tax cut releasing a previously pent-up supply of shares held by tax-sensitive investors. Finally, in supplementary analysis, we consider whether firms substitute from repurchases to dividends in response to capital gains tax overhang. We find that the probability that a firm pays a dividend, as well as the amount of the dividend, conditional on one being paid, both increase with the embedded capital gains of tax-sensitive institutional investors, consistent with the substitution hypothesis. A back-of-the-envelope calculation suggests that if a firm reduces its repurchases by $X in response to a $1 increase in embedded capital gains of tax-sensitive investors, it will increase its dividends by $0.07X in the same period. The results further our understanding of how investor-level taxes affect firms' payout decisions.

Tax-Induced Trading around the Taxpayer Relief Act of 1997

ABSTRACT: We examine investor trading around the passage of the Taxpayer Relief Act of 1997 (TRA97), which reduced the capital gains tax rate from 28 percent to 20 percent. We provide evidence that individual investors increase their demand for equity shares on the announcement day of TRA97, consistent with the capitalization of capital gains taxes. On the effective day of TRA97, we find that individual investors increase the supply of equity shares with accrued gains, consistent with the lock-in effect of capital gains taxes. Regression results suggest that the demand-side effect associated with tax capitalization is a more powerful effect on abnormal trading than the supply-side effect associated with lock-in for the median stock trading around TRA97. Overall, our results suggest that capital gains taxes influence both the demand and supply for equity by tax-sensitive investors and that the effect on demand is more pronounced than the effect on supply.

Tax Induced Trading around the Taxpayer Relief Act of 1997

We examine investor trading around the passage of the Taxpayer Relief Act of 1997 (TRA97) that reduced the capital gains tax rate from 28% to 20%. We provide evidence that individual investors increase their demand for equity shares on the announcement day of TRA97, consistent with the capitalization of capital gains taxes. On the effective day of TRA97, we find that individual investors increase the supply of equity shares with accrued gains, consistent with the lock-in effect of capital gains taxes. Regression results suggest that tax capitalization is associated with a more powerful effect on abnormal trading than the lock-in effect for the median stock trading around TRA97. Overall, our results suggest that capital gains taxes influence both the demand and supply for equity by tax sensitive investors and that the effect on demand is more pronounced than the effect on supply.

Capital Gain Tax Overhang and Price Pressure

Capital gains tax can impose potentially large cost on investors selling stocks. This cost can sometimes be an order of magnitude larger than conventional transaction costs. This paper addresses the question of whether capital gains taxes serve as an impediment to selling and if so, to what degree this delayed selling by investors correspondingly affects stock prices. Using a database of large U.S. institutions' stock holdings with data on institutions' client profiles, two main results are obtained. First, selling decisions by institutions serving tax-sensitive clients are shown to be sensitive to their cumulative capital gains, which is not the case for institutions with predominantly tax-exempt clients. In particular, both the likelihood and magnitude of selling by institutions that serve taxsensitive clients are negatively related to the cumulative capital gains. Second, tax-related underselling appears to significantly impact stock prices during negative earnings announcements, for stocks held by a large number of tax-sensitive investors. Specifically, following a negative quarterly earnings surprise, tax-sensitive investors sell less aggressively a stock that has large capital gains; thus for a stock held primarily by taxsensitive investors, the corresponding price reaction is less negative if it has accumulated large capital gains. Further analysis shows that the price reaction pattern is more severe when arbitrage is more costly.

Know When oo Hold 'Em and When to Fold 'Em

Using historical returns of the S&P 500, the authors simulate the after-tax return enhancement from minimizing short-term capital gains, tax deferral of long-term gains, high cost-basis tax lot sales, and tax-loss harvesting. They also demonstrate the relationship of the estate tax to these investment strategies. They show that tax deferral is not an interest-free loan from the government, but rather that the tax code operates more like a partnership carried interest and that the mechanism of tax deferral is a non-linear function of different compounding rates. They extend prior research showing that tax-sensitive investors can reap significant after-tax return advantages that are hard to match with conventional active management. In an addendum, they analyze the effect of the newly enacted tax rates under the Jobs and Growth Tax Relief Reconciliation Act of 2003, and find that the benefits of tax deferral are less, but remain significant.