Open-End Mutual Funds and Capital-Gains Taxes

Open-end mutual funds realize a large fraction of their capital gains every year and pass them through to investors as taxable distributions. This behavior is surprising since the funds' existing shareholders would prefer to defer realization of the gains as long as possible. We examine the question of why mutual funds realize such a large fraction of their capital gains realizations illustrating that both fund managers and investors might prefer early realization of capital gains in a long-run, steady-state equilibrium. Unrealized capital gains in the funds portfolio increase the likely magnitude of future taxable distributions and therefore increase the expected present value of a new investor's tax liability. Thus, even though existing shareholders would prefer that gains be deferred as long as possible, potential new investors will be attracted to funds with a smaller overhang of unrealized capital gains. Consequently, managers have incentives to reduce the overhang to attract new investors. Our model explains some of the cross-sectional variation in capital gains realization policies. As predicted by our model, overhangs are negatively correlated with the funds growth-rate volatility, and the funds cash balances