How to Diversify the Tax-Sheltered Equity Fund

Advanced in Investment Analysis and Portfolio Management, Vol. 1, pp. 117-125, 1991

9 Pages Posted: 9 Mar 2008 Last revised: 20 Apr 2014

See all articles by Frank J. Fabozzi

Frank J. Fabozzi

EDHEC Business School

Jongmoo Jay Choi

Temple University; National Bureau of Economic Research (NBER); Temple University - International Business

Uzi Yaari

Rutgers University; School of Business-Camden

Abstract

Resemblance in portfolio composition of sheltered and unsheltered equity funds held by open-end U.S. investment companies is consistent with their practice of identifying sheltered vs. unsheltered claims on the same portfolios instead of segregating portfolios based on shareholders' tax treatment. This paper questions the consistency of this policy with the objective of maximizing tax-sheltered return and value. If, as evidence suggests, the market is dominated by tax-paying individual investors, risk-adjusted rates of return would approach uniformity after tax, but not before tax. To the extent that capital gains are taxed at preferential effective rates, uniform posttax returns imply higher risk-adjusted pretax returns of those stocks in which a greater proportion of the return is paid in dividends. Elton and Gruber (JFE 1978) derive the optimal portfolio of an investor who is in a tax bracket different from that dominating the market, but without reference to the CAPM. That framework is not relevant for large investors, like mutual funds, holding highly diversified portfolios. Brennan (NTJ 1979) extends the CAPM to an environment of personal taxes, but does not investigate the implications for individual investors who are tax sheltered. We provide a correct, practical method for constructing an optimal stock portfolio that is tailored for the tax-sheltered fund operating in the environment of preferential tax treatment of capital gains. In such an environment, the performance of a sheltered equity fund may be substantially enhanced by a segregated portfolio with composition that differs from that which is optimal for an unsheltered fund.

Keywords: tax-sheltered equity portfolio, tax-sheltered diversification, open-end investment fund

JEL Classification: G11, G12, G23, H22, H24

Suggested Citation

Fabozzi, Frank J. and Choi, Jongmoo Jay and Yaari, Uzi, How to Diversify the Tax-Sheltered Equity Fund. Advanced in Investment Analysis and Portfolio Management, Vol. 1, pp. 117-125, 1991, Available at SSRN: https://ssrn.com/abstract=1104248

Frank J. Fabozzi

EDHEC Business School ( email )

France
215 598-8924 (Phone)

Jongmoo Jay Choi

Temple University ( email )

Fox School of Business
Temple University
Philadelphia, PA 19122
United States
215-204-5084 (Phone)
215-204-1697 (Fax)

HOME PAGE: http://astro.temple.edu/~jjchoi

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Temple University - International Business ( email )

Philadelphia, PA 19122
United States

Uzi Yaari (Contact Author)

Rutgers University ( email )

School of Business
Camden, NJ 08102
United States
610-664-2086 (Phone)

HOME PAGE: http://camden-sbc.rutgers.edu/FacultyStaff/Directory/yaari.htm

School of Business-Camden ( email )

Rutgers University
227 Penn Street
Camden, NJ 08102
United States
610-664-2086 (Phone)
610-664-2198 (Fax)

HOME PAGE: http://camden-sbc.rutgers.edu/FacultyStaff/Directory/yaari.htm

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