How to Diversify the Tax-Sheltered Equity Fund

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