The Abattoir of Large-Cap Value Fund Performance

In 1993, Joel Dickson and John Shoven came up with a breakthrough insight into the investment markets that they sought to publish in the 1993 National Bureau of Economic Research under the title “Ranking Mutual Funds On An After-Tax Basis” (Working Paper 4393). The paper never got published, but it measured the 1965-1990 investment markets to conclude that churn within the portfolio of mutual funds created significant tax liabilities that meant investors achieved significantly worse after-tax returns on investment than the advertised performance of the mutual fund.

The closest anyone came to picking up the research of Dickson and Shoven came in 2002, when Peterson, Pietranico, Riepe, and Xu published “Explaining After-Tax Mutual Fund Performance” in the FAJ. Their conclusions came with a counterintuitive spin: Although small-cap stocks are the most volatile, the ordinary 401(k) investor is actually more hurt by the behavior of other investors that own large-cap value funds.

The explanatory process is that ordinary investors typically flock to funds classified as large-cap value when making stock investments for retirement. These truly are the funds that are the most popular with the masses. As a consequence, the net redemptions of these people in response to 10-25% declines in the net asset value of mutual funds is so extreme that, along with accompanying portfolio turnover, the tax hit consumes 178 basis points of performance.

In other words, the typical large-cap value fund displaying 9.5% returns over the past ten years actually returned 7.72% after adjusting for the tax implications created by portfolio turnover. This turnover was driven by people selling their ownership positions in the fund as stock prices fell and the valuations became more favorable, forcing fund managers to sell stocks selling at the highest valuations (often because they have delivered the best recent performance) in order to avoid “selling low” the positions that have declined the most and created the declines in NAV in the first place. This is a vicious cycle.

Trying to figure out the contingent tax liabilities in a mutual fund is extraordinarily time intensive because it involves spending hours and hours weeding through a prospectus and other disclosure forms, and someone with the skill to do this can probably save the 1% or 2% fee and just make common stock investments for himself (unless the particular 401(k) puts a bar on individual investment selections.)

This difficulty, however, is overshadowed by something you cannot predict: the fund sales of other investors. When you invest in a large-cap value mutual fund, you are particularly subject to the impulses of other people holding that fund. Historians are known for saying that “those who do not understand history are doomed to repeat, and although we know history, we end up doomed to watch others repeat it.” Even if you know that 30% declines in funds that are similar to the S&P 500 often indicates a buying opportunity, you can be put at a financial disadvantage if the other people owning your fund do not know that. They sell at inopportune times, and as a consequence, your fund manager must sell at an inopportune time as well.

Small-cap value funds seem to attract investors with more of a buy-and-hold orientation, as the harm caused from net redemptions during stock market declines amount to 92 basis points–about half of the effect seen in large-cap value funds.

This is one of the reasons why I advocate a diversified portfolio of common stocks. Not only are you free from selling the stock against your will, but you get control of the tax liabilities that you incur. You reduce your dependence on the intemperance of others. You don’t have to deal with a 178 basis point reduction in performance because of tax liabilities created by general portfolio turnover mixed with net redemptions that force portfolio turnover.

Large-cap value mutual funds are the first to redemption loss in troubled economic times, and this affects performance. It is something that generally goes uncovered because mutual fund providers do not want to give you incentives not to invest in their funds. There is no well-funded platform to get this information out to investors. You have heard many complaints that active management cannot often compete with passive management of assets, and this gap widens even more when you study the unusually high tax consequences associated with owning large-cap value mutual funds.