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Capital gains tax 'locks in' investors, increases likelihood of opposition to fund management

Scott Weisbenner
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College of Business

Mutual funds are more likely to oppose a firm’s management when they are "locked-in" to a position that would otherwise trigger a capital gains tax for their investors, says research co-written by Scott Weisbenner, the James F. Towey Faculty Fellow in the College of Business.

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4/21/2014 | Phil Ciciora, Business & Law Editor | 217-333-2177;

CHAMPAIGN, Ill. — As mutual funds continue to gobble up a larger portion of equities, the influence they exert over corporate governance has likewise increased.

According to research from a University of Illinois finance professor who studies operational decisions made by institutional managers, mutual funds are more likely to oppose a firm's management when they are "locked-in" to a position that would otherwise trigger a capital gains tax for their investors.

With a capital gains tax creating a disincentive for mutual funds to sell stocks that have increased in value, the "lock-in" not only reduces the likelihood of the fund selling the stock, it also increases the likelihood of the fund voting against the firm's management – especially if they're less entrenched, says research co-written by Scott Weisbenner, the James F. Towey Faculty Fellow in the College of Business.

"We found that a mutual fund's decision to exit, or stay and support, or stay and fight a firm's management is based on how 'locked-in' they are to a position," he said. "What that means is, when aggregated across all the mutual fund shareholders in a firm, the behavior of mutual funds has real implications for vote outcomes and firm policy."

Weisbenner says considerable attention has already been paid to corporate governance – or how shareholders influence a firm's management to maximize the firm's stock price.

"Work has been done showing that the capital gains tax, which affects investors in nonretirement account funds, causes mutual funds to postpone selling stocks in their portfolio that have gone up in price," he said. "We further find that given that these funds will be holding the stock for a while anyway, they are more likely to object when management makes a contentious proposal that may not be in the best interests of the firm's shareholders."

Which is an interesting result, according to Weisbenner, "because not only are mutual funds an important shareholder class, but also because it illustrates another effect a realization-based capital gains tax" – that is, paying tax on gains only after the asset is sold – "can have on mutual fund manager decisions," he said.

Given this tax-induced illiquidity, Weisbenner and his co-authors examined whether funds with higher accrued capital gains in a stock of a company were more likely to oppose company management by using a sample of votes in which opposing management was likely to increase value for the firm.

Consistent with a tax motivation, the results indicate that the relationship between providing governance and accrued capital gains is stronger for funds with a high fraction of tax-sensitive investors.

"Since these locked-in funds are likely to continue to hold the stock for a while, they could potentially benefit from the improvement in the company," Weisbenner said.

According to Weisbenner, mutual funds typically face such tradeoffs when deciding whether to oppose management.

"On the one hand, the proposal might be bad for the firm as a whole, so voting against management's recommendation might be good for the stock they own," he said. "On the other hand, management might be upset when a fund votes against them, and deny them business such as offering products of that fund's company in the firm's 401(k) plan. For a position with an unrealized capital gain, mutual funds with taxable clientele must trade off those two countervailing forces."

If the fund disagrees with management, a simple solution is to exit their position by selling the firm's stock. But for mutual funds with taxable investors – that is, nonretirement account funds – those investors are "locked in," which not only reduces the likelihood that the fund would sell the stock, but also increases the likelihood that a locked-in fund would oppose the firm's management.

"Thus, funds with taxable investors that are holding a stock that has gone up a lot since they bought it may be more likely to stick around and fight management, given they are more likely to hold the stock for tax reasons," Weisbenner said. "Because of this lock-in effect, different mutual funds will have different liquidity in the same stock, depending on the tax status of their respective investors and the size of the accrued gain – or loss – in that stock."

In the paper, Weisbenner and his co-authors also examined a sample of more than 10,000 votes at shareholder meetings from 2003 to 2008 in which the recommendation management gave on how to vote differed from the direction of the Institutional Shareholders Services, a third-party proxy advisory firm that independently evaluates proposals on the meeting agenda.

"For this group of contentious votes, for which opposing management might be good for the stock price in the long run, management still wins the vote about three-quarters of the time," Weisbenner said.

The researchers also examined what the likelihood is of at least one such contentious proposal making it on the meeting agenda at an annual shareholder meeting.

"In our sample, we found that there is at least one contentious vote held at a meeting two-fifths of the time," Weisbenner said. "Like a deterrent effect, the simple presence of accrued capital gains among mutual fund shareholders in the firm makes it less likely such a contentious vote will occur in the first place. Thus, the lock-in effect on mutual funds for providing governance not only affects vote outcomes, but also affects the composition of the types of items shareholders will vote on to begin with."

According to Weisbenner, the research is especially relevant because mutual funds now represent more than a third of U.S. equities, up from less than 10 percent in the early 1980s.

"One of the big changes in the stock market over the last 30 years is the growth in the share of the stock market owned by mutual funds," he said. "So this lock-in effect for providing governance that effects mutual funds, should be even more important for firms in the future if this shift in ownership continues."

The paper, which won the Best Paper Award at the annual "Finance Down Under" conference in Melbourne, Australia, was co-written by Stephen G. Dimmock, of Nanyang Technological University; William C. Gerken, of the University of Kentucky; and Zoran Ivković, of Michigan State University.

Editor's note: To contact Scott Weisbenner, call 217-766-5012; email

The paper, "Locked-in to Govern: How the Capital Gain of a Stock Holding Affects a Mutual Fund's Voting Decision," is available online.

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