Tax externalities of equity mutual funds

Investors holding mutual funds in taxable accounts face a classic externality. The after-tax return of their investment depends on the behavior of others. In particular; redemptions may force the mutual fund to sell some of its equity positions in order to pay off the liquidating investors. As a result, it may be forced to distribute taxable capital gains to its shareholders. On the other hand, new investors convey a positive externality upon existing investors by diluting the unrealized capital gain position of the fund. This paper's simulations show that these externalities are important determinants of the after-tax performance of equity mutual funds.