Tax preferences of investors and fund investments

•Funds take into account the tax preferences of investors in managing portfolios.•Distributions of open-end funds are taxable in the year of distribution.•Distributions of variable annuity funds are tax-deferred until withdrawn.•Variable annuity funds distribute higher dividends than open-end funds.•Variable annuity funds distribute higher capital gains than open-end funds.

Funds must distribute all dividends and net realized short-term and long-term capital gains to their investors each year. Investors have to pay tax on these distributions. We find that funds whose distributions are taxable pay lower dividends than funds whose distributions are tax-deferred. Taxable funds also distribute relatively lower short-term and long-term capital gains. This suggests that funds take into account the tax preferences of their investors in making investment decisions.