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Dividend Tax Drag on European Funds

Posted in Mutual/Hedge Funds

Do European-listed equity index funds predictably underperform their benchmarks by the amount of total expenses, as do U.S.-listed counterparts? In the May 2010 update of their paper entitled “The Performance of European Index Funds and Exchange-Traded Funds”, David Blitz, Joop Huij and Laurens Swinkels investigate the magnitude and sources of underperformance of European index mutual funds and exchange-traded funds (ETF) relative to benchmark indexes. Using return and expense data for a sample of 40 European-listed passive funds of interest to global equity investors, and their underlying indexes, spanning January 2003 through December 2008, they find that:

  • European index funds and exchange-traded funds underperform their benchmarks by 0.5% to 1.5% (median 0.8%) annually, substantially greater deficits than explained by reported expenses. Further, variation in this “excess” underperformance across funds appears unrelated to variation in reported expenses.
  • This “excess” underperformance derives from dividend taxes withheld from fund managers by local authorities. (Index total return calculations typically assume reinvestment of all dividends, and funds do not account for withheld dividend taxes in total expenses.)
  • On average, fund expenses (dividend taxes) contribute -0.6% (-0.5%) annually to European index fund performance.

In summary, evidence indicates that both fund expenses and dividend taxes constitute substantial drags on European index funds compared to underlying indexes. In other words, each investor may want to account for the personal effect of dividend tax withholding in evaluating affected funds.

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