The impact of the short-short rule repeal on the timing ability of mutual funds

Existing empirical studies find little evidence that mutual fund managers time the market. Repealed in 1997, Internal Revenue Service Code Section 851 (b)(3), known as the 'short-short rule,' requires that mutual funds derive less than 30 percent of their gross income from the sale of securities held for less than three months. Failing to comply with the rule means that the Internal Revenue Service taxes the fund's entire gain at the 35 percent corporate tax rate. The short-short rule likely hinders mutual fund managers from timing the market, as it constrains hedging and trading strategies involving short-term trades. In this paper we exploit the natural experiment arising from the repeal of the tax regulation. We find that the timing performance of mutual fund managers improves significantly after the short-short rule repeal. This result suggests that the perverse timing ability documented in the previous literature is partly due to the tax regulation imposed on mutual funds.