The capital gain lock-in effect and perfect substitutes

This paper analyses the effect of investors' accrued capital gains on optimal portfolio composition and equilibrium returns under the assumption that investors are able to re-balance with perfect substitute securities. No-dominance arguments are used to show that pricing differences because of accrued capital gains do not arise among securities which are perfect substitutes. These arguments are insufficient, however, to prevent pricing differences because of accrued capital gains among securities which are not perfect substitutes. Trading rules are developed which outline the conditions necessary for the realisation of accrued capital gains and the deferral of capital losses. These trading rules also provide guidance on which securities investors should sell, given their tax basis, when re-balancing their portfolios.