Abstracts - Financial Services Review

Abstracts:

Financial Services Review
Volume 6 Number 4, 1997 (Index Issue)

An Analysis of the Tradeoff Between Tax Deferred Earnings in IRAs and Preferential Capital Gains
(pp. 227-242) DOWNLOAD FULL-TEXT ARTICLE
Terry L. Crain, Jeffrey R. Austin

ABSTRACT
This paper extends prior research in evaluating the decision of whether to invest in a mutual fund either outright or through one of the three available IRAs: the deductible IRA, the Roth IRA, and the nondeductible IRA. We provide mathematical models for after-tax accumulations for each of the investments that are a function of return, the percentage of the return currently taxable to the investor, the time horizon of the investment, the capital gain tax rate, and the ordinary income tax rate. The Roth IRA and the deductible IRA always dominate investments in the nondeductible IRA or through outright investment. However, in comparing the nondeductible IRA and outright investments, the outcome is dependent on the investment goals of the mutual fund and whether it generates substantial dividend distributions or capital gain distributions. Mutual funds with small dividend and capital gain distributions may accumulate larger amounts if held outright while mutual funds that pay substantial dividends or make substantial capital gain distributions accumulate larger after-tax amounts when invested in a nondeductible IRA.

An Analysis of Nondeductible IRA Contributions and Roth IRA Conversions
(pp. 243-256) DOWNLOAD FULL-TEXT ARTICLE
Stephen M. Horan, Jeffrey H. Peterson, Robert McLeod

ABSTRACT
On average investors have an income replacement rate of 64 percent of their pre retirement income, which in many cases results in a lower tax rate in retirement. We analyze the impact of declining withdrawal tax rates on the choice between taxable mutual fund investments and nondeductible IRAs. The relative attractiveness of the taxable mutual fund option declines significantly when withdrawal tax rates decline. Converting existing IRAs to Roth IRAs is generally beneficial for investors who remain in the same tax bracket upon withdrawal. For short (long) time horizons and low (high) expected returns, the marginal value of conversion in 1998 is greater (less) than the marginal value of optimal conversion. For investors dropping into the 15 percent tax bracket, conversion is generally not beneficial unless the conversion is done optimally, the time horizon is long, and the expected return is high. Investors in the 15 percent tax bracket should convert existing IRA assets.

Performance of Mutual Funds Before and After Closing to New Investors
(pp. 257-269) DOWNLOAD FULL-TEXT ARTICLE
Merman Manakyan, Kartono Liano

ABSTRACT
This study examines the decision to close mutual funds to new investors due to the growth of the funds' assets. The evidence indicates that funds perform better three years prior to closing to new investors than they do afterwards. Furthermore, the evidence indicates that the closed funds outperform the control portfolios of funds with similar investment objectives and asset size during the one- and three-year periods after closing. However, there is no significant difference in the performance of closed funds and their matched control portfolios during the one- and three-year period after closing. Although the primary reason given for closing the funds is the desire to maintain performance in the face of growing assets, the strategy does not appear successful in accomplishing this objective.

The Optimal Choice of Index-Linked GICs: Some Canadian Evidence
(pp. 271-284) DOWNLOAD FULL-TEXT ARTICLE
Moshe Arye Milevsky, Sharon Kim

ABSTRACT
Indexed Linked Guaranteed Investment Certificates (ILGICs), also known as equity linked term deposits, have become quite popular over the last few years. From the consumer's point of view, there are two basic categories of Indexed Linked GIC, the Capped ILGIC and the Participating ILGIC. This paper compares the relative value and appeal of the two ILGIC products from the perspective of the individual investor, using valuation techniques from option pricing theory. We compute the Value per Premium Dollar invested in an ILGICs. Our main conclusions are that ILGICs become less attractive the longer the time horizon of the investor. In addition, participating ILGICs are preferable to capped ILGICs for short term maturities and vice versa for longer maturities. A detailed analysis of two particular Canadian products is provided as an application of the basic concepts. We conclude by demonstrating that Values per Premium Dollar range from 94%-98%, corresponding to a 2%-6% total expense ration on Index Linked GICs.

A Simple and Effective Trading Rule for Individual Investors
(pp. 285-294) DOWNLOAD FULL-TEXT ARTICLE
Laurie Prather,William J. Bertin

ABSTRACT
This study advocates the use of a simple trading strategy that is shown to outperform a passive buy and hold the market strategy. Based on prior studies that find long-term stock price responses to economic news, the strategy utilizes the announcement of discount rate changes to predict (and profit from) market movements. Statistical testing indicates that the strategy correctly predicts market movements. Furthermore, the results indicate that the proposed trading strategy produces higher risk adjusted returns than a buy and hold strategy. Thus individual investors may reasonably expect to profit by following this easy to implement trading strategy.


THE JOURNAL OF INDIVIDUAL FINANCIAL MANAGEMENT
*Abstracts:* Financial Services Review Volume 6 Number 4, 1997 (Index Issue) An Analysis of the Tradeoff Between Tax Deferred Earnings in IRAs and Preferential Capital Gains (pp. 227-242) DOWNLOAD FULL-TEXT ARTICLE Terry L. Crain, Jeffrey R. Austin ABSTRACT This paper extends prior research in evaluating the decision of whether to invest in a mutual fund either outright or through one of the three available IRAs: the deductible IRA, the Roth IRA, and the nondeductible IRA. We provide mathematical models for after-tax accumulations for each of the investments that are a function of return, the percentage of the return currently taxable to the investor, the time horizon of the investment, the capital gain tax rate, and the ordinary income tax rate. The Roth IRA and the deductible IRA always dominate investments in the nondeductible IRA or through outright investment. However, in comparing the nondeductible IRA and outright investments, the outcome is dependent on the investment goals of the mutual fund and whether it generates substantial dividend distributions or capital gain distributions. Mutual funds with small dividend and capital gain distributions may accumulate larger amounts if held outright while mutual funds that pay substantial dividends or make substantial capital gain distributions accumulate larger after-tax amounts when invested in a nondeductible IRA. An Analysis of Nondeductible IRA Contributions and Roth IRA Conversions (pp. 243-256) DOWNLOAD FULL-TEXT ARTICLE Stephen M. Horan, Jeffrey H. Peterson, Robert McLeod ABSTRACT On average investors have an income replacement rate of 64 percent of their pre retirement income, which in many cases results in a lower tax rate in retirement. We analyze the impact of declining withdrawal tax rates on the choice between taxable mutual fund investments and nondeductible IRAs. The relative attractiveness of the taxable mutual fund option declines significantly when withdrawal tax rates decline. Converting existing IRAs to Roth IRAs is generally beneficial for investors who remain in the same tax bracket upon withdrawal. For short (long) time horizons and low (high) expected returns, the marginal value of conversion in 1998 is greater (less) than the marginal value of optimal conversion. For investors dropping into the 15 percent tax bracket, conversion is generally not beneficial unless the conversion is done optimally, the time horizon is long, and the expected return is high. Investors in the 15 percent tax bracket should convert existing IRA assets. Performance of Mutual Funds Before and After Closing to New Investors (pp. 257-269) DOWNLOAD FULL-TEXT ARTICLE Merman Manakyan, Kartono Liano ABSTRACT This study examines the decision to close mutual funds to new investors due to the growth of the funds' assets. The evidence indicates that funds perform better three years prior to closing to new investors than they do afterwards. Furthermore, the evidence indicates that the closed funds outperform the control portfolios of funds with similar investment objectives and asset size during the one- and three-year periods after closing. However, there is no significant difference in the performance of closed funds and their matched control portfolios during the one- and three-year period after closing. Although the primary reason given for closing the funds is the desire to maintain performance in the face of growing assets, the strategy does not appear successful in accomplishing this objective. The Optimal Choice of Index-Linked GICs: Some Canadian Evidence (pp. 271-284) DOWNLOAD FULL-TEXT ARTICLE Moshe Arye Milevsky, Sharon Kim ABSTRACT Indexed Linked Guaranteed Investment Certificates (ILGICs), also known as equity linked term deposits, have become quite popular over the last few years. From the consumer's point of view, there are two basic categories of Indexed Linked GIC, the Capped ILGIC and the Participating ILGIC. This paper compares the relative value and appeal of the two ILGIC products from the perspective of the individual investor, using valuation techniques from option pricing theory. We compute the Value per Premium Dollar invested in an ILGICs. Our main conclusions are that ILGICs become less attractive the longer the time horizon of the investor. In addition, participating ILGICs are preferable to capped ILGICs for short term maturities and vice versa for longer maturities. A detailed analysis of two particular Canadian products is provided as an application of the basic concepts. We conclude by demonstrating that Values per Premium Dollar range from 94%-98%, corresponding to a 2%-6% total expense ration on Index Linked GICs. A Simple and Effective Trading Rule for Individual Investors (pp. 285-294) DOWNLOAD FULL-TEXT ARTICLE Laurie Prather,William J. Bertin ABSTRACT This study advocates the use of a simple trading strategy that is shown to outperform a passive buy and hold the market strategy. Based on prior studies that find long-term stock price responses to economic news, the strategy utilizes the announcement of discount rate changes to predict (and profit from) market movements. Statistical testing indicates that the strategy correctly predicts market movements. Furthermore, the results indicate that the proposed trading strategy produces higher risk adjusted returns than a buy and hold strategy. Thus individual investors may reasonably expect to profit by following this easy to implement trading strategy.