Asset Location in Tax-Deferred and Conventional Savings Accounts

The optimal allocation of assets among different asset classes (such as stocks and bonds) has received considerable attention in financial theory and practice. On the other hand, investors have not been given much guidance about which assets should be located in tax-deferred retirement accounts and which in conventional savings accounts. This paper derives optimal asset allocations (which assets to hold) and asset locations (where to hold them) for a risk-averse investor saving for retirement. Locating assets optimally can significantly improve the risk-adjusted performance of retirement savings.

Stochastic Taxation and Asset Pricing in Dynamic General Equilibrium

Tax rates have fluctuated considerably since federal income taxes were introduced in the United States in 1913. This paper analyzes the effects of stochastic taxation on asset prices in a dynamic general equilibrium model. Stochastic taxation affects the after-tax returns of both risky and safe assets. Whenever taxes change, bond and equity prices adjust to clear the asset markets. These price adjustments affect assets with long durations, such as equities and long-term bonds, more than short-term assets. Under plausible conditions, investors require higher term and equity premia as compensation for the risk introduced by tax changes.

Portfolio Concentration and the Performance of Individual Investors

Using data on the investments a large number of individual investors made through a discount broker from 1991 to 1996, we find that the stock trades by households with concentrated portfolios outperform those with diversified portfolios. While in general the stocks bought by individual investors significantly underperform the stocks they sell, the reverse is true for households whose holdings are concentrated in a few stocks. The excess return of concentrated relative to diversified portfolios is stronger for households with large account balances as well as for stocks not included in the S&P 500 Index and local stocks, potentially reflecting concentrated investors' successful exploitation of information asymmetries. This finding is very robust to alternative concentration measures and regression specifications, and to alternative explanations such as differences across concentrated and diversified investors in the portfolio turnover and access to inside information, suggesting that some of these concentrated households have superior information processing skills. Moreover, controlling for a household's average investment ability, the household's trades perform better as the household's portfolio includes fewer stocks. However, while concentrated household portfolios on average outperform diversified ones, their levels of total risk are larger and the Sharpe ratios of their stock portfolios are lower.

Tax Changes and Asset Pricing: Time-Series Evidence

The effective tax rate on equity securities has fluctuated considerably in the U.S. between 1917-2004. This study investigates whether personal taxes on equity securities are related to stock valuations using the time-series variation in tax burdens. The paper finds an economically and statistically significant relationship between asset valuations and personal tax rates. Consistent with tax capitalization, stock valuations tend to be relatively low when tax burdens are relatively high.

The Tradeoff Between Mortgage Prepayments and Tax-Deferred Retirement Savings

We show that a significant number of households can perform a tax arbitrage by cutting back on their additional mortgage payments and increasing their contributions to tax-deferred accounts (TDA). Using data from the Survey of Consumer Finances, we show that about 38% of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice. For these households, reallocating their savings can yield a mean benefit of 11 to 17 cents per dollar, depending on the choice of investment assets in the TDA. In the aggregate, these mis-allocated savings are costing U.S. households as much as 1.5 billion dollars per year. Finally, we show empirically that this inefficient behavior is unlikely to be driven by liquidity considerations and that self-reported debt aversion and risk aversion variables explain to some extent the preference for paying off debt obligations early and hence the propensity to forgo our proposed tax arbitrage.

The tradeoff between mortgage prepayments and tax-deferred retirement savings

We show that a significant number of households can perform a tax arbitrage by cutting back on their additional mortgage payments and increasing their contributions to tax- deferred accounts (TDA). Using data from the Survey of Consumer Finances, we show that about 38% of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice. For these households, reallocating their savings can yield a mean benefit of 11 to 17 cents per dollar, depending on the choice of investment assets in the TDA. ; In the aggregate, these misallocated savings are costing U.S. households as much as 1.5 billion dollars per year. Finally, we show empirically that this inefficient behavior is unlikely to be driven by liquidity considerations or other constraints, and that self-reported debt aversion and risk aversion variables explain to some extent the preference for paying off debt obligations early and hence the propensity to forgo our proposed tax arbitrage.Mortgage loans ; Retirement income ; Taxation

On the Industry Concentration of Actively Managed Equity Mutual Funds

Mutual fund managers may decide to deviate from a well-diversified portfolio and concentrate their holdings in industries where they have informational advantages. In this paper, we study the relation between the industry concentration and the performance of actively managed U.S. mutual funds from 1984 to 1999. Our results indicate that, on average, more concentrated funds perform better after controlling for risk and style differences using various performance measures. This finding suggests that investment ability is more evident among managers who hold portfolios concentrated in a few industries.

Tax Externalities of Equity Mutual Funds

Investors holding mutual funds in taxable accounts face a classic externality. The after-tax return of their investment depends on the behavior of others. In particular, redemptions may force the mutual fund to sell some of its equity positions in order to pay off the liquidating investors. As a result, it may be forced to distribute taxable capital gains to its shareholders. On the other hand, new investors convey a positive externality upon existing investors by diluting the unrealized capital gain position of the fund. This paper's simulations show that these externalities are important determinants of the after-tax performance of equity mutual funds.

Asset Location for Retirement Savers

This paper uses data on actual returns on taxable bonds, tax-exempt bonds, and a small sample of equity mutual funds over the 1962-1998 period to compare two asset location strategies for retirement savers. The first strategy gives priority to holding equities, through equity mutual funds, in a saver's tax-deferred account, while the second strategy gives priority to holding fixed-income investments in the tax-deferred account. We consider high-income taxable individual investors who saved in each year and invested in one of actively-managed funds in our sample. Over the thirty-seven year span that we consider, such savers would have accumulated a larger stock of wealth if they had held their equity mutual fund in their tax-deferred account than if they had held the fund in a conventional taxable form. The explanation for this apparent contradiction of the often-stated bonds in the tax-deferred account' prescription has two parts. First, many equity mutual funds impose substantial tax burdens on their investors. This raises the effective tax rate on investing in equities through mutual funds rather than in a buy-and-hold personal portfolio. Second, taxable investors who wish to hold fixed income assets can do so by holding tax-exempt bonds as well as by holding taxable bonds. The interest rate differential between taxable and tax-exempt bonds suggests that the effective tax rate on fixed income investments may be lower than the statutory tax rate for high-income investors.

PIPE Dreams? The Performance of Companies Issuing Equity Privately

Private Investments in Public Equity (PIPEs) have become an important source of financing for young, publicly traded firms whose poor operating performance may limit alternative financing options. We propose that firms are motivated to sell these securities to minimize costs associated with asymmetric information. We find that both the security structure and the investor composition of a PIPE security matter in the subsequent performance of the issuing firm. Poor post-issuance performance is associated with securities where investors obtain significant repricing rights, which protect them from future stock price declines. Furthermore, companies that obtain financing from hedge funds tend to under-perform companies that obtain financing from other institutional investors. We argue that hedge funds act as investors of last resort, playing an important role in the market for young, high-risk firms with substantial asymmetric information. Hedge funds are willing to fund such high-risk companies because they can protect against possible price declines in the issuing companies by either negotiating PIPE securities with repricing rights or by entering into short positions of the underlying stocks of the issuing companies.