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Journal of Applied Research in Accounting and Finance

Vol 6 (1) July 2011


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Is Portfolio Theory Harming Your Portfolio? by Scott Vincent

Modern Portfolio Theory (MPT) teaches us that active equity managers who use judgment in making investment decisions won't be able to match the returns (after fees and expenses) of blindly-invested, passively-managed index funds. Data on returns supports the theory, so it's no surprise that investors are leaving actively-managed funds in droves for the better average returns of super-diversified index strategies. Yet the reality is much murkier than we've been led to believe. It turns out that the portfolio theories which inspired the creation and popularity of index funds and top-down, quantitatively-driven index-like strategies, are both flawed and impractical. There's compelling evidence, moreover, that a subset of active managers do persistently outperform indexes.

Regardless of MPT's shortcomings on both a theoretical and empirical level, its dominating influence will not easily be dislodged. However, as highly-diversified strategies gain assets, inefficiencies become more prevalent because share prices are increasingly driven by factors other than fundamentals. Individual investors, seeking to exploit these inefficiencies and outperform indexes, should invest in several concentrated funds with strong track records. Managers of these funds have proven themselves adept at turning inefficiencies into strong returns for their investors, and persistence data demonstrates that past performance can indicate which managers are likely to continue to outperform. Concentrated fund returns may exhibit more volatility than indexes, but we now have proof that over the long-term, good judgment will be rewarded.

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Three Letters that Move the Markets: Credit Ratings between Market Information and Legal Regulation by Ulrich G Schroeter

As demonstrated by the market reactions to downgrades of various sovereign credit ratings in 2011, the credit rating agencies occupy an important role in today's globalised financial markets. This article provides an overview of the central characteristics of credit ratings and discusses risks arising from both their widespread use as market information and from the increasing references to credit ratings contained in laws, legal regulations and private contracts.

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Deferred Tax Assets & The Disclosure of Tax Planning Strategies by Charles Mulford and Eugene Comisky

Citigroup, Inc and American International Group, Inc have two very disparate views on the realisability of their deferred tax assets. Important to each company's decision is the assessed availability or lack of tax-planning strategies needed to generate future taxable income. Yet, notwithstanding the importance of such strategies to these firms and others generally, little is known about them. Further, we find that companies are often not forthcoming in their disclosures of what tax-planning strategies are available to them and how they might be used. Investors and analysts could use this information in assessing the likelihood of future taxable income and the need for a valuation allowance against reported deferred tax assets.

In this research report we look closely at tax-planning strategies and the details, or lack thereof, provided by firms in describing them. From a sample of 34 firms drawn from recent filings with the SEC, we identify and categorise tax-planning strategies currently being used. We find that investment-related tax-planning strategies, eg., selling appreciated securities or switching tax-exempt securities to taxable ones are the most common strategy in use, comprising 47 per cent of our sample. Planned sales of other assets comprise 16 per cent and transactions related to sale and leaseback transactions and other income-acceleration transactions constitute 13 per cent of the sample. Five percent of the sample each employ a permanent reinvestment of foreign subsidiary earnings or capitalising R&D costs for tax purposes. The remaining sample firms use a host of other miscellaneous practices, including the purchase of replacement properties, the merging of subsidiaries, or the shifting of entities to lower tax-rate jurisdictions. Given the general lack of disclosures observed, the FASB may wish to consider requiring more disclosure of tax-planning strategies by reporting firms.

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