Returns and Portfolio Diversification of Tax-incentive Equity Funds

Abstract

Background and Objectives: Nowadays, the investment of tax-incentive equity funds, particularly Retirement Mutual Funds (RMF) and Long-Term Funds (LTF), are chosen for savings by more investors every year.  Nevertheless, investors also have the choice of nontax-incentive equity funds for investment or saving.  Tax-incentive equity funds have an advantage over tax saving(s) for investors. However, investors will have to accept a time constraint rule, whereby they must hold tax-incentive funds for a certain lengthy period of time, possibly ten years or longer. Non-tax-incentive equity funds, however, do not have such time constraint rules as tax-incentive equity funds have. Moreover, there is controversy regarding the performance of tax-incentive and nontax-incentive equity funds when compared over time. This research compares different mutual fund performances and risk diversification between tax-incentive and nontax-incentive equity funds. Furthermore, it reveals the investment performance and portfolio diversification between two groups. Our findings will serve to guide investment decisions according to appropriate levels of risk and return.  We hypothesize that tax-incentive equity funds will differ in investment performance from that of nontax-incentive equity funds.

Methodology: This research aims to compare asset characteristics, rates of return, risk diversification, and investment performamnce between tax-incentive and nontax-incentive equity funds. Investment performance is measured by using the five following methods: Jensen’s alpha, Treynor ratio, Sharpe ratio, Excess Standard Deviation Adjusted Return, and Information ratio. The residual variance (RV) is also used to control portfolio diversification in these five methodologies. We expect different performances between tax-incentive and nontax-incentive equity funds.

Main results: The results of this research indicate that tax-incentive equity funds have larger sizes, higher returns, and lower risk than those of nontax-incentive equity funds. However, neither group has significant differences in investment performance. For portfolio diversification, we found that there is a significant difference at 0.05 between the two groups of funds. Tax-incentive equity funds have better portfolio diversification and lower risk than the nontax-incentive funds.

Discussion: Analysis of the rate of return, mutual fund characteristics, risk diversification, and investment performance between tax-incentive and nontax-incentive equity funds shows that tax-incentive equity funds have triple the size of nontax-incentive funds. While nontax-incentive equity funds are smaller in size, their investment strategy focuses on stock clustering. Tax-incentive equity funds, however, have larger rates of return and lower risk than nontax-incentive funds. Even so, analysis of investment performance shows that both groups either perform similarly or there is an insignificant statistical difference between investment performances when compared.

Conclusion: Although tax-incentive and nontax-incentive equity funds differ in risk diversification, their investment performance is either the same or lacks any significant statistical difference when investment performances are compared. Hence, investors can choose to invest in either group of equity funds depending on their goals and limitations on investments. If investors have no time constraints on their investment, they can invest in tax-incentive equity funds, where they can get tax-saving benefits as well. Thus, investors who have time constraints on their investment horizon should invest in nontax-incentive equity funds. Investors who invest in nontax-incentive equity funds can sell their investment any time if they prefer.