Academic journal article Financial Services Review

A Tax-Free Exploitation of the Turn-of-the-Month Effect: C.R.E.F

Academic journal article Financial Services Review

A Tax-Free Exploitation of the Turn-of-the-Month Effect: C.R.E.F

Article excerpt

By applying knowledge of the "turn-of-the-month" effect investors will improve the risk-adjusted performance of their retirement accounts by using a simple and easily implemented "switching" strategy. Our exploitation of the turn-of-the-month anomaly achieves a 17.7 percent average annual rate of return by switching between a money market account and a broad market indexed stock account. This is compared to a 15.6 percent average annual rate achieved by simply buying and holding the stock account, or a 5.8 percent rate on the money market account. Additionally, volatility is cut in half and there are no tax consequences or transactions fees when the switching strategy is used within a retirement account. Our results suggests that this strategy might be successfully implemented, under current tax laws, in qualified retirement plans and in variable annuities.


The turn-of-the-month effect in stock returns has received much attention recently, especially by those who have attempted to document opportunities to exploit this apparent market anomaly. In one recent study, Henzel and Ziemba (1996) demonstrate a trading strategy which achieves superior performance by switching between an interest bearing cash account and the S&P 500 Index around the turn-of-the-month. While ignoring transfer costs and the tax consequences, they claim the results would appeal to institutional investors concerned with the timing of purchases and sales. This paper examines whether individual investors can exploit the turn-of-the-month effect in retirement accounts and variable annuities. By applying a similar switching strategy in a tax-deferred, no transfer cost retirement fund we find that individual investors can exploit the turn-of-the-month effect and earn superior risk-adjusted returns while avoiding the transfer costs and tax consequences of account switching.


Evidence of seasonal anomalies in stock returns has generated considerable public interest in recent years and a significant amount of research has been devoted toward documenting their existence and potential for generating abnormal returns. Much of the empirical evidence suggests that these abnormal returns are economically insignificant once transactions costs and tax consequences are considered.

The January effect, in which average stock returns are higher in January than in any other month, is perhaps the best known and most extensively documented seasonal anomaly. The persistence of this phenomenon over the years, despite the attention it has generated in the popular press, has been reaffirmed in innumerable academic articles since it was first observed more than 50 years ago (Wachtel, 1942) and rediscovered more recently (Rozeff & Kinney, 1976). Among the possible explanations proposed by Wachtel are yearend selling of stocks for tax loss purposes and a "general feeling of good fellowship and cheer" during Christmas holidays (Wachtel, p.186). The tax-loss selling hypothesis is generally considered the most likely explanation for the January rebound and has received the strongest support in the academic literature.

Early work by Keim (1983), Roll (1983), and Reinganum (1983) link the observed January seasonal to small firm return patterns in January and this connection has been reinforced by others. Lakonishok and Smidt (1984), Ritter (1988), and Johnston and Cox (1996) find that tax motivated trading of small capitalization stocks by individual investors drives the January rebound. Haugen and Lakonishok (1987), and Ritter and Chopra (1989) suggest that portfolio rebalancing (or window dressing) by professional portfolio managers to clear smaller, lesser known companies off the books is another likely source of the apparent anomaly. Several studies attribute the January effect to variation in risk premia or expected returns and suggest either that the assumed positive risk-return tradeoff is restricted to small stocks in January (Tinic & West, 1984) or that smaller stocks are simply riskier in January than at other times of the year (Chan, Chen, & Hsieh, 1985; Rogalski & Tinic, 1986). …

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