By Diane Luckow
Illustrated by Harvey Chan
"Death and taxes and childbirth! There's never any convenient time for any of them! "
- Scarlett O'Hara in Gone with the Wind
Peter Klein would agree with Scarlett's sentiment - particularly the bit about the taxes. The inconvenience of a capital gains tax bill forms the crux of the SFU business professor's research into two unexplained stock market anomalies that financial economists have documented but failed to adequately explain.
The anomalies? Well, stock market analysts know that a stock that does well over a long horizon of, for example, five years, will tend to do less well over the subsequent five years. Finance economists have dubbed this phenomenon "long horizon return reversal." The other phenomenon is the "January effect, " which acknowledges that stock returns in the month of January tend to be higher than in all other months.
Klein figures he has the answer - one that takes into account investor behaviour instead of conjuring up increasingly complex empirical and theoretical models.
"The basic idea is that stocks that have done well in the past create accrued capital gains for their shareholders," explains Klein, who is also a chartered financial analyst. "When these shareholders finally decide to sell, they realize they'll need a higher price to offset their capital gains tax bill. In order to diversify their portfolios, buyers interested in these particular stocks are willing to pay this higher price to acquire some shares, although they'll acquire fewer shares because of the higher price. The result is that supply equals demand at a higher price, which implies smaller price gains - and hence lower returns - in subsequent periods."
Explaining the January effect
The January effect is also caused by capital gains taxes, but comes into play due to accrued capital losses. Investors with a capital loss are better off if they sell a stock in December because if they wait until January, the benefit of the tax loss is deferred another 12 months. Thus they will sell in January only if the price is higher than in December, which explains the large returns in the month of January, particularly for stocks that have done poorly in the previous year.
"Many researchers have said it's due to investor irrationality," says Klein. "I've come out with an argument that just requires the proper analysis of the effects of taxes."
Klein understands investor behaviour - he worked for nine years at a senior level in the international finance industry.
A joint business and law degree from the University of Western Ontario in 1984 took him to Wood Gundy's underwriting department for two years before he moved to the Tokyo office as vice-president, investment banking. There, he helped provincial governments and large corporations woo private money from wealthy Japanese companies. "We were the only Canadian company doing that, " he recalls. "They were exciting times."
When CIBC bought Wood Gundy in 1988, Klein moved to London, England, where he became chief trader for the CIBC's European Derivatives Book. The "Book" is a daily printout of all the bank's transactions. It was Klein's job to examine these and ensure that the bank's risks were secured, or hedged, and, if they weren't, to at least be aware of the risks.
He left England in 1990 to return to Canada because of his eldest son's medical problems. In Toronto, he became vice-president, structured finance, and then vice-president, commodity derivatives, starting up CIBC's commodities derivatives operation. This market was somewhat similar to the market in options and forwards on foreign currencies, but with several complicating factors such as delivery of large and bulky items. The trick was to get out of the position before delivery occurred. Klein remembers one of the players, Enron, which was accepting delivery for goods that no one else in the market could do. For example, they had five delivery hubs for natural gas compared to the standard hub in Houston. "Ten years hence, we see that what they were doing may not have been well thought-out."
At the same time, Klein was teaching corporate finance part-time at the University of Toronto. He discovered he enjoyed teaching and decided to quit CIBC to spend more time with his kids while he worked on a PhD, with a view to becoming a professor.
He finished his PhD in 1996, at age 37, winning the Harvey Rorke Memorial Prize for Best Dissertation on a Canadian Investment Topic. His dissertation examined capital gains taxation.
Klein then accepted a visiting professorship for one year at SFU and interviewed for permanent positions with Ivy League schools in the U.S., including the Wharton School of the University of Pennsylvania. What he was really after, however, was a tenure-track position with the SFU business faculty. "I liked the people, " he says, "and we're not too stuck up as a university - we're willing to allow people to do what they want to do. There's a strong research focus but we're open-minded as long as the regular work gets done."
After just two years on faculty, Klein won a coveted Canada Trust Distinguished Teaching award based on student and peer reviews. Klein attributes the award to his ability to relate theory to the real world. "I can lecture on the theory and give examples of how it was, or wasn't, applied - or was badly applied - in the real world," he says.
Global Asset and Wealth Management MBA
Klein is now using his industry experience and knowledge of investor behaviour to guide SFU's new Global Asset and Wealth Management MBA program, which commences this fall. It's a finance MBA with a twist, he says, because it includes a focus on the architectural aspects of investment management, such as estate planning and client relationship management. "This is where the industry is heading, " says Klein. "This is where there's interest. " He points out that the SFU business faculty had no trouble convincing 11 of Canada's top financial services firms to ante up $75,000 for a three-year term on the program's business council. "We're saving them recruitment and training costs, " he says. "That's why they're joining."
Klein also plays the market these days and has a few research-based tips for other investors about how accrued capital gains and losses should influence their investing behaviour.
"You're correct to hold on to your stocks with accrued capital gains, even if it means your portfolio is somewhat unbalanced, " he says. "Further, my work states pretty clearly that you should avoid stocks that have had very large price run-ups because, on average, for valid reasons relating to taxes, the returns in subsequent periods will be lower. And finally, the January effect is something you should reliably be able to profit from, particularly if you are tax-exempt, or are investing within your RRSP."
While Klein concedes that his research is unconventional, it has received critical acclaim in the world of academia and recently attracted a major Social Sciences and Humanities Research Council grant. "The support I've had to pursue this unconventional research," he says, "is what makes SFU business, and Simon Fraser University, such an outstanding place to work."
For more information on the Global Asset and Wealth Management MBA visit their website. aq