Volume 3, No. 2, Second Quarter 2005
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Practitioner's Digest
Practitioner’s Digest • Vol. 3, No. 2
The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.
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Insight
The Lorenz Curve
For a century, the critics' favorite example of the failures of capitalism has been the Lorenz curve. They rank households from poorest to richest and then plot cumulative wealth against the cumulative number of households. The critics argue that, if capitalism were fair, the Lorenz curve would be a straight line: the poorest 10% of the households would own 10% of the wealth, the poorest 20% would own 20%, etc. Actual Lorenz curves are not straight. Instead, they are sharply curved, showing that much of society's wealth is owned by the richest households. Economics textbooks (e.g., Samuelson) display these curves for actual countries, citing them as examples of "market failure." This paper develops a theory of the economic forces that shape the Lorenz curve. It explains why actual curves have the shape they have.
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Article
Developing Better Fee Structures for Mutual Funds
This paper presents a management decision model for setting mutual fund fees. The model pairs information obtained from a conjoint analysis, designed to uncover investors' preferences for different fee structures, with information on the expected revenue generated from various fee structures to suggest a set of "efficient" fees to mutual fund managers. Companies that market mutual funds can use this model to refine the fees they impose. We demonstrate our modeling approach using data collected from mutual fund investors. Finally, we show how this same data, and the conjoint analysis methodology, can be used to uncover price discrimination opportunities in this marketplace.
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Article
How New Entry in Options Markets Affected Market Making and Trading Costs
A significant competition for order flow in options markets occurred in August 1999. Before the competition, the majority of option volume arose from exclusive listings. By the end of September 1999, entry by existing option exchanges had shifted the majority of option volume to multiple-listing status. Both effective and quoted bid-ask spreads decrease significantly after entry with spreads remaining at lower levels 1 year later. A pooled regression analysis shows that new inter-exchange competition reduces option trading costs. This analysis also rejects the view that economies of scale in market making or lower hedging costs contribute significantly to the decrease in spreads.
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Article
The Kiss Of Death: A 5-Star Morningstar Mutual Fund Rating?
We examine the effect that an initial 5-starMorningstar mutual fund rating has on future fund performance, strategy, risk-taking, expenses, and portfolio turnover. Using a sample of diversified domestic equity funds from the 1990s we find that during the 3 years after a fund received its initial 5-star rating, fund performance severely falls off. This result is robust across different performance measures and different samples of funds. We also find that after receiving their initial 5-star rating, the risk levels of funds rise and the funds are not able to load on momentum stocks as well as they did before receiving the 5-star rating. These results suggest that funds, to some degree, alter their portfolios after receiving a 5-star rating and that investors should be very wary about using the 5-star rating as a signal of future 3-year performance.
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Article
Global Diversification
Correlations between the returns of US stocks and international stocks were higher recently than in the past, reaching 0.86 during the 60 months ending in December 2003. Today's investors note the high correlations between US and international stocks and doubt the benefits of global diversification. We argue that the benefits of global diversification remain high and that the correlation between US and international stocks is a misleading measure of the benefits of global diversification. This is for two reasons. First, the benefits of global diversification depend not only on the correlation between the returns of US and international stocks but also on the standard deviations of these returns. Second, we tend to have poor intuition about the link between correlation and the benefits of diversification. A 0.86 correlation seems high enough to eliminate the benefits of diversification, but even correlations much higher than 0.86 are associated with substantial benefits. Dispersion of returns is a better measure of the benefits of diversification because it accounts for the effects of both correlation and standard deviation and because it provides an intuitive measure of the benefits of diversification. We present the relationship between correlation, standard deviation, and dispersion.
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Article
Motivation and Performance Following Open-Ending of Closed-End Funds
This study investigates the motives for open-ending closed-end funds, and performance of closed-end funds following open-ending announcements. We find that the propensity to open end is higher for funds that are larger, have high expense ratios, exhibit high volatility, and whose prices reflect large discounts from net asset value. The total wealth effects of open-ending announcements are stronger for smaller closed-end funds, and in periods when market conditions are relatively weak. There is no observable evidence that the governance-related factors found to predict future open ending are being successfully used to extract higher gains.
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Case Study
Financial Literacy
“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.
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Survey & Crossover
Genetic Algorithms
“Surveys& Crossovers” This section provides surveys of the literature in investment management or short papers exemplifying advances in finance that arise from the confluence with other fields. This section acknowledges current trends in technology, and the cross-disciplinary nature of the investment management business, while directing the reader to interesting and important recent work.
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Book Review
Neoclassical Finance
Experimental Economics
“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.