Volume 4, No. 1, First Quarter 2006

Practitioner’s Digest • Vol. 4, No. 1

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.

Skill – Based Investment Management: The Next Evolution in the Asset Management Industry

by: Pranay Gupta and Jan Straatman

In this paper, we discuss the structure of investment management organizations from a business model perspective, investment structure perspective, and return analysis perspective. We argue that the definition of a business model to align the interest of the asset owner and asset manager is critical to maximizing investment returns. Failure in this process leads to a vicious circle, both for the organization and the investments. Further, we propose that the investment structure of investment management organizations needs to evolve from an asset class demarcated and regional structure, to a global skill-based structure, where there are no asset classes and no regions, and only skills. As a result, asset allocation has to evolve to exposure allocation. In the proposed multi-strategy, exposure-based framework, the definition of alpha and beta needs to evolve to exposure premium and arbitrage return, and portfolio risk should be decomposed into intended and unintended, rather than into systematic and unsystematic.

Does the Stock Market Underreact to R&D Increases?

by: Allan C. Eberhart, William F. Maxwell and Akhtar R. Siddique

We examine a sample of 8,313 cases, between 1951 and 2001, where firms unexpectedly increase their research and development expenditures (R&D) by a significant amount. We find consistent evidence that our sample firms are undervalued following their R&D increases as manifested in the significantly positive long-term stock returns that our sample firms' shareholders experience. We also find consistent evidence that our sample firms have significantly positive long-term abnormal operating performance following their R&D increases. Our findings suggest that R&D increases are beneficial investments, and that the market is slow to recognize the extent of this benefit (consistent with investor underreaction).

Mutual Fund Dilution from Market Timing Trades

by: Jason T. Greene and Conrad S. Ciccotello

This paper introduces a model to measure the dilution impact on an open-end fund due to market timing trades. When a timer buys shares of a fund just prior to positive returns, the extra cash in the fund dilutes the fund's return. While this impact can be directly measured on the day after a timer's purchase, the impact on subsequent days depends on whether the fund's cash balance remains distorted. Our model offers a framework that allows the timer's holding period and the portfolio manager's treatment of cash flows to inform an accurate calculation of the dilution impact.

Can Contrarian Strategies Improve Momentum Profits

by: Kalok Chan and Hung Wan Kot

This paper investigates whether investors can exploit the contrarian cycle to improve the profitability of momentum strategies. We conjecture that the momentum strategies implemented in the early stage of price reversal (MSES) are more profitable than those implemented in the late stage of price reversal (MSLS). Our empirical results show that while MSES records significant positive returns, the profits from MSLS are not significant. There is a continuation of momentum profits in MSES up to 60 months, but not in MSLS. The overall evidence indicates that we can improve the profits of momentum strategies if we also consider past long-term performance.

Great Moments in Financial Economics: IV. The Fundamental Theorem (Part II)

by: Mark Rubinstein

This is Part II of the fourth in a series of articles in this Journal examining the historical origins of key ideas in the history of financial economics. It describes an extension of the "fundamental theorem" from buy-and-hold strategies developed in Part I to dynamic portfolio strategies. Part II presumes the reader is familiar with Part I. The extension can be traced back to work by Blaise Pascal and Pierre de Fermat in the 17th century, with a subsequent path in the 20th century that leads to modern option pricing theory.

When Plant Wears Out – A Case

by: Jack L. Treynor

“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.

Understanding Arbitrage: An Intuitive Approach to Financial Analysis

by: Randall S. Billingsley • reviewed by: Tim Adler

The Legacy of Fisher Black

by: Bruce Lehmann • reviewed by: Craig W. French

“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.