Volume 4, No. 2, Second Quarter 2006

Practitioner’s Digest • Vol. 4, 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.

A Dynamic Model of Portfolio Management

by: Richard Grinold

This paper presents a simplified model of dynamic active portfolio management. It is designed to answer questions about product design and provide a guide to better implementation. The model has four inputs: an information ratio that measures the anticipated ability to add value, a risk aversion parameter, a speed of decay of our information called the half-life, and finally a measure of transactions costs. With this structure and some assumptions we can derive relatively simple algebraic expressions for the annualized alpha, risk and transactions costs of the strategy. This allows us to construct both pre-and post-cost measures of implementation efficiency.
The model can be used in many ways. First establishing sensitivity of outputs to inputs. This sensitivity can be an aid in the allocation of research effort. Second, measuring the effect of increased assets under management on the ability to deliver post-cost results. Third, investigating the cost of parameter errors; if we think transactions costs are X but they really are 2*X, what are the implications. Fourth, weighting multiple signals.

S&P 500 Index Changes and Investor Awareness

by: Honghui Chen, Gregory Noronha and Vijay Singal

We find that, on average, firms added to the S&P 500 index experience a permanent price increase, while those deleted from it suffer only a temporary price decline. Existing theories, such as a downward sloping demand curve, liquidity, and information, fail to explain the asymmetric response. We propose a new explanation for the observed price patterns: changes in investor awareness. Investors become more aware of a stock upon its addition to the S&P 500 index but do not become similarly unaware of a stock following its deletion. This results in a significant price increase after an addition but not an equivalent decline after a deletion. Consistent with our hypothesis, we find that Merton's (Journal of Finance, 1987, 42, 483-510) measure of awareness improves after an addition but remains essentially unchanged after a deletion. The price reaction is related to changes in the measure of awareness. From a practical standpoint, our results suggest that index fund managers who are not constrained by tracking error minimization are better off not trading on the effective date. Rather, they may be able to benefit their shareholders by executing purchases of additions upon announcement, but waiting to sell deleted firms until well after the effective date.

Employee Stock Options and Taxes

by: Courtney H. Edwards, John R. Graham, Mark H. Lang and Douglas A. Shackelford

In this paper, we investigate the effect of stock options on the tax position of the firm. We argue that option tax deductions can significantly affect a firm's marginal tax rate and that the effect is masked by current financial reporting rules. We present an approach for factoring in option deductions in assessing a firm's tax position and document that the effect can be substantial. In particular, many firms that appear to be profitable and face high income tax burdens (based on public financial statement data) actually pay relatively little in taxes. We provide evidence that the effect of options on taxes may help to explain managerial decisions such as why apparently profitable firms carry so little debt, lease rather than purchase, and outsource tax-advantaged activities, such as research and development, to syndicated partnerships.

How Do IPO Issuers Pay for Analyst Coverage?

by: Michael T. Cliff and David J. Denis

This article reports evidence consistent with the view that initial public offering (IPO) issuers purchase high-quality analyst coverage with greater underpricing of the IPO. Specifically, we report that underpricing is positively related to analyst coverage by the lead underwriter and to the presence of an all-star analyst on the research staff of the lead underwriter. Moreover, if underwriters do not deliver the expected analyst coverage (conditional on the level of underpricing) IPO issuers are more likely to switch underwriters when they conduct a subsequent seasoned equity offer.

Are the Probabilities Right? Dependent Defaults and the Number of Observations Required to Test for Default Rate Accuracy

by: Roger M. Stein

Users of default prediction models often desire to know how accurate the estimated probabilities are. There are a number of mechanisms for testing this, but one that has found favor due to its intuitive appeal is the examination of goodness of fit between expected and observed default rates. While large data sets are required to test these estimates, particularly when probabilities are small as in the case of higher credit quality borrowers, the question of how large often arises. In this short note, we demonstrate, based on simple statistical relationships, how a lower bound on the size of a sample may be calculated for such experiments. Where we have a fixed sample size, this approach also provides a means for sizing the minimum difference between predicted and empirical default rates that should be observed in order to conclude that the assumed probability and the observed default rate differ. When firms are not independent (correlation is non-zero), adding more observations does not necessarily produce a confidence bound that narrows quickly. We show how a simple simulation approach can be used to characterize this behavior. To provide some guidance on how severely correlation may impact the confidence bounds for of an observed default rate, we suggest an approach that makes use of the limiting distribution of Vasicek (1991) for evaluating the degree to which we can reduce confidence bounds, even with infinite data availability. The main result of the paper is not so much that one can define a likely error bound on an estimate (one can), but that, in general,under realistic conditions, the error bound is necessarily large implying that it can be exceedingly difficult to validate the levels of default probability estimates using observed data.

The Undercover Economist

by: Tim Harford • reviewed by: Javier Estrada

The Future for Investors

by: Jeremy Siegel • reviewed by: Javier Estrada

“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.

Multiple-Core Processors For Finance Applications

by: Sanjiv R. Das

“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.