Volume 4, No. 3, Third Quarter 2006

Practitioner’s Digest • Vol. 4, No. 3

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.

Bruno de Finetti and Mean-Variance Portfolio Selection

by: Mark Rubinstein

Bruno de Finetti is generally regarded as the finest Italian mathematician of the 20th century. Among his many achievements, economists are familiar with his work on the axiomatization of subjective probability. To the surprise of many, a treasure-trove of other results in economics has recently come to light which until now has never been translated into English. Foremost among these is his paper, The Problem of Full-Risk Insurances, which anticipates much of Markowitz's mean-variance portfolio theory by over a decade. This issue of the Journal includes Luca Barone's translation of de Finetti's first chapter on this subject and a review by Harry Markowitz.

de Finetti Scoops Markowitz

by: Harry M. Markowitz

In 1940, in the context of choosing optimum reinsurance levels, Bruno de Finetti essentially proposed mean-variance analysis with correlated risks. It was not until 1952 that Markowitz and Roy introduced mean-variance analysis with correlated risks into the financial literature. De Finetti solved the problem of computing mean-variance efficient frontiers for a particular constraint set (one that describes the reinsurance problem) assuming uncorrelated risks. While he understood and explained the importance of the case with correlated risks, he did not provide an algorithm for this case. In fact, one of his conjectures concerning its solution was incorrect. The present article summarizes de Finetti's contribution, presents an algorithm for solving "the de Finetti problem" when risks are correlated, and illustrates these matters with an easily visualized two-policy reinsurance problem.

Bruno de Finetti, The Problem of “Full-Risk Insurances”

by: Luca Barone

We examine-in its different aspects-the problem of the risk due to hedging a set of insurances and, consequently, the problem of the retention levels, i.e., of the most efficient method to reinsure a part of such insurances to reduce the risk within the desired limits, while minimizing the loss of profit. The different aspects we considered are: the risk within a single accounting period (Chap. I), the risk for the whole existing portfolio (Chap. II), the risk related to the whole future development of the firm (Chap. III). Some concluding remarks follow (Chap. IV).

Cap Weighted Portfolios Are Sub-Optimal Portfolios

by: Jason Hsu

In this paper, we show that under a fairly innocuous assumption on price inefficiency, market capitalization weighted portfolios are sub-optimal. If market prices are more volatile than is warranted by changes in firm fundamentals, then cap-weighted portfolios do not capture the full premium commensurate their risk. The sub-optimality arises because cap-weighting tends to overweight stocks whose prices are high relative to their fundamentals and underweight stocks whose prices are low relative to their fundamentals. The size of the cap-weighted portfolio underperformance is increasing in the magnitude of price inefficiency and is roughly equal to the variance of the noise in prices. However, portfolios constructed from weights, which do not depend on prices, do not exhibit the same underperformance observed for cap-weighted portfolios. We illustrate this cap-weighting underperformance empirically by comparing returns from cap-weighted portfolio versus non-cap-weighted portfolios with similar characteristics. We also derive testable implications from our model assumption and find empirical support.

The Fundamental Law of Active Portfolio Management

by: Roger Clarke, Harindra de Silva and Steven Thorley

The strategic perspectives and terminology of the fundamental law is a common framework in the practice of active portfolio management. For tractability, fundamental law theory depends on the simplifying assumption of a diagonal covariance matrix of security returns, though the matrices supplied to numerical optimizers are fully populated. We extend the fundamental law of active management to allow for a full covariance matrix and show that the resulting ex-ante (expected) and ex-post (realized) return equations are exact in contrast to the approximate equality of previous derivations. The exactness of ex-post equations allows for performance attribution of realized returns that completely decomposes the return. Because the various fundamental law parameters we define incorporate all the information in the covariance matrix, they should also provide better ex-ante insights as to the sources and limitations of risk-adjusted active return. In addition to the generalization of the fundamental law, we describe a full covariance matrix alpha generation process and add some comments to the concept of implied breadth. The mathematics and practical application of the full covariance matrix fundamental law parameters are illustrated using an EAFE benchmarked portfolio with the 21 countries as individual securities.

Stock Return Momentum and Investor Fund Choices

by: Travis Sapp and Ashish Tiwari

Recent research by Gruber (1996) and Zheng (1999) has shown that investors are able to predict mutual fund performance and invest accordingly. This phenomenon has been dubbed the "smart money" effect. We show that the smart money effect is explained by stock return momentum at the one year horizon. Further analysis suggests that investors do not select funds based on a momentum investing style, but rather simply chase funds with recent large returns. Our finding that a common factor in stock returns explains the smart money effect offers no affirmation of investor fund selection ability.

Gas Caps and the Sherman Act

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.

Credit Default Swap Spreads

by: Sanjiv R. Das and Paul Hanouna

We review the literature on credit default swap spreads, which are fast replacing bond spreads as source data for analyzing and predicting credit risk. We review results that examine the basis, i.e. the difference between bond and CDS spreads, enabling the extraction of liquidity measures. Results show that pure structural models may be enhanced by macro and firm level variables to better explain spreads; credit premiums extracted from reduced-form models are highly variable; and that there are statistically significant interactions between the term structures of interest rates and spreads.

A History of the Theory of Investments

by: Mark Rubinstein • reviewed by: Craig W. French

The Nobel Memorial Laureates in Economics: An Introduction to Their Careers and Main Published Works, 2005

by: Howard R. Vane and Chris Mulhearn • reviewed by: Frank Jones

“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.

The Logic of Life

by: Tim Harford • 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.