Volume 4, No. 4, Fourth Quarter 2006

Practitioner’s Digest • Vol. 4, No. 4

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.

On the Financial Interpretation of Risk Contribution: Risk Budgets Do Add Up

by: Edward Qian

Due to a lack of clear financial interpretation, there are lingering questions in the financial industry regarding the concepts of risk contribution. This paper provides as well as analyzes risk contribution’s financial interpretation that is based on expected contribution to potential losses of a portfolio. We show risk contribution, defined through either standard deviation or value at risk (VaR), is closely linked to the expected contribution to the losses. In addition, for VaR contribution, our use of Cornish–Fisher expansion method provides practitioners an efficient way to calculate risk contributions of portfolios with non-normal underlying returns. Empirical evidences are provided with asset allocation portfolios of stocks and bonds.

The Right Answer to the Wrong Question: Identifying Superior Active Portfolio Management

by: W. V. Harlow and Keith C. Brown

The debate over the value of active portfolio management has often centered on whether the average active manager is capable of producing returns that exceed expectations. We argue that a more useful way to frame this issue is to focus on identifying those managers who are the most likely to generate superior risk-adjusted returns (i.e., alpha) in the future. Using a style-classified sample of mutual funds, we document several tractable relationships between observable fund characteristics and its future alpha, most notably the tendency for performance to persist over time. While median managers produce positive risk-adjusted performance approximately 45% of the time, we document a selection process that improves an investor’s probability of identifying a superior active manager to almost 60%. We conclude that there is a place in the investor’s portfolio for the properly chosen active manager.

Empirical Dynamic Asset Pricing: Model Specification and Econometric Assessment

by: Kenneth J. Singleton • reviewed by: Cel Kulasekaran

Confession of an Economic Hit Man

by: John Perkins • reviewed by: Tim Adler

“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 Stock Market’s Reaction to Unemployment News, Stock-Bond Return Correlations, and the State of the Economy

by: John H. Boyd, Ravi Jagannathan and Qianqiu Liu

We confirm Boyd et al.’s (2005) finding that on average a surprise increase in unemployment is “good news” for stocks during economic expansions and “bad news” during economic contractions. Unemployment news bundles information about future interest rates, equity risk premium, and corporate earnings. For stocks as a group information about interest rates dominates during expansions, and information about future earnings dominates during contractions. Hence, (a) ceteris paribus, the correlation between stock and bond returns will be greater during economic expansions and (b) stock price responses to the unemployment news will convey information about the state of the economy.

The Worldwide Financier

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.

Aggregate Idiosyncratic Risk and Market Returns

by: Turan G. Bali and Nusret Cakici

This paper tests the empirical performance of a model-independent measure of aggregate idiosyncratic risk introduced by Bali and Cakici (2004) in the intertemporal capital asset pricing framework. The results indicate a significantly positive relation between the equal-weighted average stock volatility and the value-weighted portfolio returns on the NYSE/AMEX/NASDAQ stocks for the sample period of 1963:08–1999:12.We show that this result is driven by small stocks traded on the NASDAQ. In addition, the positive risk-return tradeoff does not exist for the extended sample of 1963:08–2004:12 and for portfolios of NYSE/AMEX and NYSE stocks. More importantly, we find almost no evidence of a significant link between the value-weighted portfolio returns and various measures of the value-weighted average idiosyncratic volatility.

The Relation Between Fixed Income and Equity Return Factors

by: Jaime Lee, Terry Marsha, Robert Maxim and Paul Pfleiderer

This paper provides an analysis of the relation between equity and fixed income returns over time. As measured by realized correlation, this relation has changed substantially over the last decade, from positive to negative through the market collapse and is currently around zero. We find “jumps” in the co-movements of equity and bond returns at a daily frequency; these jumps can at times be attributed to “flight to liquidity” phenomena in the markets, and at other times, to apparent surprise announcements in expected inflation or related macro conditions. We find no evidence of short-run persistence in the jumps in daily co-movement of bond and equity returns, but there does seem to be a “regime-like” longer-run persistence in them, perhaps associated with Federal Reserve “management over the last decade.