Volume 5, No. 1, First Quarter 2007
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Case Study
Reifen AG
“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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Article
What Every Investor Should Know About Commodities Part I: Univariate Return Analysis
In this paper we study the univariate return properties of a large variety of commodity futures. Our analysis shows that the volatility of commodity futures is comparable to that of US large cap stocks. Yet, with the exception of energy, a consistently positive risk premium is lacking in commodity futures. We also find that for many commodities, futures returns and volatility can vary considerably over different phases of the business cycle, under different monetary conditions as well as with the shape of the futures curve. Skewness in commodity futures returns is largely insignificant, whereas kurtosis is significantly positive and comparable to that of US large cap stocks. In almost all commodities we find significant degrees of autocorrelation, which affects the properties of longer horizon returns.
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Article
Measuring the True Cost of Active Management by Mutual Funds
This article derives a rigorous method for allocating fund expenses between active and passive management and that enable one to compute the implicit cost of active management. Computing this "active expense ratio" requires only a fund's published expense ratio, its R-squared relative to a benchmark index, and the expense ratio for a competitive fund that tracks that index. This method is then applied to the Morningstar universe of large-cap mutual funds and active expense ratios are found to average more than 7%. The cost of active management for other classes of mutual funds is also found to substantial.
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Article
Industry Concentration and Mutual Fund Performance
We study the relation between the industry concentration and the performance of actively managed U.S. mutual funds from 1984 to 2003. Our results indicate that the most concentrated funds perform better after controlling for risk and style differences using factor-based performance measures. This finding suggests that investment ability is more evident among managers who hold portfolios concentrated in a few industries.
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Article
The Value of Transaction Cost Forecasts: Another Source of Alpha
This article examines the impact of transaction costs on portfolio performance. Previous research on this topic has focused largely on post-trade considerations, i.e., the impact of realized transaction costs on investment performance. By contrast, we focus on pre-trade considerations, namely the impact of transaction costs on portfolio breadth, turnover, and expected returns. Although costs reduce the information ratio, improvements in transaction cost modeling can mitigate these effects by increasing skill and breadth. Transactions cost considerations also affect the choice of portfolio turnover. Greater turnover allows for more active bets, increasing breadth, but magnifies the impact of trading costs. Balancing these considerations yields an optimal turnover level. The analysis provides insights into the determinants of optimal fund capacity. We show that capacity problems are manifested gradually in the form of higher expected costs, reduced breadth, and lower turnover. Capacity is an elastic concept that is surprisingly responsive to even relatively modest gains in transaction cost control or forecasting ability. This suggests that fund managers can influence their capacity through investments in better execution research and technology.
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Article
Proxy Voting Brand Competition
Institutional and individual investors can coordinate their proxy voting to improve corporate governance. A new funding design for professional proxy advisors can increase their quality and competition. These reforms would reduce the need for the public sector to police boards of directors by onerous regulation and expensive lawsuits.
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Book Review
A Behavioral Approach To Asset Pricing
Investors and Markets
“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.
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Practitioner's Digest
Practitioner’s Digest • Vol. 5, 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.
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Article
What Every Investor Should Know About Commodities Part II: Multivariate Return Analysis
In this paper, we study the multivariate return properties of a large variety of commodity futures. We find that between commodity groupings (such as metals, energy, etc.) correlations are very low and mostly insignificant whereas within groups they tend to be much stronger. In addition, commodity futures are roughly uncorrelated with stocks and bonds. Still, correlations may vary somewhat over the different phases of the business cycle, suggesting that not all commodities make equally good diversifiers at all times. Copula-based tests do not indicate any deviant behavior in the tails of the joint return distribution of commodity futures and stocks or bonds. Contrary to equities and bonds, we show that commodity futures returns are positively correlated with unexpected inflation (i.e., 25% on average with CPI inflation as opposed to −30% for equities and −50% for bonds). There are significant differences between the various commodities, however, with energy, metals, cattle, and sugar offering the best hedging potential. Altogether, assuming that the observed regularities will persist, our results confirm that a well-balanced commodity futures portfolio could offer a worthwhile diversification service to the typical traditional investment portfolio.