Volume 7, No. 1, First Quarter 2009

Performance-Based Fees and Risk Shifting with the Knockout Barrier

by: Xiaodong Xu and Bernd Scherer

Many investment firms reward portfolio managers based on their performance. This article investigates a manager's optimal active risk policy using stochastic programming techniques. Our multiple-period model incorporates the most common incentive-fee structures, and captures the risk that the manager is fired for underperformance. In contrast to single-stage models, the manager shows remarkable prudence as he strives to safeguard future fee flows. We observe that if the client is too intolerant of underperformance, the manager will be incentivized to reduce active risk despite earning active fees.We also observe that capping fees too early will causes a lock-in effect.

Stockholder Rights and Carl Icahn

by: Harold Bierman, Jr.

One might conject that shareholder activism should be praised and welcomed by shareholders. This paper suggests that actions, alleged to be on behalf of shareholders, can be shown to be on behalf of a small group of activist investors, and not for the broader group of stock owners. To investigate the issue the actions of Carl Icahn are studied. His strategies are likely to be rewarding for Carl Icahn and his fellow investors.

The Clustering of Extreme Movements: Stock Prices and the Weather

by: Atanu Saha, Burton G. Malkiel and Alex Grecu

One striking feature of the United States stock market is the tendency of days with very large movements of stock prices to be clustered together. We define an extreme movement in stock prices as one that can be characterized as a three sigma event; that is, a daily movement in the broad stock-market index that is three or more standard deviations away from the average movement. We find that such extreme movements are typically preceded by unusually large stock-price movements in previous trading days. Interestingly, a similar clustering of extreme observations of temperature in New York City can be observed. A particularly robust finding in this paper is that extreme movements in stock prices and temperature are usually preceded by large average daily movements during the preceding three-day period. This suggests that investors might fashion a market timing strategy, switching from stocks to cash in advance of predicted extreme negative stock returns. In fact, we have been able to simulate market timing strategies that are successful in avoiding nearly eighty percent of the negative extreme move days, yielding a significantly lower volatility of returns. We find, however, that a variety of alternative strategies do not improve an investor's long-run average return over the return that would be earned by the buy-and-hold investor who simply stayed fully invested in the stock market.

Shorting Demand and Predictability of Returns

by: Lauren Cohen, Karl B. Diether and Christopher J. Malloy

We examine the link between shorting and future returns in the equities market using a proprietary dataset of stock loan fees and quantities. We find that separating supply and demand shifts provides a richer view of the information contained in the securities lending market. Specifically, when separating into supply and demand shifts, we find that increases in shorting demand predict large negative abnormal returns next month (−2.98%), while changes in supply exhibit only modest predictive ability. The returns to a strategy exploiting the information in these demand shifts is large and significant even after: risk adjusting, taking into account the explicit costs of shorting, and taking into account additional transaction costs of the strategy. Collectively these results suggest that understanding more deeply the dynamics of the securities lending market can help us to make better predictions of future stock returns.

Optimal Rebalancing: A Scalable Solution

by: Mark Kritzman, Simon Myrgren and Sébastien Page

Institutional investors usually employ mean-variance analysis to determine optimal portfolio weights. Almost immediately upon implementation, however, the portfolio's weights become sub-optimal as changes in asset prices cause the portfolio to drift away from the optimal targets. We apply a quadratic heuristic to address the optimal rebalancing problem, and we compare it to a dynamic programming solution as well as to standard industry heuristics. The quadratic heuristic provides solutions that are remarkably close to the dynamic programming solution. Moreover, unlike the dynamic programming solution, the quadratic heuristic is scalable to as many as several hundreds assets.

Never Look a Gift Horse In the Mouth

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.

The Housing Bubble and Resulting Mortgage Crisis

by: Robert Hendershott, Patric Hendershott and James Shilling

In the late 1990s, United States house prices began a long boom that peaked in mid 2006. The subsequent reversal of the housing boom has spawned a major crisis in the credit markets. This paper reviews the financial developments that stimulated the house price bubble and the financial repercussions of it bursting.

Plight of the Fortune Tellers: Why We Need to Manage Risk Differently

by: Riccardo Rebonato • reviewed by: Lisa R. Goldberg

“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.

Practitioner’s Digest • Vol. 7, 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.