Volume 10, No. 1, First Quarter 2012

Live Prices and Stale Quantities: T+1 Accounting and Mutual Fund Mispricing

by: Peter Tufano, Michael Quinn and Ryan Taliaferro

Most mutual funds use day-old fund holdings but current-day prices to calculate net asset values. This practice, sanctioned under SEC Rule 2a-4, results in deviations between reported net asset values (NAVs) and returns and the economic values of those quantities. Using a sample of 26 funds' trading data, we establish that small distortions in both NAVs and returns were fairly common in the early 2000s, and distortions were much more pronounced in the volatile markets of 2008. We discuss policy implications of this pricing rule, including mandating same-day pricing or ex post disclosure of pricing discrepancies.

Lifecycle Consumption-Investment Policies and Pension Plans: A Dynamic Analysis

by: Zvi Bodie, Jérôme Detemple and Marcel Rindisbacher

This paper explores the optimal design of personal pensions based on the economic theory of the life cycle. It assumes that individuals derive utility from consumption of goods and leisure and that at some date they retire and stop earning income from labor. The existence of this retirement phase of the life cycle has a profound impact on optimal consumption and portfolio policy. We describe the properties of the optimal pension contract and derive the dynamic trading strategy that hedges the contract. In view of the popularity of age-based strategies like target date funds as default options in 401k and other defined contribution retirement plans, some of our results are particularly noteworthy. All target date funds start with a high proportion in equities at a young age and reduce it as a person ages. We identify conditions where the fraction of wealth optimally invested in equities increases or decreases over time as an individual ages. We also analyze the dynamics of pension plans, wealth and optimal policies. Distributional properties of endogenous variables are examined and the robustness of patterns to variations in parameters such as risk aversion and mortality risk is examined.

Timing the Value Style Index in a Markov Regime-Switching Model

by: Hany Guirguis, Ted Theodore and Michael Suen

We construct and test a popular indicator for timing value style investment: the earnings yield dispersion (EYD). Conventional wisdom holds that one should invest in value style when there is a wide dispersion in earnings yield (E/P ratios) across the equity market. This hypothesis is based on a simple argument: many value stocks are depressed during such periods, causing yields to increase and the earnings yield dispersion (EYD) to widen. Investors believe that depressed prices are bound to revert upward, causing the dispersion to narrow. Using a Markov regime-switching model, we demonstrate that the effect of an EYD signal is conditional on the market regime. In a low-variance regime, an increase in EYD predicts positive returns for the value style index, as suggested by the conventional wisdom. In a high-variance regime, however, an increase in EYD predicts negative returns for the value style index. High-variance regimes tend to be associated with strong negative price momentum and overreacting, pessimistic investors. Thus, it is very difficult for depressed value stocks to bounce back in a high-variance regime. The effect of EYD during a high-variance regime is exactly opposite to the conventional wisdom prediction.

Calibrating Neutrality: The Evolving Global Opportunity Set

by: Sharon Hill and Chris Gowlland

Modern portfolio theory suggests that investors can achieve maximum diversification holding a portfolio of risky assets reflecting the entire market, but no generally accepted method exists to construct such a portfolio. We present data on global equities and global fixed-income securities since 1990, and show that the relative weights of different asset classes have changed substantially, such that the market-neutral portfolio in these two major asset classes has not been constant over time. These results may be important for investors seeking to mimic the investable market, and could represent a benchmark for active allocation funds which principally hold equities and bonds.

Baby Boomers in Retirement

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.

Expected Returns: An Investor's Guide to Harvesting Market Rewards

by: Antti Ilmanen • reviewed by: Graham Rennison

“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. 10, 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.