Volume 10, No. 3, Third Quarter 2012

Practitioner’s Digest • Vol. 10, 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.

Redemption Fees and the Risk-Adjusted Performance of International Equity Mutual Funds

by: Iuliana Ismailescu and Matthew Morey

In the wake of the market timing and late trading mutual fund scandals, many mutual funds adopted redemption fees to limit market timing. In this paper we investigate the impact of redemption fees on the risk-adjusted performance of U.S. based international equity funds, the very funds that many market timers used. We find three interesting results. First, using event study methodology we find that after the introduction of redemption fee there is a significant increase in the risk-adjusted fund performance. Second, we find that funds that introduced larger-size redemption fees have significantly better performance after the introduction of the redemption fee than other funds. Third, we find that the main reason for the improvement in fund performance after the introduction of the redemption fee is due to lower amounts of cash being held by the fund after the redemption fee. In sum our results suggest that implementation of redemption fees are performance enhancing for international equity funds. As such, long-term investors of international equity funds should actively look for international equity funds that have redemption fees.

How Does Your State Stack Up? Participation Costs in Higher Education Optional Retirement Plans

by: Daniel Bradley and Lei Wedge

We examine the costs to higher education employees investing in optional retirement plans (ORP). We find vast differences across states in terms of the number of providers, number of funds offered per provider, and fees. We find the same provider offering the same fund oftentimes charges significantly different fees across states. Net performance is 18 basis points lower than what an investor would otherwise be able to directly invest in funds not within an ORP system. Cross-sectionally, we find that funds offered by insurance companies systematically have worse performance than mutual fund providers. Further, we find that states with more ORP providers have better net performance. Our evidence suggests that by giving employees more choices, the additional competition within the ORP system would result in lower fees, thereby increasing terminal wealth for participants. Our paper has important policy implications as these plans become popular in the public sector as governments try to cut costs by reducing severely underfunded pension liabilities.

The Relative Strength of Industries versus Countries in Global Equity Markets

by: Jose Menchero and Andrei Morozov

The relative strength of industries versus countries is of great practical interest for global equity investors. In this article, we investigate the relative strength of these effects in the global equity markets over the sample period 1994-2010. In particular, we examine three market segments: (a) the world market, (b) emerging markets, and (c) developed Europe. We employ a factor-based approach to construct portfolios that capture the pure effect of each industry or country. We define two quantities to measure the relative strength of the two effects: diversification potential and mean absolute deviation. For the world market, we find that industry and country effects are of comparable strength, although each dominates during different sub-periods. In particular, countries dominated in the mid-to-late 1990s, whereas industries dominated in the aftermath of the internet bubble. For emerging markets, we find that countries have dominated industries over the entire sample period. In developed Europe, by contrast, we find that industries have dominated countries since the introduction of the euro. We also investigate the size dependency of the relative strength of industry versus country effects. In particular, we find that in the small-cap segment, industry effects become weaker whereas country effects retain their full strength.

Estimating the Negative Impact of “Noise” on the Returns of Cap-Weighted Portfolios In Various Segments of the Equity Markets

by: Russell J. Fuller, Bing Han and Yining Tung

Capital Market Theory assumes that the ex ante market portfolio (which is cap-weighted) lies on the (ex ante) efficient frontier. However, we show that ex ante cap-weighted portfolios will always be interior portfolios relative to the end-of-investment-period ex post efficient frontier. This is due to the arrival of unanticipated information, which we refer to as noise that causes unexpected price changes and creates either winner or loser stocks. By construction, ex ante cap-weighted portfolios will be overweighted in loser stocks and underweighted in winners during the return measurement period. To estimate the negative impact of noise on the returns of ex ante cap-weighted portfolios, we use the concept of a perfect foresight (PF) portfolio. The PF portfolio for any given equity segment is a buy-and-hold portfolio of all stocks in that segment with weights at the beginning of the return period set to be proportional to the market capitalization of the stocks at the end of the return period. We show that the PF portfolio will always be on the ex post efficient frontier and outperform its ex ante cap-weighted counterpart. Because the PF portfolio has risk characteristics that are similar to the ex ante capweighted portfolio for a particular equity segment, the excess return of the PF portfolio provides an estimate of the maximum annual amount of available alpha to all investors involved in that segment in a given year. For example, the total excess return of the PF portfolio for the large-cap US equity segment (which we define as the 1,000 largest US stocks based on market values at the beginning of each year) is about 7%, on average, per year. This can be thought of as the maximum amount of alpha, or ex ante mispricing (in percentage terms), available to all investors in the large-cap US equity market segment.

A New Perspective on the Validity of the CAPM: Still Alive and Well

by: Moshe Levy and Richard Roll

The Capital Asset Pricing Model (CAPM) has far-reaching practical implications for both investors and corporate managers. The model implies that the market portfolio is mean-variance efficient, and thus advocates passive investment. It also provides the most widely used measure of risk, beta, which is used to calculate the cost of capital and excess return (alpha). Most academic studies empirically reject the CAPM, leaving the lack of a better alternative as the only uneasy justification for using the model. Here we take a reverse-engineering approach for testing the model and show that with slight variations in the empirically estimated parameters, well within their estimation-error bounds, the CAPM perfectly holds. Thus, in contrast to the widely held belief, the CAPM cannot be empirically rejected.

Investing Early for 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.

What Investors Want

by: Meir Statman • reviewed by: Manny Hunjan

Pension Finance: Putting the Risk and Costs of Defined Benefit Plans Under Your Control

by: M. Barton Waring • reviewed by: Bruce Grantier

“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.