Volume 12, No. 2, Second Quarter 2014

THE LINK BETWEEN INFLATION AND THE VALUE OF PLANT

by: Jack L. Treynor

When negotiators have fixed the money wage, if the central bank wants to change the level of money prices, it has to change the real wage. But the real wage changes whenever the identity—hence the age and productivity—of the marginal plant changes. On the other hand the scarcity rents on younger, more productive plant are measured relative to the marginal plant. Investors who understand this link won’t wait for central bank action to adjust their forecasts of the rents.

Sovereign Credit Default Swap Premia

by: Patrick Augustin

This paper reviews the young but rapidly growing literature on sovereign credit default swap premia. A discussion of current debates in the academic and popular press hopefully raises thought-provoking questions with valuable insights for academics, policymakers and practitioners alike. The main elements of the review relate to the determinants of sovereign CDS spreads, spillovers and contagion, frictions, the relationship to and impact on public bonds, as well as trading in the market for sovereign credit derivatives. In addition, I describe key statistical and stylized facts about prices, the market, and its players.

Mutual Fund Outperformance and Growth

by: Gregg S. Fisher, Philip Z. Maymin and Zakhar G. Maymin

Does better performance lead to more assets? We examine nearly 30,000 mutual funds to determine the effect that a fund’s outperformance relative to its peers has on the fund’s later asset size. We find that a fund that earns ten percent more than the size-weighted average of its peers in its style group in one year will on average experience an extra 5% excess asset growth in the subsequent year. The findings are robust to all types of fund styles and all fund sizes, with two exceptions: small funds of any style and very large fixed income funds.

The Shadow Price of Liquidity in Asset Allocation – A Case Study

by: Bac Van Luu, Yazid Sharaiha, Nikolay Doskov, Chirag Patel and David Turkington

We apply a framework for estimating the investor-specific value of liquidity which can be used to inform asset allocation decisions. The shadow price of liquidity is a central concept in this framework. In the case study, the investor considers allocation to private equity, real estate, and infrastructure alongside a public equity and bond portfolio. Given the assumptions made on how this investor uses portfolio liquidity, we find that the shadow cost of liquidity is less than 1%. In other words, the additional return required for taking on illiquidity risk is not very demanding for the case in question, but may be higher for other investors.

Restoring Value to Minimum Variance

by: Lisa Goldberg, Ran Leshem and Patrick Geddes

A long-only investable minimum variance strategy outperformed the S&P 500 over the four decades from January 1973 to December 2012. Through the lens of a factor model, we show that this outperformance can be largely attributed to implicit style bets. Specifically, minimum variance has thrived by tilting toward stocks that have lower market capitalization and volatility, and a higher ratio of earnings to price. As funds have poured into minimum variance in the wake of the financial crisis, and plausibly as a consequence of this trend, the value tilt has disappeared and a momentum tilt has emerged. This suggests that the cost of entry to minimum variance is at a historic high. We show how the value tilt can be restored to minimum variance by targeting specific exposures, and that there was a substantial long-term benefit to the restoration at most recent points of entry to the strategy.

Does Factor Timing Explain Hedge Fund Alpha?

by: Hyuna Park

This paper empirically decomposes hedge fund excess return into factor timing, security selection, and risk premium. Portfolio-level tests show that security selection explains most of the excess return generated by hedge funds during 1994–2009, and the contribution of factor timing is small. Fund-level tests find significant evidence of both positive and negative timing funds, but the excess return of positive timing funds is not significantly higher than that of the other funds. These findings imply that factor timing is not the main source of hedge fund alpha, and the results are robust to different factor models.

Global Macro: Theory & Practice

by: Andrew Razanov • reviewed by: Cel Kulasekaran

“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.

A Solution to the Trade Deficit?

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.

Practitioner’s Digest • Vol. 12, No. 2

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.