Volume 12, No. 3, Third Quarter 2014

Time Diversification

by: Jack L. Treynor

To maintain constant dollar risk, an investor concerned with his terminal wealth must sell when the stock market rises and buy when it falls. Although an asset with constant dollar risk doesn’t exist in nature, it can be approximated with actual investment positions.

A Rule-Based Commodity Index

by: John M. Mulvey

A commodity index is designed as an equal-weighted set of four complementary tactics. The resulting portfolio takes advantage of well-established patterns in commodity markets, including high volatility and the relative independence of the return drivers. These conditions are ideal for achieving rebalancing gains and thusly for improving risk-adjusted performance. Index performance is compared with long commodity indexes and commodity hedge funds. The benefits of an overlay strategy is shown vis-à-vis a traditional stock/bond portfolio.

Corporate Credit Limits for Fixed Income Portfolios

by: Miikka Taurén and Thomas Philips

Fixed income portfolio managers and risk managers constantly grapple with the question of how to size their corporate credit trades. Their task is made more difficult by the fact that corporate credit events are rare, particularly among Investment Grade bonds, and that tail risk is not well captured by most multifactor risk models. In this article, we propose a simple, but effective, method for sizing credit trades based on their spread. In particular, we model the cross-sectional behavior of corporate spreads, estimate the expected shortfall of monthly spread returns, and use our results, along with some observations on the duration of corporate bonds, to derive a simple upper bound on the permissible exposure to any single issuer in a credit portfolio.

The method has been applied successfully to Investment Grade and High Yield fixed income portfolios in both developed and emerging markets, and has proven its worth in daily use by protecting portfolios against disproportionate idiosyncratic losses, while allowing portfolio managers sufficient flexibility to express their investment views with clarity. Its use is not confined to limits on issuers—our method is easily extended to create limits on a portfolio’s exposures to individual industries, sectors, countries, and regions.

Dilution of Sector Exposures: When Does Unintended Indexing Happen?

by: Michael Stein and Svetlozar T. Rachev

We analyze how the inclusion of several sectors in a portfolio leads to a countering of exposures and to a replication of the index. Using a weight-based measure, we find that on a composition level unintended indexing appears to happen with only moderate severity. However, co-movement with the broad index as measured with standard techniques is a result that is found at already small numbers of included sectors. The results found are robust over time and market phases. We show that investors to sector exchange-traded funds should carefully select the number of investments and base this on the resulting exposure rather than on portfolio-weighting observations. Otherwise, their sector bets or selections are diluted by unintended indexing.

A Survey of University Endowment Management Research

by: Georg Cejnek, Richard Franz, Otto Randl and Neal Stoughton

There is significant interest in how university endowments manage money and perform, and an emerging strand of finance research specializes in this growing area. The purpose of this paper is to survey and review the state-of-the-art in this field. We classify papers into four areas. (1) asset allocation, where we discuss the main theoretical framework and the relevant observations both across time and types of endowment; (2) performance, where (risk-adjusted) performance is discussed and distinguished by type and size of endowment; (3) spending, where the relation to the classical views and theoretical literature is reviewed as well as what university endowments do in practice; and (4) organization, where governance structure and the investment policy statement are discussed. We find that the modern framework for theoretical and empirical analyses can provide a very useful perspective for understanding the role of endowments. Nonetheless we highlight areas where more work remains to be done.

The Undercover Economist Strikes Back - How to Run or Ruin an Economy

by: Tim Harford • reviewed by: Javier Estrada

“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.

The Undercover Economist Strikes Back - How to Run or Ruin an Economy

by: Tim Harford • reviewed by: Javier Estrada

“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.

Large Price Changes and Subsequent Returns

by: Suresh Govindaraj, Joshua Livnat, Pavel G. Savor and Chen Zhao

We investigate whether large stock price changes are associated with short-term reversals or momentum, conditional on the issuance of analyst price target or earnings forecast revisions immediately following these price changes. Our study provides evidence that prices of stocks exhibit momentum when analysts issue revisions after large price shocks, and suggests that the initial price changes were indeed based on new information. In contrast, when price changes are not followed by immediate analyst revisions, we document short-term reversals, indicating that the initial price shocks were likely caused by liquidity or noise traders. A trading strategy that is based on the direction of the price change and the existence of analyst revisions in the same direction earns significant abnormal monthly returns (over 1%).

Hedge Fund Beta Replication: A Five-Year Retrospective

by: Peter A. Lee and Andrew W. Lo

During the past few years, hedge fund beta replication strategies have become more common. At the same time, questions about the relevance, performance, and applicability of these strategies have been raised in response to the rapidly shifting landscape in the hedge fund industry. We present a review of the growing beta replication industry with particular emphasis on the ASG Global Alternatives Fund. We discuss the motivation for its existence and the logic of its absolute and relative performance over time and across different market environments. We also explain why these strategies are complements to, and not substitutes for, direct investments in hedge funds, and provide examples of their value-added in investors’ portfolios.

Time Diversification

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. 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.

Practitioner’s Digest • Vol. 12, 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.