Volume 13, No. 3, Third Quarter 2015
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Book Review
Investors and Markets
“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.
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Article
The Value of Active Investing
We examine whether the value of active investment management can exceed its cost, and find that it can, by a substantial margin. We consider the 0.67% average cost estimate in French (2008), comparing it with the expected value of a known active investment strategy. For a “passive” benchmark, we develop a 225 year index of monthly U.S. equity market returns, from July 1789 through June 2014. This timeframe encompasses the entire history of every U.S. exchange and includes all known periods of secondary market stock trading in the United States. We then estimate the long-run monthly returns of an active investment strategy based on an actual 11-year investment strategy. We present a new performance model extending the Treynor and Mazuy (1966) model and implement it to estimate monthly returns to the active strategy over the same 225 year period.We believe that this experiment offers a good example of how the value of well-constructed active investment strategies can be worth substantially more than their cost.
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Article
Beware of Children Trading
Guardians behind underaged accounts are successful at picking stocks. These informed traders tend to channel their best trades through the accounts of children, especially when they trade just before major earnings announcements, large price changes, and takeover announcements. Building on these results, we argue that the proportion of total trading activity through underaged accounts (labeled BABYPIN) is an effective proxy for firm-specific information asymmetry. Consistent with this claim, we show that investors demand a higher return for holding stocks with a higher probability of informed trading as proxied by BABYPIN.
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Article
Augmented Risk Models to Mitigate Factor Alignment Problems
Construction of optimized portfolios entails a complex interaction between three key entities, namely, the risk factors, the alpha factors and the constraints. The problems that arise due to mutual misalignment between these three entities are collectively referred to as Factor Alignment Problems (FAP). Examples of FAP include risk u underestimation of optimized portfolios, undesirable exposures to factors with hidden and unaccounted systematic risk, consistent failure in achieving ex-ante performance targets, and inability to harvest high quality alphas into above-average IR. In this paper, we give a detailed analysis of FAP and discuss solution approaches based on augmenting the user risk model with a single additional factor y. For the case of unconstrained mean–variance optimization (MVO) problems, we develop a generic analytical framework to analyze the ex-post utility function of the corresponding optimal portfolios, derive a closed-form expression of the optimal factor volatility value and compare the solutions for various choices of y culminating with a closed-form expression for the optimal choice of y. Augmented risk models not only correct for risk underestimation bias of optimal portfolios but also push the ex-post efficient frontier upward thereby empowering a portfolio manager (PM) to access portfolios that lie above the traditional risk–return frontier. We corroborate our theoretical results by extensive computational experiments, and discuss market conditions under which augmented risk models are likely to be most beneficial.
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Article
Decentralization in Pension Fund Management
The past few decades have seen a major shift from centralized to decentralized investment management by pension fund sponsors, despite the increased coordination problems that this brings. Using a unique, proprietary dataset of pension sponsors and managers, we identify two secular decentralization trends: sponsors switched (i) from generalist (balanced ) to specialist managers across asset classes and (ii) from single to multiple competing managers within each asset class.We study the effect of decentralization on the risk and performance of pension funds, and find evidence supporting some predictions of recent theory on this subject. Specifically, the switch from balanced to specialist managers is motivated by the superior performance of specialists, and the switch from single to multiple managers is driven by sponsors properly anticipating diseconomies of scale within an asset class (as funds grow larger) and adding managers with different strategies before performance deteriorates. Indeed, we find that sponsors benefit from alpha diversification when employing multiple fund managers. Interestingly, competition between multiple specialist managers also improves performance, after controlling for size of assets and fund management company-level skill effects. We also study changes in risk-taking when moving to decentralized management. Here, we find that sponsors appear to anticipate the difficulty in coordinating multiple managers by reducing their overall risk budget following decentralization, which helps to compensate for the suboptimal diversification that results. In summary, our results shed light on the complex array of factors that affect the decision of pension funds to delegate investment choice.
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Article
Retirement Readiness and Behavioral Finance
More than 10,000 Baby Boomers will be reaching retirement age every year from now through 2030. Inadequate savings, high cost and poorly designed retirement plans as well as investor behavioral mistakes combine to level most of them woefully unprepared for retirement. The paper suggests a number of possible solutions to improve our country’s retirement readiness.
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Insight
Consumption, Investment and Insurance in the Game of Life
Markowitz (1991) proposed the development of a “Game of Life” simulator in which portfolio selection was just one type of move in the financial actions of a subject household. Sherri Grabot’s invitation to Markowitz in the late 1990s to form and join the design committee of GuidedChoice (originally a 401k advisory service) permitted Markowitz and team to take the first steps in applying the theory in practice, with favorable results for participants.
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Practitioner's Digest
Practitioner’s Digest • Vol. 13, 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.