Volume 14, No. 1, First Quarter 2016

By the Numbers: 10 Things My Hobbies Have Taught Me About Investing

by: Vineer Bhansali

I discuss ten common themes between non-investment related activities that shed practical and useful light on investing. While readers might not be familiar with these particular activities, I believe that combining analogies from any accumulated skill in intrinsically rewarding activities (also known as hobbies), with a disciplined analytical approach yields significant benefits. The five activities discussed are ultra-running, flying, theoretical physics, screenwriting and programming. The lessons are mostly commonsensical: from focusing on structure and the environment, to paying attention to data and momentum, to avoiding the basic types of errors, and the use of tools such as simulation and thought experiments. I finish with a bonus tip. I hope that the reader finds these examples useful as complements to rigorous mathematical models.

Tax-Cognizant Portfolio Analysis: A Methodology for Maximizing After-Tax Wealth

by: Kenneth A. Blay and Harry M. Markowitz

The most prevalent methods of incorporating taxes into the portfolio construction process are the preliminary adjustment of asset allocation inputs for taxes and the post-optimization application of asset location heuristics. We argue that these methods are unsatisfactory in that they fail to address taxation dynamics that result from investment and consumption-dependent illiquidities. Tax-Cognizant Portfolio Analysis (TCPA) is proposed as a methodology that addresses these issues while seeking to maximize expected after-tax wealth for given levels of risk. TCPA achieves this through the use of simulation methods to assess the impact of portfolio turnover, sequence of investment returns, and wealth consumption decisions on after-tax wealth outcomes from taxable, tax-deferred, and tax-exempt accounts.

The Self-Fulfilling Prophecy of Popular Asset Pricing Models

by: Bradford Cornell and Jason Hsu

The assumption that asset prices are determined by the efforts of end investors to maximize intertemporal utility supports a pricing theory that is both elegant and intuitive. Unfortunately, the assumption is counterfactual. End investors, with few exceptions, lack the capacity to behave in a fashion consistent with the theory. More to the point, they don’t try. Instead, they delegate investment decision-making. Thus, it is important to understand the investment management ecosystem. Is it a simple pass-through mechanism? We do not believe so and argue, instead, that the lack of alignment implies the cross-section of asset returns is significantly influenced by active money managers and deviates from the predictions of the consumption-based model. Using a simple thought experiment, we demonstrate that the widely adopted discounted cash flow model is likely both to drive prices and to determine the cross-section of average returns. This leads to a self-fulfilling feedback loop in which once an asset pricing model is adopted by active managers as a means of estimating the discount rate, it becomes a determinant of expected returns.

The Information Content of Analysts’ Recommendations Revisited

by: Daniel Bradley, Jonathan Clarke, Suzanne Lee and Chayawat Ornthanalai

Bradley et al. (BCLO, 2014) find evidence that the time stamps reported in I/B/E/S for analysts’ recommendations are systematically delayed giving the appearance that recommendations are uninformative.We review the findings of BCLO and extend their analyses along three dimensions. First, we show that time stamp delays are less likely to be associated with all-star analysts, affiliated analysts, and analysts from high reputation banks, but are more likely from independent analysts. Second, we show that recommendations from all-star analysts, analysts working for high reputation banks, and analysts who issued a previous influential recommendation are more likely to be influential. Finally, we examine post-recommendation drift following influential revisions and find post-revision returns of 18(−44) basis points for upgrades (downgrades) over the 2.5 hours following the revision.

Optimal Municipal Bond Portfolios for Dynamic Tax Management

by: Andrew Kalotay

As currently practiced, tax-loss selling of municipal bonds is typically an ad hoc year-end exercise. Under dynamic tax management the right to execute a tax-beneficial trade is considered to be a valuable option. Selling a bond and reinvesting in another entails swapping the associated tax options. The generalized tax efficiency measure signals the optimum time to transact. Long-duration bonds trading at a premium are best poised to achieve superior performance; bonds purchased below par are unsuitable for tax management. The incremental return from dynamic management is significant, particularly when short-term gains are available to offset short-term losses.

Global Asset Allocation: A Survey of the World’s Top Asset Allocation

by: Mebane Faber • 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.

Practitioner’s Digest • Vol. 14, 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.