Volume 14, No. 2, Second Quarter 2016

Practitioner’s Digest • Vol. 14, 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.

The Big Short: Inside The Doomsday Machine

by: Michael Lewis • reviewed by: Craig French

“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.

Portfolio Diversification In Concentrated Bond And Loan Portfolios

by: Paul Kupiec

I develop an algorithm to approximate the loss rate distribution for fixed income portfolios with obligor concentrations. The approximation requires no advanced mathematics or statistics, only the summation of large exposures and the evaluation of binomial probabilities. The approximation is model-independent and can be used after removing default dependence using any risk modeling approach. It is especially useful for capital calculations given its inherent accuracy in the upper tail of the cumulative portfolio loss rate distribution. The approximation provides a simple way to calculate the capital benefits of risk mitigation or the capital needed when a marginal credit is added to a concentrated portfolio.

Price Dynamics And Liquidity Of Exchange-Traded Funds

by: Ananth Madhavan and Aleksander Sobczyk

Exchange-traded funds (ETFs) have grown substantially in diversity, market significance, and size in recent years. As a consequence, there is increased interest by practitioners in the pricing and trading of these investment vehicles. This paper develops a model to examine ETF price discovery and premium dynamics, and estimates the model individually for 947 US-domiciled ETFs in the period 2005–2014. We find that pricing efficiency varies significantly across funds and is systematically related to cross-sectional measures of liquidity. We provide an illustration of a bond ETF during the financial crisis of 2008 to highlight how apparently dramatic discounts really reflected price discovery when the underlying basket was illiquid in the extreme.

Factor Misalignment And Portfolio Construction

by: Jose Menchero

In recent years, there has been heightened interest among practitioners in the topic of factor misalignment; this term refers to the practice of employing mean-variance optimization to construct portfolios when the alpha signal is not contained within the set of risk model factors. In this paper, we employ a realistic simulation framework to study the efficiency of optimized portfolios under a variety of conditions. In particular, we study the case in which the alpha factor contains true systematic risk, and the case in which it does not. We also consider two risk models: one that contains the alpha factor, and the other that omits it.We find some evidence to support a modest increase in portfolio information ratio when the alpha factor is included in the risk model, provided two conditions hold: (1) the alpha factor must include true systematic risk, and (2) the factor correlations must be estimated with sufficient precision. If the alpha factor does not contain true factor risk, we find that including the alpha signal in the risk model is detrimental to portfolio information ratio. Finally, we conduct an empirical analysis of portfolio efficiency in the US stock market and find that the results are in excellent agreement with our simulations.

Combining Value And Momentum

by: Gregg Fisher, Ronnie Shah and Sheridan Titman

This paper considers several popular portfolio implementation techniques that maximize exposure to value and/or momentum stocks while taking into account transaction costs. Our analysis of long-only strategies illustrates how a strategy that simultaneously incorporates both value and momentum outperforms a strategy that combines pure-play value and momentum portfolios that are formed independently. There are two advantages of the simultaneous strategy. The first is the reduction in transaction costs; the second is better utilization of unfavorable value and momentum information in a long-only portfolio. Our analysis also addresses the optimal way to combine the faster-moving momentum signal with the slower-moving value signal.

Market Risk, Mortality Risk, And Sustainable Retirement Asset Allocation: A Downside Risk Perspective

by: W. V. Harlow and Keith C. Brown

Despite its clear importance, there is no consensus on the optimal asset allocation strategy for retirement investors of varying age, gender, and risk tolerance. This study analyzes the allocation question by focusing on the downside risks that result from the joint uncertainty over investment returns and life expectancy. Using a new analytical approach, we show that concentrating on the severity of retirement funding shortfalls, rather than just the probability of ruin, markedly increases the sustainability of a retirement portfolio. We demonstrate that for retirement investors attempting to minimize downside risk while sustaining future withdrawals, appropriate equity allocations range between five and 25 percent, levels that are strikingly low compared to those typically found in life-cycle funds. Further, these optimal portfolio constructions appear to vary little with alternative capital market assumptions. We also show that more aggressive investors having substantial bequest motives should still be relatively conservative in their stock allocations. We conclude that the higher equity allocations commonly employed in practice significantly underestimate the risks that these higher-volatility portfolios pose to the sustainability of retirement savings and incomes.