Volume 14, No. 3, Third Quarter 2016

Practitioner’s Digest • Vol. 14, 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.

Mass Customization Versus Mass Production – How an Industrial Revolution is About to Take Place in Money Management and Why it Involves a Shift From Investment Products to Investment Solutions

by: Lionel Martellini

While mass production has happened a long time ago in investment management through the introduction of mutual funds and more recently exchange traded funds, a new industrial revolution is currently under way, which involves mass customization, a production and distribution technique that will allow individual investors to gain access to scalable and cost-efficient forms of goal-based investing solutions.

How Do Private Equity Investments Perform Compared to Public Equity?

by: Robert S. Harris, Tim Jenkinson and Steven N. Kaplan

The merits of investing in private versus public equity have generated considerable debate, often fueled by concerns about data quality. In this paper, we use cash flow data derived from the holdings of almost 300 institutional investors to study over 1,800 North American buyout and venture capital funds. Average buyout fund returns for all vintage years but one before 2006 have exceeded those from public markets; averaging about 3% to 4% annually. Post-2005 vintage year returns have been roughly equal to those of public markets. We find similar performance results for a sample of almost 300 European buyout funds. Venture capital performance has varied substantially over time. North American venture funds from the 1990s substantially outperformed public equities; those from the early 2000s have underperformed; and recent vintage years have seen a modest rebound. The variation in venture performance is significantly linked to capital flows: performance is lower for funds started when there are large aggregate inflows of capital to the sector. We also examine the variation in performance of funds started in the same year. We find marked differences between venture and buyout funds leading to a more pronounced impact of accessing high-performing funds in venture investing.

It’s Easy to Beat the Market

by: Moshe Levy

The perception that it’s hard to beat the market portfolio is widespread. Indeed, passive investment has more than doubled in the last decade. While various different strategies have been suggested to outperform passive indexing, the market is still considered by many as the relevant benchmark to beat. The evidence in this paper suggests that this perception requires a fundamental re-examination. We compare the market with a large number of randomly constructed and passively held portfolios. We find that 69% of these random portfolios yield higher Sharpe ratios than the market. Practical implications and theoretical consequences for market equilibrium are discussed.

The Profitable Dividend Yield Strategy

by: Wai Mun Fong and Zhehan Ong

Stocks with high dividend yield (DY) have value-like returns and defensive qualities that make them highly attractive to investors. We show that this investment strategy can be powerfully enhanced by choosing stocks with both highDY and high gross profits-to-assets (GPA). Consistent with the predictions of the clean surplus accounting model, high-GPA stocks have high average returns despite their relatively low book-to-market ratios (Novy- Marx, 2013). Profitable firms are also less prone to distress than unprofitable firms. The resulting Profitable Dividend Yield (PDY) strategy inherits the defensive nature of high- DY stocks, while providing superior average returns than either standalone strategies. Bootstrap simulations show that the PDY delivers superior long-term outcomes.

Misbehaving The Making of Behavioral Economics

by: Richard Thaler • 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.

Developing Countries

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.

Correlation or Causation?: The Sorry State of Inference in Empirical Modeling

by: Xiaojing Dong and John Heineke

For decades, statistical methods, many based upon the “general linear model,” have been used to do estimation and test hypotheses in the social and natural sciences, in medicine, and in the private sector. These tools have become increasingly sophisticated and are often paired with powerful open source data analytic software. We now regularly see mathematical/statistical output combined with data visualizations that are truly mindboggling and, once in a while, thought provoking. But an increasing number of papers and studies appear to have little statistical validity, in which the line between causality and correlation is often non-existent. This is a danger sign not only in science and medicine but also to companies who unwittingly rely on such results for forecasting and business strategy. Could it be true that researchers and analysts who learn ever more powerful analytical methods lack even a basic understanding of the limitations of these methods? The purpose of this short, non-technical paper, which relies heavily upon examples, is to shed some light on the underlying statistical issues. The ideas here are certainly not original with us and have been raised for a number of years across multiple disciplines.