Volume 15, No. 3, Third Quarter 2017

Measuring Portfolio Performance: Sharpe, Alpha, or the Geometric Mean?

by: Moshe Levy

The most popular portfolio performance measures are the Sharpe ratio and alpha. While the Sharpe ratio is optimal under the capital asset pricing model (CAPM) assumptions of normal return distributions and unlimited borrowing at the risk-free rate, we find that it is not well aligned with investors’ preferences in more realistic settings. Alpha is a poor measure under both the theoretical and the realistic settings. For investors with typical borrowing constraints, the geometric mean provides an alternative measure that is much better than both the Sharpe ratio and alpha. It may very well be the most important single number to consider in portfolio selection.

What is Value in an Equity Market?

by: Michael Suen, Hany Guirguis, Stan Beckers and Ted Theodore

What is value in an equity market? Among investors, there is no universally accepted definition. This paper constructs a value index for the US equity market using the Stock and Watson (1988, 1991) methodology. The new value index is derived from a dynamic single factor model taking five relative valuation metrics as inputs. These inputs are commonly used by investors to gauge whether the market is expensive (low in value) or cheap (high in value). The value index is the (unobserved) common component in the Stock and Watson model. Investors can gauge whether the equity market is cheap or expensive by referring to a historical time series of the value index. We also develop a tactical asset allocation strategy based on the trend of the value index. Its performance indicates that the new value definition contains investible information.

Market Timing: Sin a Little Resolving the Valuation Timing Puzzle

by: Cliff Asness, Antti Ilmanen and Thomas Maloney

Successful market timing is a tantalizing holy grail for investors, especially when there seems to be persuasive evidence that simple valuation measures can predict subsequent market performance. But, as both researchers and investors have discovered, outperforming a passive buy-and-hold approach is harder than it might seem. Is market timing a useful source of added value or a sin to be avoided? In this paper we explore the difference between the encouraging in-sample long-horizon evidence and directionally right but weak and disappointing out-of-sample performance.We propose an interpretation that offers a practical enhancement to value timing strategies: adding a dose of momentum.

Multi-Period Portfolio Rebalancing with Personal Tax

by: Ganlin Xu

This paper compares two heuristic rebalancing rules for taxable accounts. The first one is trading X percent annually. The second one is based on the result of recent research, which indicate there existence of no-trading zone. The no-trading zone is obtained by using a quadratic function to approximate the optimal value function. We show a simple and implementable approximation. We also show that the no-trading zone-based rebalancing rule performs better than trading X percent annually.

Practitioner’s Digest • Vol. 15, 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.

The Index Revolution –Why Investors Should Join it Now

by: Charles Ellis • 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.

Portfolio Manager Selection

by: Michael Christensen

“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.