Volume 17, No. 1, First Quarter 2019

Does Extreme Correlation Matter in Global Equity Asset Allocation?

by: Bruno Solnik and Thaisiri Watewai

Global asset allocation provides risk diversification. But international market correlation increases sharply during global crises and diversification benefit disappears when it is most needed. We model these correlation breaks and derive the asset allocation implications. The model can quickly detect crises and suggests adapting allocation for changing correlation and volatility, as the crisis probability evolves. The out-of-sample results for ten major equity markets over 2008–2016 show significant improvements in the Sharpe ratio and maximum drawdown over mean–variance, fat-tail distribution, passive indices, and 1/N rule. A benefit of the model is that it is conceptually intuitive and amenable to simple implementation in asset allocation and risk management.

Explaining Buyout Industry Returns: New Evidence

by: David Turkington

Traditional equity factors such as the leveraged equity risk premium, the small-cap premium, and the value premium have had high historical returns on average, as has the buyout fund industry in aggregate. Previous research has argued that these factors explain the excess performance of private equity over public equity. However, time series regression analysis reveals that these factors explain surprisingly little variation in buyout performance. In contrast, I find that other factors such as the credit premium and dynamic sector selection are more effective at explaining variation in performance of the buyout industry over time.

Rational Investing: The Subtleties of Asset Management

by: Hugues Langlois and Jacques Lussier • reviewed by: Savannah Smith

“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.

Lessons Learned From Student Managed Portfolios

by: Stephan Kranner , Neal Stoughton, and Josef Zechner

We study asset management decisions of three competing student managed funds in Vienna, Austria for a ten-year period. This real-world experience allows us to precisely test the tournament effect of fund management, the disposition effect, and managerial team size. We find support for risk taking by the trailing funds in an annual tournament, and risk reductions by leading funds. The disposition effect usually observed in the case of retail investors is reversed. Finally, we find that smaller management teams outperform larger ones. Using a partly controlled setting, we relate the results to practice in the areas of institutional client evaluation of managers and the social and organizational structure of asset management companies.

Portfolio Optimization With Noisy Covariance Matrices

by: Jose Menchero and Lei Ji

In this paper, we explore the effect of sampling error in the asset covariance matrix when constructing portfolios using mean–variance optimization.We show that as the covariance matrix becomes increasingly ill-conditioned (i.e., “noisy”), optimized portfolios exhibit certain undesirable characteristics such as under-prediction of risk, increased out-of sample volatility, inefficient risk allocation, and increased leverage and turnover. We explain these results by utilizing the concept of alpha portfolios (which explain expected returns) and hedge portfolios (which serve to reduce risk). We show that noise in the covariance matrix leads to systematic biases in the volatility and correlation forecasts of these portfolios, which in turn explains the adverse effects cited above.

Predicting Investor Success Using Graph Theory and Machine Learning

by: Jeffrey Glupker, Vinit Nair, Benjamin Richman, Kyle Riener and Amrita Sharma

“Surveys& Crossovers” This section provides surveys of the literature in investment management or short papers exemplifying advances in finance that arise from the confluence with other fields. This section acknowledges current trends in technology, and the cross-disciplinary nature of the investment management business, while directing the reader to interesting and important recent work.

Practitioner’s Digest • Vol. 17, 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.