Volume 21, No. 4, Fourth Quarter 2023

Practitioner’s Digest • Vol. 21, No. 4

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.

Grow The Pool: Diverse Directors Associated with Stronger Performance, but not if they are Too Busy

by: Mouhamadou M. Ba, Gerald T. Garvey, Brett Z. Miller and Katharina J. Schwaiger

Minority representation on US boards has grown more than 50% in the last eight years, but this reflects an increase in the number of seats for existing minority directors as much as a diversification of the director talent pool. We find that the share of minority directors only has a positive association with future returns if we restrict attention to those with less than four seats. Furthermore, there is a negative stock price reaction when a minority director obtains more than three seats on other boards. Diverse, non-busy boards are also associated with stronger employee ratings on social media.

Reimagining Index Funds

by: Rob Arnott, Chris Brightman, Xi Liu and Que Nguyen

“Gold-standard” cap-weighted indices have a buy-high and sell-lowdynamic that causes a structural long-term performance drag. Of course,relative to itself, no index can underperform, which is the reason it goes unnoticed. If we use a company’s fundamentals to choose stocks—and then cap-weights them—improves the risk-adjusted returns of gold-standard cap-weighted indices. This index, which we call Fundamental-selection Cap-weighted (FS-CW), has outperformed the most popular cap-weighted equity indices around the world over the last 30 years, while reducing risk, and with additional benefits of slightly lower turnover and transaction costs. Live results further support its merits. Building a better index fund that can earn a superior risk-adjusted return versus other cap-weighted indices is not only possible—it is a reality!

The Diminishing Role of Active Mutual Funds: Flows and Returns

by: James X. Xiong, Thomas M. Idzorek and Roger G. Ibbotson

U.S. active equity mutual funds have experienced net outflows since around 2006. The AUM-weighted performance remains similar over time, but equal-weighted performance (which emphasizes small AUM active funds) has deteriorated. Inflows/outflows contribute to the over/underperformance of individual active funds. We estimate that the flow-impact on annualized alpha for aggregated active funds industry was a positive 0.33% between 1/1991 and 12/2005, but it was a negative −0.10% between 1/2006 and 9/2021. If the current flow trend continues, the AUM of active mutual funds will drop to 17% of the total AUM of equity funds after 15 years.

Realativity in Finance: Goals and Risk-Based Asset Pricing for Investors with Multiple Stochastic Goals and Agents

by: Arun Muralidhar

This asset pricing model incorporates four positive realities of investing; that investors have many stochastic goals, seek to delegate to skillful agents, explicitly specify risk budgets, and maximize risk-adjusted relative returns. As a result, it also incorporates the relative nature of investing—“Realativity”. Critical to investment practice, it provides asset pricing, asset allocations, and risk-adjusted performance measures that are consistent. Assets are priced with just two goal-replicating assets and the absolute risk-free asset. The pair-wise equilibrium model uses observable assets and risk budgets, offers practical asset allocation recommendations, and captures dual attributes of risky assets (i.e., risky asset and hedge for other goals). Furthermore, asset allocation is “view neutral” and does not require expected return forecasts which are notoriously incorrect. It also possibly explains other interesting investment phenomena—e.g., why two pension funds with similar risk budgets could have very different asset allocations or why their expected returns forecasts may differ

Tradeoffs in Goosing the IRR

by: Ivan Asensio and Seoyoung Kim

“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.

Principles for Dealing with the Changing World Order: Why Nations Succeed and Fail

by: Ray Dalio • reviewed by: Fangzhong Liu

“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.