Volume 23, No. 1, First Quarter 2025

Practitioner’s Digest • Vol. 23, 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.

Forecasting and Managing Volatility: An S&P 500 Case Study

by: Wei Dai, Xing Hong, Robert C. Merton and Mathieu Pellerin

Using daily and intraday data from 1997 to 2023, we study strategies that stabilize volatility around a target by rebalancing between the S&P 500 and Treasury bills based on a broad set of volatility forecasts. Somewhat counterintuitively, lower forecasting errors do not necessarily result in more stable strategy volatility. Simple forecasts with fewer parameters can stabilize volatility as well as more complex models. In particular, combinations of implied volatility and simple estimators based on past returns exhibit good volatility control and lower turnover. On the implementation front, we show that the target volatility strategies we study are viable in the presence of realistic trading costs, delays between forecasting and rebalancing, or constraints on rebalancing frequency. Collectively, our findings can help design target volatility strategies that improve upon portfolios with constant target weights (e.g., a 60/40 portfolio) in achieving and maintaining investors’ desired volatility exposures over time.

Can Under-Diversification Explain the Size Effect?

by: Moshe Levy

None of the explanations suggested so far for the size anomaly seems to be consistent with the empirical evidence. This paper examines under-diversification as a possible explanation for the size effect. When the portfolio weight of a stock is non-negligible, its variance is priced. As small stocks are much more volatile than large stocks, this induces a size effect. We analytically derive the relation between under-diversification and the size premium, which allows us to estimate the magnitude of the under-diversification-induced size effect. We find it to be in close agreement with the empirically measured size effect.

The CAPM, APT, and PAPM

by: Thomas M. Idzorek, Paul D. Kaplan and Roger G. Ibbotson

The Popularity Asset Pricing Model (PAPM) generalizes the Capital Asset Pricing Model (CAPM) with popularity as the basis for multiple priced characteristics. The CAPM along with the Arbitrage Pricing Theory (APT) are the dominant textbook asset pricing models. Both require restrictive and unrealistic assumptions. The former suffers empirical shortcomings, and the latter is largely unused. Fama and French (2007) identify “tastes” and “disagreement” as impacting asset prices. In the PAPM, investors have a variety of risk and non-risk preferences (tastes) and divergent beliefs about expected returns and risk (disagreement), in which aggregate tastes and disagreement impact equilibrium prices.

Fixed Income Index Funds: Demystifying Portfolio Construction and Rebalancing

by: Stephen Laipply, Ananth Madhavan, James Mauro and Nogie Udevbulu

Assets in fixed income index mutual funds and exchange-traded funds (ETFs) have grown substantially in recent years. This paper examines fixed income index fund portfolio rebalancing efficiency using empirical evidence from four large fixed income index funds. We show how fund managers can preserve value in these portfolios using a wide range of dynamic portfolio management strategies while navigating the challenges posed by the general lack of liquidity and transparency in fixed income markets.

The ESG Conundrum

by: Ye Cai 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.

The Psychology of Leadership

by: Sébastien Page • reviewed by: Will Kinlaw

“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.