JOIM: 2004
Volume 2, No. 1, First Quarter 2004
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Practitioner's Digest
Practitioner’s Digest • Vol. 2, 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.
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Insight
The Market Maker in the age of the ECN
Electronic trading venues demonstrate an impressive ability to successfully match trades with high accuracy, low cost, and at remarkable speeds. Are they on track to take over the trading process, or will there always be activities better performed by human beings?
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Article
Great Moments in Financial Economics: III. Short-Sales and Stock Prices
This is the third in a series of articles on Great Moments in Financial Economics to appear in the Journal. For each, the purpose is to trace, as well as the author can, the history of the development of an important idea. In this case, the idea, usually associated with the work of Edward Miller, is that in the real-world of investors with (1) heterogeneous beliefs and of markets with (2) significant barriers to short-sales, stocks for which these barriers are binding will have prices at least temporarily too high relative to an alternative economy in which these two features are not both simultaneously present. In the early 21st century this idea has experienced a sort of renaissance of research which has been used to explain a large number of phenomena which can otherwise appear anomalous, from the momentum factor in stock returns, to market crashes, to the recent Internet-based stock market "bubble", and to the growing popularity of certain hedge fund strategies.
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Article
Managed Futures and Hedge Funds: A Match Made in Heaven
We study the possible role of managed futures in portfolios of stocks, bonds and hedge funds. We find that allocating to managed futures allows investors to achieve a very substantial degree of overall risk reduction at, in terms of expected return, relatively limited costs. Adding managed futures to a portfolio of stocks and bonds will reduce that portfolio's standard deviation more and quicker than hedge funds will, and without the undesirable side-effects on skewness and kurtosis. Apart from their lower expected return, managed futures therefore appear to be more effective diversifiers than hedge funds. Overall portfolio standard deviation can be reduced further by combining both hedge funds and managed futures with stocks and bonds. As long as at least 45-50% of the alternatives allocation is allocated to managed futures, this will have no negative side-effects on skewness and kurtosis.
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Article
Institutional Management Fees: Are the Annual Fees You Pay For Money Management Appropriate?
The authors quantify and analyze the current annual fees in the institutional mutual fund industry. They identify the primary determinants of fund expenses and develop a methodology for gauging whether fees on an institutional investment are consistent with other similar alternative investments. This methodology treats fixed income, domestic equity and international equity funds separately and can be applied to the pricing of potential separate account service providers as well as institutional mutual funds.
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Article
Can Simple Buy and Sell Rules Increase Index Future Day Trading Profitability?
Day trading index futures is popular. Two common strategies are trend-following and gap-reversal. This paper uses these strategies as "base strategies" and asks whether simple intraday exit rules can increase their profitability. Intraday stop-loss exit rules appear to add return to a trend-following base strategy of buying index futures at the opening and closing out the position at the close. There is no strong evidence that the same is true of profit-lock exit rules or that either works with a corresponding gap-reversal strategy.
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Case Study
An Invitation to the Readers of JOIM
“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.
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Survey & Crossover
Technical Analysis
“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.
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Book Review
Beyond the Random Walk
Investment Management Portfolio Diversification, Risk, and Timing - Fact and Fiction
“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.
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Survey & Crossover
Pension Fund Management Revisited
“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.
Volume 2, No. 2, Second Quarter 2004
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Practitioner's Digest
Practitioner’s Digest • Vol. 2, No. 2
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.
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Article
Predictions of Default Probabilities in Structural Models of Debt
This paper examines default probabilities predicted by alternative "structural" models of risky corporate debt. We focus on default probabilities rather than credit spreads because (i) they are not affected by additional market factors such as liquidity and tax differences; and (ii) prediction of the relative likelihood of default is often stated as the objective of bond ratings. We have three objectives:
(1) To distinguish "exogenous default" from "endogenous default" models
(2) To compare these models' predictions of default probabilities, given common inputs
(3) To examine how well these models capture actual average default frequencies, as reflected in Moody's (2001) corporate bond default data 1970-2000.
We find that endogenous and exogenous default boundary models fit observed default frequencies very well for horizons 5 years and longer, for both investment grade and non-investment grade ratings. Shorter-term default frequencies tend to be underestimated. This suggests that a jump component should be included in asset value dynamics.
Both types of structural models fit available default data equally well. But the models make different predictions about how default probabilities and recovery rates change with changes in debt maturity or asset volatility. Further data and testing will be needed to test these differences. Finally, we compare and contrast these structural models' default predictions with a simplified version of the widely-used Moody's-KMV "distance to default" model described in Crosbie and Bohn (2002). -
Article
Structural Versus Reduced Form Models: A New Information Based Perspective
This paper compares structural versus reduced form credit risk models from an information based perspective. We show that the difference between these two models types can be characterized in terms of the information assumed known by the modeler. Structural models assure that the modeler has the same information set as the firm's manager - complete knowledge of all the firm's assets and liabilities. In most situations, this knowledge leads to predictable default time. In contracts, reduced form models assume that the modeler has the same information set as the market - incomplete knowledge of the firm's condition. In most cases, the imperfect knowledge leads to an inaccessible default time. As such, we argue that the key distinction between structural and reduced form models is not whether the default is predictable or inaccessible, but whether the information set is observed by the market or not. Consequently, for pricing and hedging, reduced form models are the preferred methodology.
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Article
Non-Parametric Analysis of Rating Transition and Default Data
Non-parametric analysis of rating transition intensities is a powerful way of visualizing such effects and is therefore useful both for quickly understanding the behavior of a rating system and for exploring data before setting up a full statistical model. In this paper we illustrate the use of non-parametric and smoothing methods for analyzing rating transitions by showing how the time spent in a particular rating class and the direction of the move into this class influence transition intensities away from the class.
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Case Study
Fiduciary Funds
“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.
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Survey & Crossover
Private Equity Returns
“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.
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Book Review
The Bond King: Investment Secrets From Pimco's Bill Gross
Portfolio Theory and Performance Analysis
“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.
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Article
Valuing High Yield Bonds: A Business Modeling Approach
This paper proposes a valuation model of a bond with default risk. Extending from the Brennan and Schwartz real option model of a firm, the paper treats the firmas a contingent claim on the business risk. This paper introduces the “primitive firm,” which enables us to value firms with operating leverage relative to a firm without operating leverage. This paper emphasizes the business model of the firm, relating the business risk to the firm’s uncertain cash flow and its assets and liabilities. In so doing, the model can relate the financial statements to the risk and the value of the firm. The paper then uses Merton’s structural model approach to determine the bond value. This model considers the fixed operating costs as payments of a “perpetual debt,” and the financial debt obligations are junior to the operating costs. Using the structural model framework, we relative value the bond to the observed firm’s market capitalization, and provide a model that is empirically testable. We also show that this approach can better explain some of the high yield bond behavior. In sum, this model extends the valuation of high yield bonds to incorporate the business models of the firms and endogenizes the firm value stochastic process, which is a key element in high yield valuation, in practice.We have shown that in relating the firm’s business model to the firm value, the resulting firm value stochastic process affects the bond value significantly.
Volume 2, No. 3, Third Quarter 2004
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Practitioner's Digest
Practitioner’s Digest • Vol. 2, 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.
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Article
The IPO Quiet Period Revisited
A newly public company is subject to a "quiet period," which restricts insiders and affiliated underwriters from issuing earnings forecasts and research reports regarding the firm for a specified period following the initial public offering (IPO). As soon as this quiet period ends, the analysts of managing underwriters typically initiate research coverage with favorable recommendations, and the market responds positively even though this information is predictable. In this article, we discuss previous findings regarding price patterns and analyst initiations at the end of the quiet period and introduce new evidence based on recent trends in the IPO market. We discuss trading implications and examine the effect of new regulatory requirements that extend the quiet period from 25 to 40 calendar days post-IPO.
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Article
MaxVaR: Long-Horizon Value at Risk in a Mark-to-Market Environment
The standard VaR approach considers only terminal risk, completely ignoring the path of the portfolio value prior to this final horizon. This assumption is unrealistic interim risk may be critical in a mark-to-market environment because interim values of a portfolio may generate margin calls and affect trading strategies.We provide a simple framework for adjusting standard VaR for interim risk. We introduce the notion of MaxVaR, which is analogous to VaR except that it considers the probability of seeing a given low cumulative return on or before the terminal date. Under the standard lognormality assumption and for reasonable parameterizations MaxVaR may exceed VaR by over 40%. We show that adjustingVaR for interim mark-to-market risk is critically important for high Sharpe Ratio portfolios (e.g., for hedge funds).
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Article
Active Risk and Information Ratio
One of the underlying assumptions of the Fundamental Law of Active Management is that the active risk of an active investment strategy equates estimated tracking error by a risk model. We show there is an additional source of active risk that is unique to each strategy. This strategy risk is caused by variability of the strategy's information coefficient over time. This implies that true active risk is often different from, and in many cases, significantly higher than the estimated tracking error given by a risk model. We show that a more consistent estimation of information ratio is the ratio of average information coefficient to the standard deviation of information coefficient. We further demonstrate how the interaction between information coefficient and investment opportunity, in terms of cross sectional dispersion of actual returns, influences the IR.We then provide supporting empirical evidence and offer possible explanations to illustrate the practicality of our findings when applied to active portfolio management.
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Article
Predictability of Long-Term Spinoff Returns
Investment strategies of buying and holding recently spun off companies and their parents have received significant attention from the investment community in the recent past. Despite their popularity, the existing evidence on the attractiveness of spinoffs appears piecemeal. In this paper, we examine in detail the stock price performance of spinoffs and their parents on a comprehensive sample that covers the last 36 years.We show that excess returns are indeed positive for both subsidiary and parent companies over almost all holding periods considered. For subsidiaries, the results appear both economically and statistically significant after various adjustments for risk. This evidence is consistent with investors earning an above normal rate of return by investing in recently spun off subsidiaries. For parents, however, after correcting for one very large positive outlier, returns are not statistically or economically different from zero.
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Article
In Search of a Modigliani-Miller Economy
The Modigliani-Miller theorem describes conditions under which the value of a firm is independent of its leverage ratio. It is one of the cornerstones of finance. A history of this result along with a modern perspective on its derivation is given in Rubinstein (2003), Journal of Investment Management 1(2). We extend this history by examining the relationship between theModigliani-Miller theorem and quantitative models of credit risk. In the first part of the paper, we sort out the role of the Modigliani-Miller theorem and Merton's classical structural model. This material may be familiar to some readers. Subsequently, we explore the relationship between theModigliani-Miller theorem and I 2, which is a hybrid structural-reduced form model based on incomplete information, Goldberg (2004), Risk 17(1), 515-518. The I 2 model is not consistent with the Modigliani-Miller theorem. It provides a new way to measure the deviation of real markets from the idealized markets in which the Modigliani-Miller theorem holds.
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Case Study
Poosha-Carta Food Stores
“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.
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Book Review
Capital-The Story of Long-Term Investment Excellence
Asset Pricing and Portfolio Performance
“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.
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Survey & Crossover
The Progeny of CAPM
“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.
Volume 2, No. 4, Fourth Quarter 2004
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Practitioner's Digest
Practitioner’s Digest • Vol. 2, 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.
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Article
Fees on Fees in Funds of Funds
Funds of funds are an increasingly popular avenue for hedge fund investment. Despite the increasing interest in hedge funds as an alternative asset class, the high degree of fund-specific risk and the lack of transparency may give fiduciaries pause. In addition, many of the most attractive hedge funds are closed to new investment. Funds of funds resolve these issues by providing investors with diversification across manager styles and professional oversight of fund operations that can provide the necessary degree of due diligence. In addition, many such funds hold shares in hedge funds otherwise closed to new investment allowing smaller investors access to the most sought-after managers. However, the diversification, oversight and access comes at the cost of a multiplication of the fees paid by the investor. One would expect that the information advantage of funds of funds would more than compensate investors for these fees. Unfortunately, individual hedge funds dominate fund of funds on an after-fee return or Sharpe ratio basis. In this paper we argue that the disappointing after-fee performance of some fund of funds might be explained by the nature of this fee arrangement, and that fund of funds providers may actually benefit from considering other possible fee arrangements. These alternative arrangements will improve reported performance and may make funds of funds more attractive to a growing institutional clientele.
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Article
Extracting Portable Alphas from Equity Long/Short Hedge Funds
This paper shows empirically that Equity Long/Short (Equity L/S) hedge funds have significant alpha to both conventional as well as alternative (hedge fund-like) risk factors utilizing hedge fund data from three major data bases. Following the terminology introduced in Fung and Hsieh (2003) Journal of Fixed Income 58, 16-27, we call these Equity alternative alphas (or Equity AAs for short). Equity AAs are extracted from Equity L/S hedge fund returns by first identifying the systematic risk factors inherent in their strategies. Hedging out these systematic risk factors, the resultant AA return series are empirically shown to be independent of systematic risks during normal as well as stressful conditions in asset markets. This provides collaborative evidence that AA returns are portable across conventional asset-class indices. By modeling the AA return series as GARCH(1,1)vAR(1) processes, it is shown that the unconditional return distributions are normal with time-varying variance free of serial correlations, skewness, and kurtosis. Alpha-enhanced equity alternative are constructed admitting higher mean return, better annual returns, and Sharpe ratios to the S&P 500 index over the sample period 1996-2002.
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Article
Alternative Investments: CTAs, Hedge Funds, and Funds-of-Funds
In this paper, we study alternative investment vehicles such as hedge funds, funds-of-funds, and commodity trading advisors (CTAs) by investigating their performance, risk, and fund characteristics. Considering them as three distinctive investment classes, we study them not only on a stand-alone basis but also on a portfolio basis.We find several interesting results. First, CTAs differ from hedge funds and funds-of-funds in terms of trading strategies, liquidity, and correlation structures. Second, during the period 1994v2001, hedge funds outperform funds-of-funds, which in turn outperform CTAs on a stand-alone basis. These results can be explained by the double fee structure but not survivorship bias. Third, correlation structures for alternative investment vehicles are different under different market conditions. Hedge funds are highly correlated to each other and are not well hedged in the down markets with liquidity squeeze. The negative correlations with other instruments make CTAs suitable hedging instruments for insuring downside risk. When adding CTAs to the hedge fund portfolio or the fund-of-fund portfolio, investors can benefit significantly from the risk-return trade-off.
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Article
The Dangers of Mechanical Investment Decision-Making: The Case of Hedge Funds
Over the last 20 years, investors have come to approach investment decision-making in an increasingly mechanical manner. Optimizers are filled up with historical return data and the "optimal" portfolio follows almost automatically. In this paper, we argue that such an approach can be extremely dangerous, especially when alternative investments such as hedge funds are involved. Proper hedge fund investing requires a much more elaborate approach to investment decision-making than currently in use by most investors. The available data on hedge funds should not be taken at face value, but should first be corrected for various types of biases and autocorrelation. Tools like mean-variance analysis and the Sharpe ratio that many investors have become accustomed to over the years are no longer appropriate when hedge funds are involved as they concentrate on the good part while completely skipping over the bad part of the hedge fund story. Investors also have to find a way to figure in the long lock-up and advance notice periods, which makes hedge fund investments highly illiquid. In addition, investors will have to give weight to the fact that without more insight in the way in which hedge funds generate their returns it is very hard to say something sensible about hedge funds' future longer-run performance. The tools to accomplish this formally are not all there yet, meaning that more than ever investors will have to rely on common sense and doing their homework.
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Article
AIRAP – Alternative RAPMs for Alternative Investments
This paper highlights the inadequacies of traditional RAPMs (risk-adjusted performance measures) and proposes AIRAP (alternative investments risk-adjusted performance), based on Expected Utility theory, as a RAPM better suited to alternative investments. AIRAP is the implied certain return that a risk-averse investor would trade off for holding risky assets. AIRAP captures the full distribution, penalizes for volatility and leverage, is customizable by risk aversion, works with negative mean returns, eschews moment estimation or convergence requirements, and can dovetail with stressed scenarios or regime-switching models. A modified Sharpe ratio is proposed. The results are contrasted with Sharpe, Treynor, and Jensen rankings to show significant divergence. Evidence of non-normality and the tradeoff between meanvvariance merits vis-a-vis higher moment risks is noted. The dependence of optimal leverage on risk aversion and track record is noted. The results have implications for manager selection and fund of hedge funds portfolio construction.
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Article
Sifting Through the Wreckage: Lessons from Recent Hedge-Fund Liquidations
We document the empirical properties of a sample of 1,765 funds in the TASS Hedge Fund database from 1977 to 2004 that are no longer active. The TASS sample shows that attrition rates differ significantly across investment styles, from a low of 5.2% per year on average for convertible arbitrage funds to a high of 14.4% per year on average for managed futures funds. We relate a number of factors to these attrition rates, including past performance, volatility, and investment style, and also document differences in illiquidity risk between active and liquidated funds. We conclude with a proposal for the US Securities and Exchange Commission to play a new role in promoting greater transparency and stability in the hedge-fund industry.
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Case Study
The Fed Watchers
“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.
-
Book Review
The Wisdom of Crowds
The Oxford Guide to Financial Modeling
“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.