JOIM: 2006
Volume 4, No. 1, First Quarter 2006
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Practitioner's Digest
Practitioner’s Digest • Vol. 4, 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
Skill – Based Investment Management: The Next Evolution in the Asset Management Industry
In this paper, we discuss the structure of investment management organizations from a business model perspective, investment structure perspective, and return analysis perspective. We argue that the definition of a business model to align the interest of the asset owner and asset manager is critical to maximizing investment returns. Failure in this process leads to a vicious circle, both for the organization and the investments. Further, we propose that the investment structure of investment management organizations needs to evolve from an asset class demarcated and regional structure, to a global skill-based structure, where there are no asset classes and no regions, and only skills. As a result, asset allocation has to evolve to exposure allocation. In the proposed multi-strategy, exposure-based framework, the definition of alpha and beta needs to evolve to exposure premium and arbitrage return, and portfolio risk should be decomposed into intended and unintended, rather than into systematic and unsystematic.
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Article
Does the Stock Market Underreact to R&D Increases?
We examine a sample of 8,313 cases, between 1951 and 2001, where firms unexpectedly increase their research and development expenditures (R&D) by a significant amount. We find consistent evidence that our sample firms are undervalued following their R&D increases as manifested in the significantly positive long-term stock returns that our sample firms' shareholders experience. We also find consistent evidence that our sample firms have significantly positive long-term abnormal operating performance following their R&D increases. Our findings suggest that R&D increases are beneficial investments, and that the market is slow to recognize the extent of this benefit (consistent with investor underreaction).
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Article
Mutual Fund Dilution from Market Timing Trades
This paper introduces a model to measure the dilution impact on an open-end fund due to market timing trades. When a timer buys shares of a fund just prior to positive returns, the extra cash in the fund dilutes the fund's return. While this impact can be directly measured on the day after a timer's purchase, the impact on subsequent days depends on whether the fund's cash balance remains distorted. Our model offers a framework that allows the timer's holding period and the portfolio manager's treatment of cash flows to inform an accurate calculation of the dilution impact.
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Article
Can Contrarian Strategies Improve Momentum Profits
This paper investigates whether investors can exploit the contrarian cycle to improve the profitability of momentum strategies. We conjecture that the momentum strategies implemented in the early stage of price reversal (MSES) are more profitable than those implemented in the late stage of price reversal (MSLS). Our empirical results show that while MSES records significant positive returns, the profits from MSLS are not significant. There is a continuation of momentum profits in MSES up to 60 months, but not in MSLS. The overall evidence indicates that we can improve the profits of momentum strategies if we also consider past long-term performance.
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Article
Great Moments in Financial Economics: IV. The Fundamental Theorem (Part II)
This is Part II of the fourth in a series of articles in this Journal examining the historical origins of key ideas in the history of financial economics. It describes an extension of the "fundamental theorem" from buy-and-hold strategies developed in Part I to dynamic portfolio strategies. Part II presumes the reader is familiar with Part I. The extension can be traced back to work by Blaise Pascal and Pierre de Fermat in the 17th century, with a subsequent path in the 20th century that leads to modern option pricing theory.
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Case Study
When Plant Wears Out – A Case
“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
Understanding Arbitrage: An Intuitive Approach to Financial Analysis
The Legacy of Fisher Black
“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.
Volume 4, No. 2, Second Quarter 2006
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Practitioner's Digest
Practitioner’s Digest • Vol. 4, 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
A Dynamic Model of Portfolio Management
This paper presents a simplified model of dynamic active portfolio management. It is designed to answer questions about product design and provide a guide to better implementation. The model has four inputs: an information ratio that measures the anticipated ability to add value, a risk aversion parameter, a speed of decay of our information called the half-life, and finally a measure of transactions costs. With this structure and some assumptions we can derive relatively simple algebraic expressions for the annualized alpha, risk and transactions costs of the strategy. This allows us to construct both pre-and post-cost measures of implementation efficiency.
The model can be used in many ways. First establishing sensitivity of outputs to inputs. This sensitivity can be an aid in the allocation of research effort. Second, measuring the effect of increased assets under management on the ability to deliver post-cost results. Third, investigating the cost of parameter errors; if we think transactions costs are X but they really are 2*X, what are the implications. Fourth, weighting multiple signals. -
Article
S&P 500 Index Changes and Investor Awareness
We find that, on average, firms added to the S&P 500 index experience a permanent price increase, while those deleted from it suffer only a temporary price decline. Existing theories, such as a downward sloping demand curve, liquidity, and information, fail to explain the asymmetric response. We propose a new explanation for the observed price patterns: changes in investor awareness. Investors become more aware of a stock upon its addition to the S&P 500 index but do not become similarly unaware of a stock following its deletion. This results in a significant price increase after an addition but not an equivalent decline after a deletion. Consistent with our hypothesis, we find that Merton's (Journal of Finance, 1987, 42, 483-510) measure of awareness improves after an addition but remains essentially unchanged after a deletion. The price reaction is related to changes in the measure of awareness. From a practical standpoint, our results suggest that index fund managers who are not constrained by tracking error minimization are better off not trading on the effective date. Rather, they may be able to benefit their shareholders by executing purchases of additions upon announcement, but waiting to sell deleted firms until well after the effective date.
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Article
Employee Stock Options and Taxes
In this paper, we investigate the effect of stock options on the tax position of the firm. We argue that option tax deductions can significantly affect a firm's marginal tax rate and that the effect is masked by current financial reporting rules. We present an approach for factoring in option deductions in assessing a firm's tax position and document that the effect can be substantial. In particular, many firms that appear to be profitable and face high income tax burdens (based on public financial statement data) actually pay relatively little in taxes. We provide evidence that the effect of options on taxes may help to explain managerial decisions such as why apparently profitable firms carry so little debt, lease rather than purchase, and outsource tax-advantaged activities, such as research and development, to syndicated partnerships.
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Article
How Do IPO Issuers Pay for Analyst Coverage?
This article reports evidence consistent with the view that initial public offering (IPO) issuers purchase high-quality analyst coverage with greater underpricing of the IPO. Specifically, we report that underpricing is positively related to analyst coverage by the lead underwriter and to the presence of an all-star analyst on the research staff of the lead underwriter. Moreover, if underwriters do not deliver the expected analyst coverage (conditional on the level of underpricing) IPO issuers are more likely to switch underwriters when they conduct a subsequent seasoned equity offer.
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Article
Are the Probabilities Right? Dependent Defaults and the Number of Observations Required to Test for Default Rate Accuracy
Users of default prediction models often desire to know how accurate the estimated probabilities are. There are a number of mechanisms for testing this, but one that has found favor due to its intuitive appeal is the examination of goodness of fit between expected and observed default rates. While large data sets are required to test these estimates, particularly when probabilities are small as in the case of higher credit quality borrowers, the question of how large often arises. In this short note, we demonstrate, based on simple statistical relationships, how a lower bound on the size of a sample may be calculated for such experiments. Where we have a fixed sample size, this approach also provides a means for sizing the minimum difference between predicted and empirical default rates that should be observed in order to conclude that the assumed probability and the observed default rate differ. When firms are not independent (correlation is non-zero), adding more observations does not necessarily produce a confidence bound that narrows quickly. We show how a simple simulation approach can be used to characterize this behavior. To provide some guidance on how severely correlation may impact the confidence bounds for of an observed default rate, we suggest an approach that makes use of the limiting distribution of Vasicek (1991) for evaluating the degree to which we can reduce confidence bounds, even with infinite data availability. The main result of the paper is not so much that one can define a likely error bound on an estimate (one can), but that, in general,under realistic conditions, the error bound is necessarily large implying that it can be exceedingly difficult to validate the levels of default probability estimates using observed data.
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Book Review
The Undercover Economist
The Future for Investors
“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
Multiple-Core Processors For Finance Applications
“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 4, No. 3, Third Quarter 2006
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Practitioner's Digest
Practitioner’s Digest • Vol. 4, 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
Bruno de Finetti and Mean-Variance Portfolio Selection
Bruno de Finetti is generally regarded as the finest Italian mathematician of the 20th century. Among his many achievements, economists are familiar with his work on the axiomatization of subjective probability. To the surprise of many, a treasure-trove of other results in economics has recently come to light which until now has never been translated into English. Foremost among these is his paper, The Problem of Full-Risk Insurances, which anticipates much of Markowitz's mean-variance portfolio theory by over a decade. This issue of the Journal includes Luca Barone's translation of de Finetti's first chapter on this subject and a review by Harry Markowitz.
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Article
de Finetti Scoops Markowitz
In 1940, in the context of choosing optimum reinsurance levels, Bruno de Finetti essentially proposed mean-variance analysis with correlated risks. It was not until 1952 that Markowitz and Roy introduced mean-variance analysis with correlated risks into the financial literature. De Finetti solved the problem of computing mean-variance efficient frontiers for a particular constraint set (one that describes the reinsurance problem) assuming uncorrelated risks. While he understood and explained the importance of the case with correlated risks, he did not provide an algorithm for this case. In fact, one of his conjectures concerning its solution was incorrect. The present article summarizes de Finetti's contribution, presents an algorithm for solving "the de Finetti problem" when risks are correlated, and illustrates these matters with an easily visualized two-policy reinsurance problem.
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Article
Bruno de Finetti, The Problem of “Full-Risk Insurances”
We examine-in its different aspects-the problem of the risk due to hedging a set of insurances and, consequently, the problem of the retention levels, i.e., of the most efficient method to reinsure a part of such insurances to reduce the risk within the desired limits, while minimizing the loss of profit. The different aspects we considered are: the risk within a single accounting period (Chap. I), the risk for the whole existing portfolio (Chap. II), the risk related to the whole future development of the firm (Chap. III). Some concluding remarks follow (Chap. IV).
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Article
Cap Weighted Portfolios Are Sub-Optimal Portfolios
In this paper, we show that under a fairly innocuous assumption on price inefficiency, market capitalization weighted portfolios are sub-optimal. If market prices are more volatile than is warranted by changes in firm fundamentals, then cap-weighted portfolios do not capture the full premium commensurate their risk. The sub-optimality arises because cap-weighting tends to overweight stocks whose prices are high relative to their fundamentals and underweight stocks whose prices are low relative to their fundamentals. The size of the cap-weighted portfolio underperformance is increasing in the magnitude of price inefficiency and is roughly equal to the variance of the noise in prices. However, portfolios constructed from weights, which do not depend on prices, do not exhibit the same underperformance observed for cap-weighted portfolios. We illustrate this cap-weighting underperformance empirically by comparing returns from cap-weighted portfolio versus non-cap-weighted portfolios with similar characteristics. We also derive testable implications from our model assumption and find empirical support.
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Article
The Fundamental Law of Active Portfolio Management
The strategic perspectives and terminology of the fundamental law is a common framework in the practice of active portfolio management. For tractability, fundamental law theory depends on the simplifying assumption of a diagonal covariance matrix of security returns, though the matrices supplied to numerical optimizers are fully populated. We extend the fundamental law of active management to allow for a full covariance matrix and show that the resulting ex-ante (expected) and ex-post (realized) return equations are exact in contrast to the approximate equality of previous derivations. The exactness of ex-post equations allows for performance attribution of realized returns that completely decomposes the return. Because the various fundamental law parameters we define incorporate all the information in the covariance matrix, they should also provide better ex-ante insights as to the sources and limitations of risk-adjusted active return. In addition to the generalization of the fundamental law, we describe a full covariance matrix alpha generation process and add some comments to the concept of implied breadth. The mathematics and practical application of the full covariance matrix fundamental law parameters are illustrated using an EAFE benchmarked portfolio with the 21 countries as individual securities.
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Article
Stock Return Momentum and Investor Fund Choices
Recent research by Gruber (1996) and Zheng (1999) has shown that investors are able to predict mutual fund performance and invest accordingly. This phenomenon has been dubbed the "smart money" effect. We show that the smart money effect is explained by stock return momentum at the one year horizon. Further analysis suggests that investors do not select funds based on a momentum investing style, but rather simply chase funds with recent large returns. Our finding that a common factor in stock returns explains the smart money effect offers no affirmation of investor fund selection ability.
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Case Study
Gas Caps and the Sherman Act
“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
Credit Default Swap Spreads
We review the literature on credit default swap spreads, which are fast replacing bond spreads as source data for analyzing and predicting credit risk. We review results that examine the basis, i.e. the difference between bond and CDS spreads, enabling the extraction of liquidity measures. Results show that pure structural models may be enhanced by macro and firm level variables to better explain spreads; credit premiums extracted from reduced-form models are highly variable; and that there are statistically significant interactions between the term structures of interest rates and spreads.
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Book Review
A History of the Theory of Investments
The Nobel Memorial Laureates in Economics: An Introduction to Their Careers and Main Published Works, 2005
“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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Book Review
The Logic of Life
“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.
Volume 4, No. 4, Fourth Quarter 2006
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Practitioner's Digest
Practitioner’s Digest • Vol. 4, 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
On the Financial Interpretation of Risk Contribution: Risk Budgets Do Add Up
Due to a lack of clear financial interpretation, there are lingering questions in the financial industry regarding the concepts of risk contribution. This paper provides as well as analyzes risk contribution’s financial interpretation that is based on expected contribution to potential losses of a portfolio. We show risk contribution, defined through either standard deviation or value at risk (VaR), is closely linked to the expected contribution to the losses. In addition, for VaR contribution, our use of Cornish–Fisher expansion method provides practitioners an efficient way to calculate risk contributions of portfolios with non-normal underlying returns. Empirical evidences are provided with asset allocation portfolios of stocks and bonds.
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Article
The Right Answer to the Wrong Question: Identifying Superior Active Portfolio Management
The debate over the value of active portfolio management has often centered on whether the average active manager is capable of producing returns that exceed expectations. We argue that a more useful way to frame this issue is to focus on identifying those managers who are the most likely to generate superior risk-adjusted returns (i.e., alpha) in the future. Using a style-classified sample of mutual funds, we document several tractable relationships between observable fund characteristics and its future alpha, most notably the tendency for performance to persist over time. While median managers produce positive risk-adjusted performance approximately 45% of the time, we document a selection process that improves an investor’s probability of identifying a superior active manager to almost 60%. We conclude that there is a place in the investor’s portfolio for the properly chosen active manager.
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Book Review
Empirical Dynamic Asset Pricing: Model Specification and Econometric Assessment
Confession of an Economic Hit Man
“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
The Stock Market’s Reaction to Unemployment News, Stock-Bond Return Correlations, and the State of the Economy
We confirm Boyd et al.’s (2005) finding that on average a surprise increase in unemployment is “good news” for stocks during economic expansions and “bad news” during economic contractions. Unemployment news bundles information about future interest rates, equity risk premium, and corporate earnings. For stocks as a group information about interest rates dominates during expansions, and information about future earnings dominates during contractions. Hence, (a) ceteris paribus, the correlation between stock and bond returns will be greater during economic expansions and (b) stock price responses to the unemployment news will convey information about the state of the economy.
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Case Study
The Worldwide Financier
“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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Article
Aggregate Idiosyncratic Risk and Market Returns
This paper tests the empirical performance of a model-independent measure of aggregate idiosyncratic risk introduced by Bali and Cakici (2004) in the intertemporal capital asset pricing framework. The results indicate a significantly positive relation between the equal-weighted average stock volatility and the value-weighted portfolio returns on the NYSE/AMEX/NASDAQ stocks for the sample period of 1963:08–1999:12.We show that this result is driven by small stocks traded on the NASDAQ. In addition, the positive risk-return tradeoff does not exist for the extended sample of 1963:08–2004:12 and for portfolios of NYSE/AMEX and NYSE stocks. More importantly, we find almost no evidence of a significant link between the value-weighted portfolio returns and various measures of the value-weighted average idiosyncratic volatility.
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Article
The Relation Between Fixed Income and Equity Return Factors
This paper provides an analysis of the relation between equity and fixed income returns over time. As measured by realized correlation, this relation has changed substantially over the last decade, from positive to negative through the market collapse and is currently around zero. We find “jumps” in the co-movements of equity and bond returns at a daily frequency; these jumps can at times be attributed to “flight to liquidity” phenomena in the markets, and at other times, to apparent surprise announcements in expected inflation or related macro conditions. We find no evidence of short-run persistence in the jumps in daily co-movement of bond and equity returns, but there does seem to be a “regime-like” longer-run persistence in them, perhaps associated with Federal Reserve “management over the last decade.