JOIM: 2007
Volume 5, No. 1, First Quarter 2007
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Case Study
Reifen AG
“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
What Every Investor Should Know About Commodities Part I: Univariate Return Analysis
In this paper we study the univariate return properties of a large variety of commodity futures. Our analysis shows that the volatility of commodity futures is comparable to that of US large cap stocks. Yet, with the exception of energy, a consistently positive risk premium is lacking in commodity futures. We also find that for many commodities, futures returns and volatility can vary considerably over different phases of the business cycle, under different monetary conditions as well as with the shape of the futures curve. Skewness in commodity futures returns is largely insignificant, whereas kurtosis is significantly positive and comparable to that of US large cap stocks. In almost all commodities we find significant degrees of autocorrelation, which affects the properties of longer horizon returns.
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Article
Measuring the True Cost of Active Management by Mutual Funds
This article derives a rigorous method for allocating fund expenses between active and passive management and that enable one to compute the implicit cost of active management. Computing this "active expense ratio" requires only a fund's published expense ratio, its R-squared relative to a benchmark index, and the expense ratio for a competitive fund that tracks that index. This method is then applied to the Morningstar universe of large-cap mutual funds and active expense ratios are found to average more than 7%. The cost of active management for other classes of mutual funds is also found to substantial.
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Article
Industry Concentration and Mutual Fund Performance
We study the relation between the industry concentration and the performance of actively managed U.S. mutual funds from 1984 to 2003. Our results indicate that the most concentrated funds perform better after controlling for risk and style differences using factor-based performance measures. This finding suggests that investment ability is more evident among managers who hold portfolios concentrated in a few industries.
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Article
The Value of Transaction Cost Forecasts: Another Source of Alpha
This article examines the impact of transaction costs on portfolio performance. Previous research on this topic has focused largely on post-trade considerations, i.e., the impact of realized transaction costs on investment performance. By contrast, we focus on pre-trade considerations, namely the impact of transaction costs on portfolio breadth, turnover, and expected returns. Although costs reduce the information ratio, improvements in transaction cost modeling can mitigate these effects by increasing skill and breadth. Transactions cost considerations also affect the choice of portfolio turnover. Greater turnover allows for more active bets, increasing breadth, but magnifies the impact of trading costs. Balancing these considerations yields an optimal turnover level. The analysis provides insights into the determinants of optimal fund capacity. We show that capacity problems are manifested gradually in the form of higher expected costs, reduced breadth, and lower turnover. Capacity is an elastic concept that is surprisingly responsive to even relatively modest gains in transaction cost control or forecasting ability. This suggests that fund managers can influence their capacity through investments in better execution research and technology.
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Article
Proxy Voting Brand Competition
Institutional and individual investors can coordinate their proxy voting to improve corporate governance. A new funding design for professional proxy advisors can increase their quality and competition. These reforms would reduce the need for the public sector to police boards of directors by onerous regulation and expensive lawsuits.
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Book Review
A Behavioral Approach To Asset Pricing
Investors and Markets
“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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Practitioner's Digest
Practitioner’s Digest • Vol. 5, 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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Article
What Every Investor Should Know About Commodities Part II: Multivariate Return Analysis
In this paper, we study the multivariate return properties of a large variety of commodity futures. We find that between commodity groupings (such as metals, energy, etc.) correlations are very low and mostly insignificant whereas within groups they tend to be much stronger. In addition, commodity futures are roughly uncorrelated with stocks and bonds. Still, correlations may vary somewhat over the different phases of the business cycle, suggesting that not all commodities make equally good diversifiers at all times. Copula-based tests do not indicate any deviant behavior in the tails of the joint return distribution of commodity futures and stocks or bonds. Contrary to equities and bonds, we show that commodity futures returns are positively correlated with unexpected inflation (i.e., 25% on average with CPI inflation as opposed to −30% for equities and −50% for bonds). There are significant differences between the various commodities, however, with energy, metals, cattle, and sugar offering the best hedging potential. Altogether, assuming that the observed regularities will persist, our results confirm that a well-balanced commodity futures portfolio could offer a worthwhile diversification service to the typical traditional investment portfolio.
Volume 5, No. 2, Second Quarter 2007
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Case Study
Rivalry at Appleton-Pearson
“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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Practitioner's Digest
Practitioner’s Digest • Vol. 5, 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
Can Hedge-Fund Returns Be Replicated?: The Linear Case
In contrast to traditional investments such as stocks and bonds, hedge-fund returns have more complex risk exposures that yield additional and complementary sources of risk premia. This raises the possibility of creating passive replicating portfolios or clones" using liquid exchange-traded instruments that provide similar risk exposures at lower cost and with greater transparency. Using monthly returns data for 1,610 hedge funds in the TASS database from 1986 to 2005, we estimate linear factor models for individual hedge funds using six common factors, and measure the proportion of the funds' expected returns and volatility that are attributable to such factors. For certain hedge-fund style categories, we and that a significant fraction of both can be captured by common factors corresponding to liquid exchange-traded instruments. While the performance of linear clones is often inferior to their hedge-fund counterparts, they perform well enough to warrant serious consideration as passive, transparent, scalable, and lower-cost alternatives to hedge funds.
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Article
How Hedge Funds Beat the Market
This paper investigates the determinants of hedge fund portfolio performance -- whether hedge funds exhibit security selection skill and market-timing skill. We examine a sample of 157 long-short equity hedge funds over the 10-year period from January, 1996 through December, 2005. To account for nonlinearities we employ the Treynor and Mazuy (1966) quadratic model. To account for illiquidity we incorporate the Scholes and Williams (1977) nonsynchronous data model. Before and after adjusting for illiquidity, we find strong evidence of security selection skill and limited evidence of market-timing skill.
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Article
Will Hedge Funds Regress towards Index-like Products?
Hedge funds have grown substantially in the past few years even as hedge fund performance has declined with the rapid increase of capital. History tells us that over-priced, active managers will be replaced by low-cost, passive, index-like alternatives. Could the same process be taking place in the hedge fund industry? Much of the innovative technology central to the creation of rule-based passive (or “synthetic”) hedge funds can be traced to the past decade’s research, which endeavored to address the fundamental question in hedge fund investing: do hedge funds add value? The key to answering this question lies with the separation of hedge fund returns into “alternative beta” and “alternative alpha,” terms that were coined by Fung and Hsieh (2003) to distinguish the problem from the familiar alpha–beta separation in measuring performance of traditional asset managers. In this paper, we extend the concept of alpha–beta separation for analyzing mutual fund performance to hedge funds. In particular, we argue that at the portfolio level, separation of alternative alpha from alternative beta involves the additional complexity of identifying alpha created by successful timing across strategies as opposed to security selection within strategies. Using historical hedge fund returns, we provide examples to illustrate the additional technology needed to successfully mimic this dynamic asset allocation process. Finally, the existence of index-like hedge fund products also act as a catalyst to improve the price-discovery process in the hedge fund industry—more efficient fee structure with equitable risk-return sharing between investors and managers. Ultimately, whether hedge funds will become index-like products will depend on the answer to the fundamental question that precipitated this process, but with this qualification, namely do hedge funds add value (have alpha) that cannot be replicated at a lower cost?
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Article
Timing Ability in the Focus Market of Hedge Funds
This paper examines the timing ability of hedge funds covering various investment categories. We extend the Treynor-Mazuy (1966) and Henriksson-Merton (1981) market timing models to a multiple market framework and propose the concept of a focus market in which a fund trades most actively. Concentrating on the focus market enables us to parsimoniously apply conditional multifactor models. With a large sample of hedge funds during 1994-2002, we show evidence of significant timing ability in the focus markets including bond, currency, and equity markets at both the category and the fund levels. Tests of performance persistence present some supportive evidence over a short horizon.
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Article
Hedge Fund Mergers
This paper examines the characteristics of merged hedge-funds. The data indicate that merged hedge-funds are larger funds that have underperformed over a two-year period prior to merger and have suffered from significantly lower money-flow prior to merger. Merged hedge-funds are also older funds. The fee structure of merged funds is similar to other hedge-funds. The paper compares these findings with recent research findings on mutual fund mergers.
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Book Review
Financial Modeling of the Equity Market: From CAPM to Cointegration
“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
Financial Modeling of the Equity Market: From CAPM to Cointegration
“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 5, No. 3, Third Quarter 2007
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Practitioner's Digest
Practitioner’s Digest • Vol. 5, 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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Insight
Will the Phillips Curve Cause WWIII?
“Insights” features the thoughts and views of the top authorities from academia and the profession. This section offers unique perspectives from the leading minds in investment management.
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Article
On the Relative Performance of Multi-Strategy and Funds of Hedge Funds
Recently, there has been explosive growth in two products from the hedge fund industry multi-strategy (MS) funds and funds of hedge funds (FOFs), both of which offer diversification across different hedge fund strategies. In well functioning markets, both investment vehicles should offer similar returns. Over the period 1994-2004, we find that MS funds outperform FOFs on a risk-adjusted basis by 2.6% to 4.8% per year on gross-of-fee and by 3.0% to 3.6% per year on net-of-fee basis. The superior performance of MS funds continues to hold even when we control for fund characteristics such as size, management and incentive fees, and other conventional control variables. Since FOFs underperform MS funds on both net- and gross-of-fee basis, their underperformance cannot be entirely explained by their double-layered fee structure. The question then is how MS funds and FOFs can co-exist in equilibrium in view of the significant differential in performance? We suggest that investors perceive greater agency risk in the structure of MS funds relative to FOFs and therefore require greater compensation for investing in MS funds. MS funds are able to generate these higher returns because they possess greater investment flexibility and are able to invest in less liquid assets. It is also possible that MS funds generate greater returns because managers with "better" ability self-select into joining MS funds and the competition among MS funds results in the rents from superior ability being passed on to the investors in the form of better returns. Controlling for the differences in agency risk, flexibility, and fee structure between MS funds and FOFs, our results suggest that self-selection by managers with superior ability in MS funds may be the driving force behind their superior performance relative to FOFs.
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Article
Active 130/30 Extensions: Alpha Hunting at the Fund Level
Active equity strategies that are highly benchmark-centric will generally have a minimal impact on fund-level volatility. Since most US institutional portfolios are overwhelmingly dominated by their equity exposure, any incremental tracking error will be submerged by the beta effect. Positive alpha opportunities from tightly beta-targeted strategies can therefore be particularly valuable because they can significantly increase the fund's total return with only minor increases in the overall volatility or other "beyond-model" forms of risk.
Active extensions strategies such as "130/30" portfolios are intrinsically benchmark-centric and can potentially lead to higher levels of active alpha. The expanded footings open the door to a fresh set of actively chosen underweight positions and provide a wider range of alpha-seeking opportunities for both traditional and quantitative management.
Active extension strategies can be designed to fit within a sponsor's existing allocation space for active US equity. With proper risk control, an active extension may entail tracking error that is only moderately greater than that of a comparable long-only fund.
A carefully implemented active extension can expand relationships with existing managers. A sponsor may wish to draw upon those active managers that have already been vetted in terms of their alpha-seeking skills, organization infrastructure, and risk-control procedures.
The preconditions for realizing any of these benefits are a credible basis for producing positive alphas in both long and short portfolios, a high level of risk discipline, an ability to minimize and/or offset unproductive correlations, and an organizational ability to pursue active extensions in a benchmark-centric, cost-efficient fashion. -
Book Review
Louis Bachelier's Theory of Speculation
“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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Case Study
Common Sense Investing
“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.
Volume 5, No. 4, Fourth Quarter 2007
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Practitioner's Digest
Practitioner’s Digest • Vol. 5, 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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Insight
A Brief Review of “The Basis”
Credit derivatives provide an alternative to the cash market, allowing investors to manage exposure to a wide range of entities. In a brief case study looking at several relatively volatile corporate names, we set out to describe, in general terms, the nature and behavior of the relationship of CDS, LCDS, and bonds over the very recent turbulent past.
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Article
Contingent Claims Approach to Measuring and Managing Sovereign Credit Risk
This paper proposes a new approach to measure, analyze, and manage sovereign risk based on the theory and practice of modern contingent claims analysis (CCA). The paper provides a new framework for adapting the CCA model to the sovereign balance sheet in a way that can help forecast credit spreads and evaluate the impact of market risks and risks transferred from other sectors. This new framework is useful for assessing vulnerability, policy analysis, sovereign credit risk analysis, and design of sovereign risk mitigation and control strategies.
Applications for investors in three areas are discussed. First, CCA provides a new framework for valuing, investing, and trading sovereign securities, including sovereign capital structure arbitrage. Second, it provides a new framework for analysis and management of sovereign wealth funds being created by many emerging market and resource rich countries. Third, the framework provides quantitative measures of sovereign risk exposures which facilitates the design of new instruments and contracts to control or transfer sovereign risk.
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Article
What Happened to the Quants in August 2007
During the week of August 6, 2007, a number of quantitative long/short equity hedge funds experienced unprecedented losses. Based on TASS hedge-fund data and simulations of a specific long/short equity strategy, we hypothesize that the losses were initiated by the rapid "unwind" of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a forced liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to a margin call or a risk reduction. These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses by triggering stop/loss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the unwind hypothesis. This dislocation was apparently caused by forces outside the long/short equity sector in a completely unrelated set of markets and instruments suggesting that systemic risk in the hedge-fund industry may have increased in recent years.
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Article
The Pricing of Credit Default Swaps During Distress
Credit default swaps (CDS) provide the buyer with insurance against certain types of credit events by entitling him to exchange any of the bonds permitted as deliverable against their par value. Unlike bonds, whose risk spreads are assumed to be the product of default risk and loss rate, CDS are par instruments, and their spreads reflect the partial recovery of the delivered bond's face value. This paper addresses the implications of the difference between bond and CDS spreads and shows the extent to which the recovery assumption matters for determining CDS spreads. A no-arbitrage argument is applied to extract joint recovery rates from CDS and bond markets, using data from Brazil's distress in 2002-2003. Results are related to the observation that preemptive restructurings are now more common than straight defaults in sovereign bond markets and that this leads to a decoupling of CDS and bond spreads.
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Article
Interest Rate Models Implied Volatility Function Stochastic Movements
This paper presents a one-factor and a two-factor arbitrage-free interest rate models with parsimonious implied volatility functions. The models are empirically tested on the entire swaption surface in three currencies (US dollar, Euro, and Japanese yen) over a 5-year period. They are shown to be robust in explaining the swaption values, and the implied volatility functions are shown to exhibit a three-factor movement in all three currencies. The results show that the observed swaption prices incorporate the market conditional expectations of the correlations of the key interest rates and the stochastic process of the yield curve, and the interest rate models should be calibrated to such market information to provide accurate relative valuation. Further this paper describes a modeling approach that has important implications on hedging interest rate derivatives dynamically taking the stochastic volatility risks into account.
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Case Study
Dependable Trust
“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
Fortune's Formula
“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
Fortune's Formula
“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.