JOIM: 2008
Volume 6, No. 1, First Quarter 2008
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Practitioner's Digest
Practitioner’s Digest • Vol. 6, 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
Why is There a Home Bias? Count the Teeth!
Under somewhat idealized conditions, investors would achieve the best risk return tradeoff by allocation equity investment in each country equal to its percentage share of world equity capitalization. But factual evidence confirms that domestic investors prefer domestic stocks. For example, domestic investors allocate about 90 percent of their portfolios to domestic equity even though US equity accounts for only about 50 percent of the world equity. This amounts to placing a 40 percent side bet on US equity. This is referred to as the home bias. Why does it exist? Many reasons have been given including lack of transparency, asymmetric information, investor protection, and transaction costs. This article recounts the experience and associated transactions cost of a US investor in Prague who attempts to buy individual stocks on the local market.
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Article
Estimation Error and Portfolio Optimization: A Resampling Solution
Markowitz (1959) mean-variance (MV) portfolio optimization has been the practical standard for asset allocation and equity portfolio management for almost 50 years. However it is known to be overly sensitive to estimation error in risk-return estimates and have poor out-of-sample performance characteristics. The Resampled Efficiency (RE) techniques presented in Michaud (1998) introduce Monte Carlo methods to properly represent investment information uncertainty in computing MV portfolio optimality and in defining trading and monitoring rules. This paper reviews and updates the literature on estimation error and RE portfolio optimization and rebalancing. We resolve several open issues and misunderstandings that have emerged since Michaud (1998). In particular, we show RE optimization to be a Bayesian-based generalization and enhancement of Markowitz's solution.
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Article
Bayes vs. Resampling: A Rematch
We replay an investment game that compares the performance of a player using Bayesian methods for determining portfolio weights with a player that uses the Monte Carlo based resampling approach advocated in Michaud (Efficient Asset Management. Boston: Harvard Business School, 1998). Markowitz and Usmen (Journal of Investment Management 1(4), 925, 2003), showed that the Michaud player always won. However, in the original experiment, the Bayes player was handicapped because the algorithm that was used to evaluate the predictive distribution of the portfolio provided only a rough approximation. We level the playing field by allowing the Bayes player to use a more standard algorithm. Our results sharply contrast with those of the original game. The final part of our paper proposes a new investment game that is much more relevant for the average investora one-period ahead asset allocation. For this game, the Bayes player always wins.
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Article
The Profound Effects of Automation on Stock Markets Around the World
We document the profound impact of technology on the functioning of financial markets around the world. Specially, we report a strong trend towards fully automated trading systems. This trend is associated with a significant decline in the cost of equity capital. These findings are consistent with the notion that computerization enhances liquidity, informativeness, and valuations in the stock markets. These results have practical significance for investors routing their trades, firms choosing their listing venues, stock exchanges crafting their competitive organizational strategies, and regulators contemplating policy initiatives.
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Article
A Model of Fund Growth For Managed Futures: Evidence of Managerial Skill
Fund size is an essential component of a funds overall value. In this work, we argue that growth in fund size results from managerial skill. To test this argument, we estimate a model that links fund growth to performance characteristics. We use the model to isolate significant performance characteristics and confirm that the model has predictive power out-of-sample. Hence, we verify that manager skill exists. This model may be useful to academics, fund managers, and fund allocators.
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Case Study
Case Studies
“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
The Little Book of Value Investing
The Little Book of Common Sense Investing
“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
NOISE, CAPM AND THE SIZE AND VALUE EFFECTS
We model a continuous time one factor economy where stock prices are noisy proxies of the informationally efficient stock values. The pricing error process is modeled as a mean-reverting process, which gives us a well-defined notion of over-pricing (positive pricing error) and under-pricing (negative pricing error) in the market. We show that in this economy, cap-weighting is a sub-optimal portfolio strategy. This is because, in a capweighting scheme, portfolio weights are driven by market prices; as such, more weights are allocated to over-valued stocks and less weight to under-valued stocks.
More importantly, we show that the CAPM would be rejected in this one factor economy with noise. Regressing portfolio returns against market clearing portfolio returns, non-capweighted portfolios exhibit significant alpha on average!
Additionally, a value tilted or size tilted portfolio is predicted to outperform(risk-adjusted). By construction, value and size are not risk factors in our one factor economy. However, in the cross-section, large cap stocks and high price-to-book stocks (growth stocks) tend to underperform. This is because higher capitalization stocks and higher price-to-books stocks are indeed more likely to be stocks with positive pricing errors.
We note that prices are explicitly inefficient in our economy. However, the inefficiency does not lead to arbitrage opportunities. We carefully show conditions which prevent arbitrage in our informationally inefficient economy.
The paper contributes to the anomalies literature by showing that mean-reversion in stock returns and the Fama–French size and value effects are driven by the same market defect—pricing noise! This suggests that models, such as disposition effect and information herding, which can generate stock price over-reaction and therefore mean-reversion in stock prices, can also explain the value and size puzzle.
Volume 6, No. 2, Second Quarter 2008
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Practitioner's Digest
Practitioner’s Digest • Vol. 6, 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
Are Analysts All Alike? Identifying Earnings Forecasting Ability
Investors and the financial media apparently believe that some Wall Street equity analysts research is superior to others. We examine whether such quality differentials exist, in terms of analysts ability to forecast earnings accurately, and whether these differentials are identifiable on an ex ante basis. The results suggest that there is some persistence in analysts forecast accuracy. In particular, forecast accuracy is associated with analyst experience, breadth of coverage, timeliness, and brokerage firm size. Analysts selected for All- Star status by industry publications also tend to have higher forecast accuracy. However, the differences in forecast accuracy do not produce material differences in the dollar magnitudes of forecast errors.
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Article
Optimal Static Allocation Decisions in the Presence of Portfolio Insurance
The focus of this paper is to determine what fraction a myopic risk-averse investor should allocate to investment strategies with convex exposure to stock market returns in a general economy with stochastically time-varying interest rates and equity risk premium. Our conclusion is that typical investors should optimally allocate a sizable fraction of their portfolio to such portfolio insurance strategies, and the associated utility gains are significant. While the fact that static investors would benefit from accessing dynamic investment strategies is in essence not surprising, we have found the size of the rational investment in such structures to be rather remarkable. This strong result is robust with respect to various parametric assumptions, as well as the presence of realistic levels of market frictions and heterogeneous expectations on volatility.
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Article
First Come First Disserved
This study investigates whether stock market reactions to earnings information of firms that release their earnings close to quarter-end (Early) are systematically different from their industry peers which report later during the quarter (Late). Unexpectedly, we find that immediate market reactions to early reporters are weaker than those to late or middle reporters. We also find that stock market returns subsequent to the earnings announcements are stronger for positive earnings surprises of early reporters than late reporters, indicating that the market systematically under reacts to the positive surprises of early reporters. These results have implications for investors who can use this systematic under reaction in their trading strategies and academics who can understand better how market participants gather and process earnings information.
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Article
How Does Investor Sentiment Affect the Cross-Section of Stock Returns?
Broad waves of investor sentiment should have larger impacts on securities that are more difficult to value and to arbitrage. Consistent with this intuition, we find that when an index of investor sentiment takes low values, small, young, high volatility, unprofitable, non-dividend paying, extreme growth, and distressed stocks earn relatively higher subsequent returns. When sentiment is high, the aforementioned categories of stocks earn relatively lower subsequent returns.
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Article
Beyond Value at Risk: Forecasting Portfolio Loss at Multiple Horizons
We develop a portfolio risk model that uses high-frequency data to forecast the loss surface, which is the set of loss distributions at future time horizons. Our model uses a fully automated, semi-parametric fitting procedure that has its basis in extreme value statistics. We take account of distributional asymmetry, heavy tails, heteroscedasticity and serial correlation. Loss distributions are time aggregated by taking products of characteristic functions. We test loss-surface-implied forecasts of value at risk and expected shortfall out of sample on a diverse set of portfolios and we compare our forecasts to industry-standard risk forecasts that are based on asset and factor covariance matrices. The empirical results make a compelling case for the application and further development of our approach.
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Case Study
Best Seller Productions
“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 Ideas Evolving
“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 6, No. 3, Third Quarter 2008
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Article
Where Do Alphas Come From?: A New Measure of the Value of Active Investment Management
The value of active investment management is traditionally measured by alpha, beta, volatility, tracking error, and the Sharpe and information ratios. These are essentially static characteristics of the marginal distributions of returns at a single point in time, and do not incorporate dynamic aspects of a manager’s investment process. In this paper, I propose a measure of the value of active investment management that captures both static and dynamic contributions of a portfolio manager’s decisions. The measure is based on a decomposition of a portfolio’s expected return into two distinct components: a static weighted-average of the individual securities’ expected returns, and the sum of covariances between returns and portfolio weights. The former component measures the portion of the manager’s expected return due to static investments in the underlying securities, while the latter component captures the forecast power implicit in the manager’s dynamic investment choices. This measure can be computed for long-only investments, long/short portfolios, and asset allocation rules, and is particularly relevant for hedge-fund strategies where both components are significant contributors to their expected returns, but only one should garner the high fees that hedge funds typically charge. Several analytical and empirical examples are provided to illustrate the practical relevance of this decomposition.
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Article
Optimal Trading Strategy with Optimal Horizon
Portfolio implementation is an essential part of active investment strategies. The trading horizon-the length of time allocated for trade implementation, is an important consideration in portfolio trading. Previous research on optimal trading limits the trading horizon as a fixed value. In this paper, we treat it as an endogenous factor and find the optimal trading horizon as a part of optimal trading strategy to further reduce trading costs. We derive analytical results for optimal trading strategy with optimal horizon and provide numerical examples for illustration.
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Article
The Structure of Hybrid Factor Models
We study the problem of augmenting fundamental risk models with statistical factors in order to capture the risk associated with omitted factors. The statistical factors are estimated by applying principal component analysis to the cross-sectional residuals. We show that in the limit of zero noise, the statistical factors can be precisely interpreted as fundamental factors that have been Gram-Schmidt orthogonalized to the existing fundamental factors. For finite noise, we determine the correlations between the true and estimated factor exposures and returns. This establishes a practical criterion for the successful detection of hidden factors.
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Article
A Structural Analysis of the Default Swap Market, Part 1 (Calibration)
We analyze the default swap market with the two factor I2 structural model, which is driven by firm value and firm leverage. As we show empirically, the de- fault swap market incorporates these risks differentially over time, by region, by industry, and by coarse quality. This leads us to pool firms with similar character- istics into calibration groups whose parameters are used to align model and market sensitivities to the risk factors. We include equity factor returns to account for contagion and momentum effects for industries or credits that have suffered recent downturns. The close alignment of our model spreads with the market enables us to extract systematic effects reflected in the dynamics of average levels of model inputs and outputs, and discern relative value among credits by analyzing model errors. Applications of our model include assessment of relative value, pricing of illiquid names, cross market hedging and monitoring credit portfolios. A rich-cheap portfolio construction strategy based on our model shows consistent profits in most calibration groups between January 2004 and May 2006.
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Article
Humpbacks in Credit Spreads
Models of credit valuation generally predict a hump-shaped spread term structure for low quality issuers. This is understood to be driven by the shape of the underlying conditional default probabilities curve. We show that (a) recovery assumptions and (b) deviation of bond's price from its par value can also drive different term structure shapes. Our analysis resolves conflicting empirical evidence on the shape of speculative grade spread curves and explains the related existing theoretical results. On examining a large set of speculative grade bonds and credit default swaps, we find evidence that par-spread term structures are likely to be downward sloping as credit quality deteriorates sufficiently.
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Case Study
Case Studies
“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
The Age of Turbulence: Adventures in a New World
“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. 6, 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.
Volume 6, No. 4, Fourth Quarter 2008
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Article
Risk and Return in Behavioral SDF-Based Asset Pricing Models
Behavioral finance has profound implications for the pricing of all assets, from standard fixed income securities and equity to complex derivatives. This paper describes a general, unified framework for analyzing the impact of sentiment on asset prices. The approach brings together the psychological assumptions favored by behavioral asset pricing theorists and the powerful pricing kernel-based methodology favored by neoclassical asset pricing theorists. Methodologically, change of measure techniques are used to provide a formal definition of sentiment and to capture the impact of behavioral beliefs and preferences on asset prices. Introducing behavioral assumptions into a pricing kernel framework provides insights into the impact of psychological features on the relationship between risk and return, mean-variance portfolios, the role of coskewness, and the pricing of derivatives. A behavioral theory for the pricing of derivatives is particularly germane to understanding the major turmoil in global financial markets which took place in 2008. That turmoil, which reflected highly volatile swings of sentiment in the markets for both equity and debt, stemmed from significant sentiment in the market for mortgages and derivatives based on mortgages.
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Article
Hedge Fund Due Diligence: A Source Of Alpha In A Hedge Fund Portfolio Strategy
Due diligence is an important source of alpha in a well designed hedge fund portfolio strategy. It is generally understood that the high returns possible in investing in hedge funds are somewhat offset by the relative lack of transparency on operational issues. The performance of a diversified hedge fund portfolio can be enhanced by excluding those funds likely to do poorly or fail due to operational risk concerns. However, effective due diligence is an expensive concern. This implies that there is a strong competitive advantage to those funds of funds sufficiently large to absorb this fixed and necessary cost. The consequent economies of scale that we document in funds of funds are quite substantial and support the proposition that due diligence is a source of alpha in hedge fund investment.
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Article
Measuring the Risk of Large Losses
Risk management is an important component of the investment process. It requires quantitative measures of risk that provide a metric for the comparison of financial positions. In this expository note we give an overview of risk measures. In particular, we contrast different risk measures with respect to their sensitivity to potentially large losses due to market wide shocks. The industry standard value at risk exhibits many deficiencies. It does not account for the size of the losses and may penalize diversification. We compare value at risk to alternative risk measures including average value at risk and the less well know but superior utility-based shortfall risk.
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Case Study
Consolidated Lunch Pail
“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
Behavioral Investing: A Practitioners Guide to Applying Behavioral Finance
“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. 6, 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.