JOIM: 2012
Volume 10, No. 1, First Quarter 2012
-
Insight
Live Prices and Stale Quantities: T+1 Accounting and Mutual Fund Mispricing
Most mutual funds use day-old fund holdings but current-day prices to calculate net asset values. This practice, sanctioned under SEC Rule 2a-4, results in deviations between reported net asset values (NAVs) and returns and the economic values of those quantities. Using a sample of 26 funds' trading data, we establish that small distortions in both NAVs and returns were fairly common in the early 2000s, and distortions were much more pronounced in the volatile markets of 2008. We discuss policy implications of this pricing rule, including mandating same-day pricing or ex post disclosure of pricing discrepancies.
-
Article
Lifecycle Consumption-Investment Policies and Pension Plans: A Dynamic Analysis
This paper explores the optimal design of personal pensions based on the economic theory of the life cycle. It assumes that individuals derive utility from consumption of goods and leisure and that at some date they retire and stop earning income from labor. The existence of this retirement phase of the life cycle has a profound impact on optimal consumption and portfolio policy. We describe the properties of the optimal pension contract and derive the dynamic trading strategy that hedges the contract. In view of the popularity of age-based strategies like target date funds as default options in 401k and other defined contribution retirement plans, some of our results are particularly noteworthy. All target date funds start with a high proportion in equities at a young age and reduce it as a person ages. We identify conditions where the fraction of wealth optimally invested in equities increases or decreases over time as an individual ages. We also analyze the dynamics of pension plans, wealth and optimal policies. Distributional properties of endogenous variables are examined and the robustness of patterns to variations in parameters such as risk aversion and mortality risk is examined.
-
Article
Timing the Value Style Index in a Markov Regime-Switching Model
We construct and test a popular indicator for timing value style investment: the earnings yield dispersion (EYD). Conventional wisdom holds that one should invest in value style when there is a wide dispersion in earnings yield (E/P ratios) across the equity market. This hypothesis is based on a simple argument: many value stocks are depressed during such periods, causing yields to increase and the earnings yield dispersion (EYD) to widen. Investors believe that depressed prices are bound to revert upward, causing the dispersion to narrow. Using a Markov regime-switching model, we demonstrate that the effect of an EYD signal is conditional on the market regime. In a low-variance regime, an increase in EYD predicts positive returns for the value style index, as suggested by the conventional wisdom. In a high-variance regime, however, an increase in EYD predicts negative returns for the value style index. High-variance regimes tend to be associated with strong negative price momentum and overreacting, pessimistic investors. Thus, it is very difficult for depressed value stocks to bounce back in a high-variance regime. The effect of EYD during a high-variance regime is exactly opposite to the conventional wisdom prediction.
-
Article
Calibrating Neutrality: The Evolving Global Opportunity Set
Modern portfolio theory suggests that investors can achieve maximum diversification holding a portfolio of risky assets reflecting the entire market, but no generally accepted method exists to construct such a portfolio. We present data on global equities and global fixed-income securities since 1990, and show that the relative weights of different asset classes have changed substantially, such that the market-neutral portfolio in these two major asset classes has not been constant over time. These results may be important for investors seeking to mimic the investable market, and could represent a benchmark for active allocation funds which principally hold equities and bonds.
-
Case Study
Baby Boomers in Retirement
“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
Expected Returns: An Investor's Guide to Harvesting Market Rewards
“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.
-
Practitioner's Digest
Practitioner’s Digest • Vol. 10, 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.
Volume 10, No. 2, Second Quarter 2012
-
Practitioner's Digest
Practitioner’s Digest • Vol. 10, 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.
-
Article
Liquidity Shocks and Hedge Fund Contagion
In Boyson, Stahel, and Stulz (2010), we investigate whether hedge funds experience worst return contagion that is, correlations in extremely poor returns that are over and above those expected from economic fundamentals. We find strong evidence of contagion among hedge funds using eight separate style indices for the period from January 1990 to October 2008: the probability of a worst return in a particular index is increasing in the number of other indices that also have extremely poor returns. We then show that large adverse shocks to asset and funding liquidity strongly increase the likelihood of this contagion. In this paper, we further investigate contagion between hedge funds and main markets. We uncover strong evidence of contagion between hedge funds and small-cap, mid-cap and emerging market equity indices, high yield bonds, emerging market bonds, and the Australian Dollar. Finally, we show that this contagion between hedge funds and markets is also significantly linked to liquidity shocks, especially for small-cap domestic equities, Asian equities, high yield bonds, and the Australian Dollar.
-
Article
Asset Allocation Dynamics in the Hedge Fund Industry
This paper examines asset allocation dynamics of hedge funds through conducting optimal change point test on an asset class factor model. Based on the average F-test and the Bayesian Information Criterion (BIC), we find that more dynamic hedge funds exhibit significantly better quality than less dynamic funds, signaled by lower return volatility, stricter share restrictions, and high water mark provision. In particular, a higher degree of dynamics is shown to be associated with better risk-adjusted performance at the individual fund level. We find that the degree of a fund's dynamics is closely related to share restrictions. However, the outperformance of highly dynamic funds is robust even after controlling for share restrictions. Sub-period analysis suggests that the superiority of asset allocation dynamics is mostly driven by performance during earlier time periods before the peak of the technology bubble. Fund flow analysis suggests that abnormal returns in the hedge fund industry are diminishing as capital flows in and arbitrage opportunities are not infinitely exploitable.
-
Article
Hedge-Fund Performance and Liquidity Risk
This paper demonstrates that liquidity risk as measured by the covariation of fund returns with unexpected changes in aggregate liquidity is an important predictor of hedge fund performance. The results show that funds that significantly load on liquidity risk subsequently outperform low-loading funds by about 6.5% annually, on average, over the period 1994 - 2009, while negative performance is observed during liquidity crises. The returns are independent of share restriction, pointing to a possible imbalance between the liquidity a fund offers its investors and the liquidity of its underlying positions. Liquidity risk seems to account for a substantial part of hedge-fund performance. The results suggest several practical implications for risk management and manager selection.
-
Insight
On the Kurz Model of Asset Prices with Rational Beliefs
Mordecai Kurz has proposed an asset pricing model incorporating endogenous uncertainty. Kurz contrasts Rational Belief Equilibrium (RBE) with the more familiar theory of Rational Expectations Equilibrium (REE). In RBE, the aggregate market will generally misprice assets and stock returns can be explained by forecasting mistakes of investors. RBE suggests a strong basis for active management of risky assets, which may in fact be harmonious with passive management, rooted in REE. I conjecture that the Theory of Rational Expectations is isomorphic to the Theory of Rational Beliefs.
-
Article
The Downside of High Water Marks: An Empirical Study
Using a large sample of hedge funds, I study the effects of the high water mark (HWM) on fund performance, risk, and fund closure. I find that as funds fall below the HWM, the standard deviation of future returns increases, the future expected Sharpe ratio decreases, and the incidence of fund closure increases. In addition to supporting predictions from models in the literature, these results resonate well with economic intuition: HWM contracts function as if the fund manager holds call options on the funds returns which have varying degrees of moneyness depending on how far the fund is from the HWM.
-
Case Study
The Race Between the Work Force and Investment
“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
Financial Risk Management - Models, History, and Institutions
“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.
-
Book Review
Financial Risk Management - Models, History, and Institutions
“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 10, No. 3, Third Quarter 2012
-
Practitioner's Digest
Practitioner’s Digest • Vol. 10, 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.
-
Article
Redemption Fees and the Risk-Adjusted Performance of International Equity Mutual Funds
In the wake of the market timing and late trading mutual fund scandals, many mutual funds adopted redemption fees to limit market timing. In this paper we investigate the impact of redemption fees on the risk-adjusted performance of U.S. based international equity funds, the very funds that many market timers used. We find three interesting results. First, using event study methodology we find that after the introduction of redemption fee there is a significant increase in the risk-adjusted fund performance. Second, we find that funds that introduced larger-size redemption fees have significantly better performance after the introduction of the redemption fee than other funds. Third, we find that the main reason for the improvement in fund performance after the introduction of the redemption fee is due to lower amounts of cash being held by the fund after the redemption fee. In sum our results suggest that implementation of redemption fees are performance enhancing for international equity funds. As such, long-term investors of international equity funds should actively look for international equity funds that have redemption fees.
-
Article
How Does Your State Stack Up? Participation Costs in Higher Education Optional Retirement Plans
We examine the costs to higher education employees investing in optional retirement plans (ORP). We find vast differences across states in terms of the number of providers, number of funds offered per provider, and fees. We find the same provider offering the same fund oftentimes charges significantly different fees across states. Net performance is 18 basis points lower than what an investor would otherwise be able to directly invest in funds not within an ORP system. Cross-sectionally, we find that funds offered by insurance companies systematically have worse performance than mutual fund providers. Further, we find that states with more ORP providers have better net performance. Our evidence suggests that by giving employees more choices, the additional competition within the ORP system would result in lower fees, thereby increasing terminal wealth for participants. Our paper has important policy implications as these plans become popular in the public sector as governments try to cut costs by reducing severely underfunded pension liabilities.
-
Article
The Relative Strength of Industries versus Countries in Global Equity Markets
The relative strength of industries versus countries is of great practical interest for global equity investors. In this article, we investigate the relative strength of these effects in the global equity markets over the sample period 1994-2010. In particular, we examine three market segments: (a) the world market, (b) emerging markets, and (c) developed Europe. We employ a factor-based approach to construct portfolios that capture the pure effect of each industry or country. We define two quantities to measure the relative strength of the two effects: diversification potential and mean absolute deviation. For the world market, we find that industry and country effects are of comparable strength, although each dominates during different sub-periods. In particular, countries dominated in the mid-to-late 1990s, whereas industries dominated in the aftermath of the internet bubble. For emerging markets, we find that countries have dominated industries over the entire sample period. In developed Europe, by contrast, we find that industries have dominated countries since the introduction of the euro. We also investigate the size dependency of the relative strength of industry versus country effects. In particular, we find that in the small-cap segment, industry effects become weaker whereas country effects retain their full strength.
-
Article
Estimating the Negative Impact of “Noise” on the Returns of Cap-Weighted Portfolios In Various Segments of the Equity Markets
Capital Market Theory assumes that the ex ante market portfolio (which is cap-weighted) lies on the (ex ante) efficient frontier. However, we show that ex ante cap-weighted portfolios will always be interior portfolios relative to the end-of-investment-period ex post efficient frontier. This is due to the arrival of unanticipated information, which we refer to as noise that causes unexpected price changes and creates either winner or loser stocks. By construction, ex ante cap-weighted portfolios will be overweighted in loser stocks and underweighted in winners during the return measurement period. To estimate the negative impact of noise on the returns of ex ante cap-weighted portfolios, we use the concept of a perfect foresight (PF) portfolio. The PF portfolio for any given equity segment is a buy-and-hold portfolio of all stocks in that segment with weights at the beginning of the return period set to be proportional to the market capitalization of the stocks at the end of the return period. We show that the PF portfolio will always be on the ex post efficient frontier and outperform its ex ante cap-weighted counterpart. Because the PF portfolio has risk characteristics that are similar to the ex ante capweighted portfolio for a particular equity segment, the excess return of the PF portfolio provides an estimate of the maximum annual amount of available alpha to all investors involved in that segment in a given year. For example, the total excess return of the PF portfolio for the large-cap US equity segment (which we define as the 1,000 largest US stocks based on market values at the beginning of each year) is about 7%, on average, per year. This can be thought of as the maximum amount of alpha, or ex ante mispricing (in percentage terms), available to all investors in the large-cap US equity market segment.
-
Article
A New Perspective on the Validity of the CAPM: Still Alive and Well
The Capital Asset Pricing Model (CAPM) has far-reaching practical implications for both investors and corporate managers. The model implies that the market portfolio is mean-variance efficient, and thus advocates passive investment. It also provides the most widely used measure of risk, beta, which is used to calculate the cost of capital and excess return (alpha). Most academic studies empirically reject the CAPM, leaving the lack of a better alternative as the only uneasy justification for using the model. Here we take a reverse-engineering approach for testing the model and show that with slight variations in the empirically estimated parameters, well within their estimation-error bounds, the CAPM perfectly holds. Thus, in contrast to the widely held belief, the CAPM cannot be empirically rejected.
-
Case Study
Investing Early for Retirement
“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
What Investors Want
Pension Finance: Putting the Risk and Costs of Defined Benefit Plans Under Your Control
“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 10, No. 4, Fourth Quarter 2012
-
Practitioner's Digest
Practitioner’s Digest • Vol. 10, 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.
-
Article
Portfolio Monitoring In Theory and Practice
The when-to-trade decision is a critical yet neglected component of modern asset management. Typical rebalancing rules are based on suboptimal heuristics. Rebalancing is necessarily a statistical similarity test between current and proposed optimal portfolios. Available tests ignore many real world portfolio management considerations. The first practical test for mean-variance optimality, the Michaud rebalancing rule, ignored the likelihood of information overlap in the construction of optimal and current portfolios. We describe two new algorithms that address overlapping data in the Michaud test and give examples. The method allows large-scale automatable non-calendar based portfolio monitoring and quadratic programming extensions beyond portfolio management.
-
Article
Coherent Asset Allocation and Diversification in the Presence of Stress Events
We propose a method to integrate frequentist and subjective probabilities in order to obtain a coherent asset allocation in the presence of stress events. Our working assumption is that in normal market asset returns are sufficiently regular for frequentist statistical techniques to identify their joint distribution, once the outliers have been removed from the data set. We also argue, however, that the exceptional events facing the portfolio manager at any point in time are specific to the each individual crisis, and that past regularities cannot be relied upon. We therefore deal with exceptional returns by eliciting subjective probabilities, and by employing the Bayesian net technology to ensure logical consistency. The portfolio allocation is then obtained by utility maximization over the combined (normal plus exceptional) distribution of returns. We show the procedure in detail in a stylized case.
-
Article
The Controversy in Fundamental Indexation: Why Both Sides of the Argument are (Mostly) Correct
We examine the contribution of noise to the theoretical underpinnings of Fundamental Indexation (FI). Although we argue that market capital-weighted indexes do not incur a structural drag due to noise as claimed by the proponents of FI, we conclude, nevertheless, that noise as advanced by FI offers a potential for achieving superior returns to those achieved by market capital-weighted indexes. As such, FI represents an important insight to our understanding of asset pricing.
-
Article
The Role of Stress Testing in Credit Risk Management
In this article, we outline some concepts relating to the use of stress testing in credit risk management. We begin by providing a simple taxonomy of stress scenarios and discussing the trade-offs that different approaches require for implementation. Our taxonomy is modeled after one that is common in the credit literature and involves concepts related to reduced-form and structural approaches to credit modeling. Recently, some have expressed the view that the use of distribution-based measures such as VaR and expected shortfall (ES) for credit risk management should be deemphasized in favor of stress-testing and scenario analysis. We consider this question in the main portion of this article. We discuss the benefits of stress testing and scenario analysis as well as describing some limitations of using scenario-based approaches as a sole mechanism for assessing portfolio risk. We provide a number of examples to illustrate these limitations. In particular, except in special cases, it is difficult to use stress scenarios alone, ex ante, for allocating capital across disparate portfolios. However, stress testing and scenario analysis are integral to prudent credit risk management and can complement measures such as VaR and ES, thereby better informing both risk assessment and business strategy development. While neither stress testing nor VaR type measures, in and of themselves, provide complete descriptions of credit portfolio risk, combining both approaches results in more robust risk analysis. This permits risk managers to integrate quantitative measures with managerial intuition and judgment to arrive at more comprehensive assessments of both portfolio risk and overall firm strategy.
-
Article
Was the Writing on the Wall? An Options Analysis of the 2008 Lehman Brothers Crisis
This paper uses risk neutral densities (RNDs) of stock options to investigate the markets perceptions of crash risk in the recent U.S. subprime crisis. RNDs were estimated using the double lognormal method for the S&P 500 market index, Lehman Brothers, Merrill Lynch and Goldman Sachs. We find strong evidence of bimodality in the RND of Lehman Brothers and Merrill Lynch as early as April 2008. In contrast, no evidence of bimodality was found for either Goldman Sachs or the S&P 500 index. These results vindicate the usefulness of the RND as a forecasting tool in extreme market conditions.
-
Case Study
Providing for Retirement
“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
On the Brink - Inside the Race to Stop the Collapse of the Global Financial System
“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.
-
Survey & Crossover
Structured Finance Deals: A Review of the Rating Process and Recent Evidence Thereof
“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.