« Making Rare Earth Element Disclosure Transparent and Compliant | Main | CFA Prep Podcast: Level III Advice »

10/24/2011

Martin L. Leibowitz: Alpha Orbits


Click to Print This Page

CFA

Let us ponder, for a moment, a hypothetical market consisting of only two assets: (1) cash and (2) one big Treasury bond. To keep things simple, let’s make the bond a perpetual with a 5 percent coupon and a current yield of 5 percent so that its price is 100. Further, let us assume that there is no credit risk whatsoever.

Now let us suppose that some investors own only cash, some own only the bond, and others own a mix of both.

We all know what happens to the bond price when the yield goes up or down: If the bond yield rose to 6 percent, the price would drop from 100 to 5/(0.06) = 83.33; if the yield fell to 4 percent, the price would rise to 5/(0.04) = 125.

But we also know that when the price goes up for any reason, the bond’s yield must fall.

In our hypothetical model, the all-cash investors are risk averse as a group, probably believing that bonds are simply not the “right kind” of asset for their highly risk-averse type of fund. But now let’s suppose that one of these all-cash funds suddenly receives an unanticipated contribution that raises its portfolio asset value to a level that modestly increases its risk tolerance. The fund decides to break out of its all-cash stance and buy some bonds, which nudges the bond price up to 101.

Then, a second all-cash fund, noticing that an all-cash fund’s buying bonds has become more acceptable, proceeds to take a nibble. The price moves up to 102.

When a third all-cash fund sees that owning a few bonds has become reasonably respectable, its bond purchases move the price up to 104.

At a cocktail reception at the next All-Cash Funds Conference, these few radical bondholders are the “talk of the town.” Having at least a small bond allocation quickly changes from being a novelty to being downright fashionable.

With this new surge in motivated buying, the price moves up to 107.

Some momentum investors observe this price action and begin to salivate. They don’t hesitate long, and their purchases raise the price to 110.

(Let’s not muddy the waters by wondering who is selling these beautiful bonds. A few contrarians are always lurking in the wings.)

Thus, over the course of a year, the bond’s 5 percent coupon, plus the 10 percent price appreciation, produces a hefty 15 percent total return.

Now let us consider a long-term investor with a 50/50 cash/bond portfolio. The assumed expected return for the bond was set at 5 percent in the last mean–variance optimization. With the dramatic shift in the structure of market returns, the fund decides to call for a new study.

Continue reading "Martin L. Leibowitz: Alpha Orbits" >>

Related Posts Plugin for WordPress, Blogger...

Comments

The comments to this entry are closed.

UConn-ad

NYSSA Job Center Search Results

To sign up for the jobs feed, click here.


UPCOMING EVENT
MF16

NYSSA Market Forecast™: Investing In Turbulent Times
January 7, 2016

Join NYSSA to enjoy free member events and other benefits. You don't need to be a CFA charterholder to join!


CFA® EXAM PREP

CFA® Level I 4-Day Boot Camp
Midtown

Thursday November 12, 2015
Instructor: O. Nathan Ronen, CFA

CFA® Level II Weekly Review - Session A Monday
Midtown

Monday January 11, 2016
Instructor: O. Nathan Ronen, CFA

CFA® Level III Weekly Review - Session A Wednesday
Midtown

Wednesday January 13, 2016
Instructor: O. Nathan Ronen, CFA

CFA® Level III Weekly Review - Session B Thursday
Thursday January 21, 2016
Instructor: O. Nathan Ronen, CFA

CFA® Level II Weekly Review - Session B Tuesday
Thursday January 26, 2016
Instructor: O. Nathan Ronen, CFA