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Recent Research: Highlights from December 2011

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A Comment on “Better Beta Explained: Demystifying Alternative Equity Index Strategies”
The Journal of Index Investing (Winter 2011)
Noël Amenc

Cap-weighted indices have been subjected to increasing criticism. Empirical evidence suggests that cap-weighted indices deliver poor risk-adjusted performance. It has also been questioned whether market cap is a reliable proxy for the size and economic influence of a company. The fact that cap-weighted indices have been found to be neither representative nor efficient has led to the development of various alternative weighting schemes. However, how to best replace cap-weighted indices remains an open question. In an article from the Summer 2011 issue of The Journal of Index Investing, Robert Arnott discusses an empirical analysis of several alternative indexing methodologies that he broadly classifies as relying on heuristics or on portfolio optimization. Although an analysis of competing non-capweighted indices should, in principle, provide useful insights, the results reported by Arnott suffer from a flawed methodology and may confuse readers about the issues with different non-cap-weighted indices in practice.

"What Can the S&P 500 Index Teach Active Managers?"
The Journal of Investing (Winter 2011)
Robi Elnekave

Implicit in active fund management is the presumption that the S&P capitalization indices (i.e., S&P 500, S&P 400, and S&P 600) can be bested. Needless to say, active fund management on the whole has not lived up to expectations, with portfolios regularly trailing their respective indices. Thus, the claim by active managers in aggregate that they can beat an index is naïve and statistically impossible. However, the performance disparity between active and index funds shows that there is a lot of room for improvement. That most managers are unable to beat their respective indices is not indicative of the quality of the selection criteria used to build these benchmarks. Rather, it is indicative of the inherent deficits of active investment management practices. The objective of this article is to highlight some of these flawed practices and, in the process, suggest ways to improve the state of the art.

"PE Managers as Registered Investment Advisors"
The Journal of Private Equity (Winter 2011)
Gary Gibbons and Heather M. Stone

The Dodd–Frank Wall Street Reform and Consumer Protection Act requires most private equity managers to register as investment advisors by March 2012. Because this is a new requirement, most PE managers have no practical knowledge of the duties and obligations that they will owe to their clients and to the SEC once they become registered. The situation is further complicated because traditional investment managers represent their clients in a fundamentally different way than the way PE fund managers represent their clients. This article describes the development of the key duties and obligations that traditional investment advisors have to their clients and discusses the new regulatory obligations and duties that registered PE managers will soon owe to their clients and the SEC.

"Is It Possible to Reconcile the Caplet and Swaption Markets? Evidence from the US-Dollar Market"
The Journal of Derivatives (Winter 2011)
Riccardo Rebonato and Andrey Pogudin

One of the persistent and annoying puzzles in the area of interest rate derivatives is that models that can price interest rate caps consistently relative to their prices in the market fail to price swaptions properly, and vice versa, even though the payoffs to both types of derivative depend on the same spot and forward interest rates. Is reconciling the two markets just a matter of finding the right interest rate process? In this article, Rebonato and Pogudin take the very general class of models that falls within the LIBOR market model-stochastic alpha, beta, rho (LMM-SABR) family to explore whether a common valuation model can be obtained. Calibrating to caplet prices, they find overall reasonable fits but have difficulty matching swaption market prices; in particular, those with long underlying swapmaturities seem overpriced in the market. Exploring alternative assumptions on the term structure of forward rate volatilities and volatility of volatility brings them to a strategy that super-replicates a swaption payoff with an early-stopping cap contract. The model can price the two reasonably well, but in the market, the swaptions are regularly priced very close to the model-free noarbitrage bound. Moreover, the assumptions needed to get to that result entail highly unrealistic expectations about future cap prices. So, after careful exploration that illuminates the nature of the puzzle, the puzzle remains puzzling.

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