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Recent Research: Highlights from October 2014

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"Lightning Strikes: The Creation of Vanguard, the First Index Mutual Fund, and the Revolution It Spawned"
The Journal of Portfolio Management 40th Anniversary Issue 
John C. Bogle

“Lightning Strikes” tells the story of how Vanguard founder John C. Bogle came to create a unique mutual mutual fund structure in 1974, and how the index fund strategy almost inevitably followed. Paul Samuelson’s essay in the first issue of The Journal of Portfolio Management was published at almost the same moment that Vanguard began. In “Challenge to Judgment,” Samuelson urged that somebody, somewhere, somehow form an index fund. Inspired, Mr. Bogle accepted the challenge, and in 1975 created the world’s first index mutual fund. Vanguard’s two disruptive innovations—mutuality and indexing—have combined to make Vanguard the largest firm in the mutual fund industry. In the second part of the essay, Mr. Bogle summarizes 10 of the 13 essays he has written for The Journal of Portfolio Management and provides a perspective on his works.

"The Impact of Equity Misvaluation on Predictive Accuracy of Bankruptcy Models"
The Journal of Fixed Income (Fall 2014)
George Batta and Wan Wongsunwai

This article examines the impact of equity misvaluation on the predictive accuracy of bankruptcy models. The authors find that structural bankruptcy prediction models are not affected by misvaluation. For hazard models, however, forecasting accuracy for properly valued firms is greater than for misvalued firms, and model forecasting accuracy improves significantly if model coefficients vary with misvaluation. The results show the importance of taking stock market misvaluation into account when forecasting bankruptcies using hazard models.

"What Is the True Cost of Active Management? A Comparison of Hedge Funds and Mutual Funds"
The Journal of Alternative Investments (Fall 2014)
Jussi Keppo, and Antti Petajisto

On the surface, hedge funds seem to have much higher fees than actively managed mutual funds. However, the true cost of active management should be measured relative to the size of the active positions taken by a fund manager. A mutual fund combines active positions with a passive position in the benchmark index, which can make the active positions expensive. A hedge fund takes both long and short positions and uses leverage, which makes the active positions cheaper, but this can be offset by the expected incentive fees, especially for more volatile funds. In this article, the authors investigate the trade-offs from the perspective of a fund investor choosing between a mutual fund and a hedge fund, examining the impact of leverage, volatility, Active Share, nominal fees, and alpha for a realistic range of parameter estimates. Their calibration shows that a moderately skilled active manager is approximately equally attractive to investors as a mutual fund manager or a hedge fund manager is, showing that both investment vehicles can coexist as efficient alternatives to investors. Further, their model explains documented empirical findings on career development of successful fund managers and on risk- taking in hedge funds.

"Fragmentation and Price Discovery: A Comparison of Reg NMS and MiFID1"
The Journal of Trading (Fall 2014)
Frederick H. deB. Harris, Thomas H. McInish, Frank J. Sensenbrenner, and Robert A. Wood

We study NYSE, NASDAQ, and ARCA prices for DJIA stocks and LSE, Xetra, and Chi-X prices for five leading British equities. MiFID1 hastened fragmentation but accomplished the intended cointegration of European equity markets that had previously been segmented. Initially, price discovery in London was largely unaffected; permanent quote innovations remained more than 90% attributable to the LSE. However, clearing and settlement fee reductions by Chi-X five months later did result in a substantial reduction in the information impounding and price discovery efficiency of London Stock Exchange trades. The contemporaneous situation in the United States with the implementation of Reg NMS was quite different. During its staggered rollout in 2007, NYSE’s price discovery declined steadily from 74% to 41%, with much of that role migrating to ARCA. In this case, the price discovery efficiency of NASDAQ substantially improved.

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