Research Overviews


Three Critical Steps for Extracting Great Insights (Step 1: Identify Parameters)

Icepic1Think of your favorite CNBC journalist and ask why he or she is likely to get more information from a CEO than a typical analyst. If you don’t have an answer, it’s because the top journalists have been trained to use best practices for interviewing (or even “interrogating”) which can make them incredibly effective.

Throughout my career as an equity research analyst, I observed some analysts were much better than others at extracting insights from information sources (e.g. proprietary industry sources, company management, etc.), but I didn’t know exactly why. Now in the role of training analysts, I’m routinely asked, “How do I get more insights from others?” In my effort to answer this question and determine why some analysts are better than others in getting insights from others, I identified the best practices in this area, which primarily come from journalism, the legal industry and law enforcement (yes, some of the most sophisticated interviewing practices are used by law enforcement).

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Recent Research: Highlights from February 2015

"On the Holy Grail of “Upside Participation and Downside Protection"
The Journal of Portfolio Management (Winter 2015)
Edward Qian

Upside participation and downside protection” is a popular motto for many investors. It has taken on much more significance in recent years, in the wake of the global financial crisis. But how do we define and evaluate strategies from the perspective of “upside participation and downside protection”? In this article, the authors present an analytic framework in which they provide a quantitative definition of upside and downside participation ratio, define participation ratio difference as a goodness measure for defensive strategies, and prove a relationship between the participation ratio difference and traditional alpha. As an illustration, they apply this new analysis to the S&P 500 Index and its 10 sectors and show that defensive, low-beta sectors tend to have positive participation ratio differences, while cyclical, high-beta sectors tend to have negative participation ratio differences. This finding is consistent with the low-beta/volatility anomaly and provides another explanation for the popularity of low-beta/volatility strategies.

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Recent Research: Highlights from November 2014

"Let’s Save Retirement: Repairing America’s Broken System of Funding Workers’ Retirement"
The Journal of Retirement 
Russell L. Olson and Douglas W. Phillip

Far too few American workers can look forward to financial independence as they age. Many will be obliged to extend their working lives, some into their seventies. A patchwork of defined contribution (DC) retirement plans now serve as the primary retirement saving vehicle in the private sector, but they are complex, costly, and challenging for employers and employees to manage. This article presents a comprehensive set of recommendations for a unified private DC pension system to cover all working Americans, with a single set of rules and without cost to the government. A key part is the creation of broadly diversified trusteed retirement funds (TRFs), whose sponsors are trustees, with fiduciary responsibilities. Employee contributions will automatically go into a broadly diversified TRF unless the employee either opts out or selects a preferred TRF or the employer already sponsors a defined benefit (DB) pension plan. TRFs will relieve employers from fiduciary responsibility for all future DC contributions. To protect retirees from inflation, longevity, and asset price volatility risk, retirees will be encouraged to use their TRF savings to buy either an immediate or deferred indexed annuity. A new government agency, the Federal Longevity Insurance Administration, will enable private insurance companies to provide low-cost annuities.

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Recent Research: Highlights from October 2014

"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.

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Recent Research: Highlights from Summer 2014

"Return Predictability and Dynamic Asset Allocation: How Often Should Investors Rebalance?"
The Journal of Portfolio Management (Summer 2014
Himanshu Almadi, David E. Rapach, and Anil Suri

To exploit return predictability via dynamic asset allocation, investors face the important practical issue of how often to rebalance their portfolios. More frequent rebalancing uses statistically and economically significant short-horizon return predictability to aggressively pursue the dynamic investment opportunities afforded by changes in expected returns. However, the degree of return predictability typically appears stronger at longer horizons, which, along with lower transaction costs, favors less frequent rebalancing. The authors analyze the performance effects of rebalancing frequency in the context of dynamic portfolios constructed from monthly, quarterly, semi-annual, and annual return forecasts for US stocks, bonds, and bills, where the dynamic portfolios rebalance at the same frequency as the forecast horizon. Along the transaction-cost/rebalancing frontier, monthly (annual) rebalancing provides the greatest outperformance when unit transaction costs are below (above) approximately 50 basis points, and dynamic portfolios based on annual rebalancing typically outperform the benchmarks for unit transaction costs well in excess of 400 basis points.

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Recent Research: Highlights from July 2014

"Going for Broke: Restructuring Distressed Debt Portfolios"
The Journal of Fixed Income (Summer 2014
Sanjiv R. Das and Seoyoung Kim

This article discusses how to restructure a portfolio of distressed debt and what the gains are from doing so, and attributes these gains to restructuring and portfolio effects. This is an interesting and novel problem in fixed-income portfolio management that has received scant modeling attention. We show that debt restructuring is Pareto improving and lucrative for borrowers, lenders, and investors in distressed debt. First, the methodological contribution of the paper is a parsimonious model for the pricing and optimal restructuring of distressed debt, i.e., loans that are under-collateralized and are at risk of borrower default, where willingness to pay and ability to pay are at issue. Distressed-debt investing is a unique portfolio problem in that a) it requires optimization over all moments, not just mean and variance, and b) with debt restructuring, the investor can endogenously alter the return distribution of the candidate securities before subjecting them to portfolio construction. Second, economically, we show that post-restructuring return distributions of distressed debt portfolios are attractive to fixed-income investors, with risk-adjusted certainty equivalent yield pickups in the hundreds of basis points, suggesting the need for more efficient markets for distressed debt, and shedding light on the current policy debate regarding the use of eminent domain in mitigating real estate foreclosures.

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Recent Research: Highlights from June 2014

"Go Big or Go Home: The Case for an Evolution in Risk Taking"
The Journal of Investing (Summer 2014
Mike Sebastian

This article argues that alternative investments—private equity, real estate, and hedge funds—have natural advantages in risk and return over traditional stock and bond investments. A large allocation to alternatives relative to current institutional practice is needed for a material contribution to an institutional investor’s bottom line. Investors should consider whether moving toward an “efficiency” portfolio with an emphasis on low-cost passive management or an “opportunity” portfolio with heavy reliance on value added through active management—especially alternative investments—is most appropriate for them. Investors who can tolerate the cost, complexity, and illiquidity should consider opportunity-type allocations of 40% of their return-seeking assets to private equity, non-core real estate, and hedge funds. Over time, institutional investors will likely choose alternative investments and indexing as their primary investment options, and traditional active management will likely transform to take on qualities currently associated with alternative investments.

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Recent Research: Highlights from May 2014

"Constraints and Innovations for Pension Investment: The Cases of Risk Parity and Risk Premia Investing"
The Journal of Portfolio Management (Spring 2014
Wai Lee

In the current low real-yield environment, institutional investors are challenged as they try to achieve their often-fixed targeted returns within the confines of their investment policy guidelines. If much-discussed solutions, such as risk parity and risk premia investing, are the new answers, they must improve portfolio efficiency and flexibility in taking risks. This article explores the ways these proposed solutions may be successful. The author argues that the solutions neither introduce new assets that offer non-replicable, non-redundant return and risk characteristics, nor do they offer new asset-pricing theories that improve forecasts of asset returns or risks. Instead, their value proposition is more in the category of improved portfolio construction. They primarily benefit practitioners by providing more-efficient risk allocations, which they do by relaxing constraints to which pension investors are often subject, including restrictions on using leverage and short selling.

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Recent Research: Highlights from February 2014

"Contribution of Pension and Retirement Savings to Retirement Income Security: More Than Meets the Eye"
The Journal of Retirement (Winter 2014)
Billie Jean Miller and Sylvester J. Schieber

Recently, much concern has been expressed about the U.S. retirement system. Social Security is underfunded, while supplemental plans reportedly provide benefits half only that of Social Security and have gained little ground over the last 40 years. The shift to defined contribution plans is often seen as problematic. Some analysts suggest scrapping tax preferences for retirement plans and expanding Social Security. Much evidence that supplemental plans are coming up short on enhancing retirement security comes from the Current Population Survey (CPS). The analysis here shows that most income from retirement plans is not captured by the CPS or the Social Security reports developed using it. Ignoring retirees’ growing private retirement savings and income distorts the role played by private pensions, resulting in inaccurate assessments of retirees’ economic status. This error may bias policymakers’ judgment as to the right policies for an aging population and underfunded pensions.

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Recent Research: Highlights from January 2014

"Hedge Funds versus Hedged Mutual Funds: An Examination of Equity Long/Short Funds"
The Journal of Alternative Investments (Winter 2014)
David McCarthy

This article offers comparative analyses of equity long/short mutual funds and equity long/short hedge funds and indices. It first identifies a universe of liquid alternative mutual funds employing an equity long/short investment strategy similar to most equity long/short private hedge funds. It then provides a general profile of these mutual funds (e.g., size, start dates, sponsorship) before comparing their equity exposure and investment performance to that of private placement equity long/short hedge funds and indices. Based on the data analyzed, the article concludes that, as a group, diversified single-manager equity long/short mutual funds offer similar equity exposures and do not perform materially differently from comparable private placement hedge funds, at least as represented by leading hedge fund indices.

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Recent Research: Highlights from November 2013

"Are Risk-Parity Managers at Risk Parity?"
The Journal of Portfolio Management (Fall 2013)
Edward Qian

Risk parity has become an accepted investment strategy, to some degree. Its main advantage is its use of risk allocation, as opposed to the capital allocation used by the traditional asset allocation approach. A balanced risk allocation provides true diversification; therefore risk parity should deliver better risk-adjusted return over time. Despite the acceptance and the fact that the term “risk parity” has been in use for almost ten years, the investment community seems confused about risk parity’s true definition. Is it just a quantitative risk-budgeting technique? Is it about operational leverage? Or is it about high exposures to fixed income and low exposures to equities? In this paper, the author aims to define the principle of risk parity investing. He then examines a sample of risk parity managers, using the return-based style analysis pioneered by William Sharpe. The results show that, according to the defined principle, a number of risk parity managers in our sample are not using true risk parity.

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Recent Research: Highlights from October 2013

"A Conditional Assessment of the Relationships Between Commodity and Equity Indexes"
The Journal of Alternative Investments (Fall 2013)
David P. Simon

This study models the conditional relationships between the Goldman Sachs Total Return Commodity Index and Sub-Indexes and the S&P 500 index from January 1991 through June 2011 within a bivariate GARCH framework that uses instruments to model time-varying conditional correlations. The results indicate the presence of important spillovers between the conditional means and volatilities of commodity and equity index returns. The findings also indicate that conditional correlations increase from roughly zero to about 0.4 during the sample period, consistent with an increased integration of commodity and equity markets. The results also indicate that conditional correlations rise when the conditional volatility of equity returns increases and when business cycle conditions deteriorate. The greater integration of these markets is also reflected in the increase of conditional betas from around zero to roughly 0.6 over the sample period. Overall, the results indicate that while the diversification benefits of commodities diminished over the sample period, the estimated conditional correlations remain low enough for commodities to provide meaningful diversification benefits to equity investors.

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Recent Research: Highlights from August 2013

"Standing Out From the Crowd: Measuring Crowding in Quantitative Strategies"
The Journal of Portfolio Management (Summer 2013)
Rochester Cahan and Yin Luo

One of the most frequently cited criticisms of quantitative investing has been the charge that everyone uses the same factors and models. In other words, the popular strategies of the last few decades, such as value and momentum, have become crowded, leaving little room for investors to generate alpha. But is this actually true? The authors propose an empirical framework for measuring crowdedness, and use this to study the crowding in common systematic strategies.

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Recent Research: Highlights from July 2013

"Framing Lifetime Income"
The Journal of Retirement (Summer 2013)
Jeffrey R. Brown, Jeffrey R. Kling, Sendhil Mullainathan, and Marian V. Wrobel

We provide evidence that individuals optimize imperfectly when making annuity decisions, and that this result is not driven by loss aversion. Annuities are more attractive when presented in a consumption frame rather than in an investment frame. Highlighting the purchase price in the consumption frame does not alter this result. The level of habitual spending has little interaction with preferences for annuities in the consumption frame. In an investment frame, consumers prefer annuities with principal guarantees; this result is similar for guarantee amounts below, at, and above the purchase price. We discuss implications for the retirement services industry and its regulators.

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Recent Research: Highlights from June 2013

"An Investment Strategy in Active ETFs"
The Journal of Index Investing (Summer 2013)
Sharon Garyn-Tal

Previous evidence suggests that selectivity or active management positively affects mutual fund performance, hedge fund performance, and passive ETF performance. I examine whether active ETF performance is also positively affected by active management. First, I look at active ETF performance estimated via the Fama–French–Carhart four-factor model. Second, using weekly return data on 10 active ETFs for the period 2008–2012, I find an investment strategy in active ETFs that earns a positive risk-adjusted excess return, based on R2 as extracted from the regression of the ETFs’ excess return on the four-factors’ excess return.

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Recent Research: Highlights from May 2013

"The Deeper Causes of the Financial Crisis: Mortgages Alone Cannot Explain It"
The Journal of Portfolio Management (Spring 2013)
Mark Adelson

Losses on US residential mortgage loans are too small to explain the magnitude of the 2008 financial crisis. Total losses, including both losses realized to date and those yet to be realized, should fall in the range of $750 billion to $2 trillion. The global magnitude of the crisis is significantly larger, probably in the range of $5 trillion to $15 trillion, depending on the measuring approach. This implies that losses on residential mortgage loans cannot be the main cause of the crisis. They can only be a trigger that unleashed the true causes. The failure (or near failure) of a significant number of major financial firms suggests that high leverage and strong risk appetites were important immediate causes of the crisis. However, explaining the sources of high leverage and strong risk appetites requires probing for deeper causes that developed over a longer period. This article proposes deeper causes that include securities firms' conversion from partnerships to corporations, the 30-year deregulation trend, the quant movement, the spread of risk-taking culture throughout the financial industry, and globalization.

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Recent Research: Highlights from April 2013

"A Fund of Hedge Funds Under Regime Switching"
The Journal of Alternative Investments (Spring 2013)
David Saunders, Luis Seco, Christofer Vogt, and Rudi Zagst

This article investigates the use of a regime-switching model of returns for the asset allocation decision of a fund of hedge funds. In each time period, returns follow a multi-variate normal distribution from one of two possible regimes, corresponding to periods of “normal” and “distressed” markets. The prevailing regime in any given period is determined by the value of a two-state Markov chain. The case where serial correlation is absent and returns in different time periods are i.i.d. Gaussian mixture variables is also considered. The models are tested on empirical data and compared to a benchmark, assuming i.i.d. normally distributed returns. The results show that in a mean–variance framework, the use of regime switching can improve risk and performance measures. The importance of the sensitivity of optimal portfolio weights to the estimate of the probability of the distressed regime is discussed, and methods for calculating sensitivities are presented and illustrated on market data.

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Recent Research: Highlights from March 2013

"Derivatives in Islamic Finance: There is No Right Way to Do the Wrong Thing – Opportunities for Investors"
The Journal of Investing (Spring 2013)
Andreas A. Jobst

Derivatives are few and far between in countries where the compatibility of financial transactions with Islamic law requires the development of shari’ah-compliant structures. However, as Islamic finance continues to develop rapidly, the rising opportunity cost of limited shari’ah-compliant risk transfer mechanisms has raised questions about the scope of religious restrictions on the use of derivatives, and the scope for efficient risk management techniques for investors. Islamic finance is governed by the shari’ah, which bans speculation and gambling, and stipulates that income must be derived as profits from the shared generation of goods and services between counterparties rather than interest or a guaranteed return. The article explains the fundamental legal principles underpinning Islamic derivatives by reviewing accepted contracts and the scholastic debate surrounding existing financial innovation in this area, in order to generate an axiomatic perspective on a principle-based permissibility of derivatives under Islamic law. An overview of recent standardization efforts also is provided.

"Pricing American Options in the Heston Model: A Close Look at Incorporating Correlation"
The Journal of Derivatives (Spring 2013)
Peter Ruckdeschel, Tilman Sayer, and Alexanger Szimayer

The Binomial model and similar lattice methods are workhorses of practical derivatives valuation. But returns processes more realistic than lognormal diffusions with constant parameters easily create difficulties for them. One of the most important extensions of the Black-Scholes paradigm is to allow stochastic volatility, but even nonstochastic timevarying volatility destroys the important property that the tree recombines, which limits the growth in the number of nodes as time advances. Stochastic volatility introduces a second random variable, which then requires adding another dimension to the tree, under the constraint that the return and volatility changes must maintain the same degree of correlation as in the data. The Heston model features correlation in return and volatility shocks, but building it into a lattice is tricky. In this article, Ruckdeschel, Sayer, and Szimayer develop a lattice method that begins with a binomial tree for the volatility and a trinomial tree for stock price, and then connects them in such a way that the empirical degree of correlation between return and volatility is maintained. Efficiency relative to existing methods is increased, and in some cases it is possible to improve performance further by matching higher moments as well.

"Key Drivers of Private Equity Firm Certification at Initial Public Offering"
The Journal of Private Equity (Spring 2013)
Mike Hopkins and Donald G. Ross

Private equity firms have been shown to add considerable value to investee companies. This article examines buy-side financial analyst perceptions of the determinants of private equity firm value added. The findings reveal significant relationships between the attractiveness of private equity firms’ IPOs and 1) their reputations, 2) their level of retained ownership, 3) the duration of their involvement prior to the IPO, and 4) the interaction between duration and intensity of involvement. The research reveals certification effects are best explained by theories of resource exchange and reduced informational asymmetries with reduced agency risk being a much lesser influence.

"An Investor’s Low Volatility Strategy"
The Journal of Index Investing (Spring 2013)
Li-Lan Kuo and Feifei Li

Investors are displaying a fast-rising appetite for low volatility strategies, given growing academic and empirical evidence of consistent outperformance over the markets from which they are drawn. However, many existing low volatile strategies are optimized, creating biases toward smaller cap stocks and over-concentration in a small number of sectors and/or countries. Instead, we develop a heuristic-based design that leads to a practical portfolio with a superior Sharpe ratio as well as more investor-friendly attributes, including a lower turnover rate, higher investment capacity, relative transparency, and broader market representativeness.

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Recent Research: Highlights from February 2013

"Volatility, Correlation, and Diversification in a Multi-Factor World"
The Journal of Portfolio Management (Winter 2013)
Richard Roll

In a multi-factor world, diversification benefits do not generally depend on correlation. Investors can restructure portfolios to align factor sensitivities. This implies that diversification benefits depend only on the idiosyncratic volatility that remains after restructuring. Similarly, the risk reduction that follows adding an asset to an existing portfolio does not depend on the asset’s correlation with the portfolio. These implications evince the fundamental importance of measuring the underlying factors and estimating factor sensitivities for every asset. Other researchers have investigated several methods for measuring factors. An easy-to-implement general method involves specifying a group of heterogeneous indexes or traded portfolios. Exchange-traded funds (ETFs) could be well suited to this purpose.

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Recent Research: Highlights from December 2012

"Framework for Hedge Fund Return and Risk Attribution"
The Journal of Investing (Winter 2012)
Rob Brown

This article provides a framework for hedge fund return and risk attribution through the construction of a relevant benchmark. It is shown that volatility is a source of systematic risk, volatility measures based on equity market returns are more robust, fees have averaged between one-half and one-third of total gross returns, and high explanatory power can be achieved without the use of exotic systematic risk factors. Finally, the article suggests that alpha and systematic risk loadings are best estimated when regressed on gross returns and that systematic risk exposures are multi-dimensional and effectively modeled using a four-factor model. Hedge fund performance is determined by exposure, skill, and cost. The framework presented here provides robust attribution to exposure, skill, and cost.

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Recent Research: Highlights from November 2012

"The Volume Clock: Insights into the High-Frequency Paradigm"
The Journal of Portfolio Management (Fall 2012)
David Easley, Marcos M. Lopez de Prado, and Maureen O’Hara

Over the last two centuries, technological advantages have allowed some traders to be faster than others. In this article, the authors argue that contrary to popular perception, speed is not the defining characteristic that sets high-frequency trading (HFT) apart. HFT is the natural evolution of a new trading paradigm that is characterized by strategic decisions made in a volume-clock metric. Even if the speed advantage disappears, HFT will evolve to continue exploiting structural weaknesses of low-frequency trading (LFT). LFT practitioners are not defenseless against HFT players, however, and this article offers options that can help them survive and adapt to this new environment.

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Recent Research: Highlights from October 2012

"Integration of Structured Finance Exposures in Basel II Model: Analytical Results"
The Journal of Fixed Income (Fall 2012)
Kilian Plank

For efficiency reasons or because of a lack of detailed data, financial institutions frequently treat structured finance securities similar to conventional fixed-income products such as bonds or loans, which are characterized by rating, correlation, and loss-given default. Structured finance securities, however, have a specific risk profile. They tend to concentrate losses in adverse states of the systematic risk factor. This fact implies that simply adopting risk parameters of conventional bonds or loans is an inappropriate technique. The author shows that, under the Basel II framework, tranches have to be modeled with an increased factor loading. They derive an analytical calibration procedure for the Basel II model that appropriately captures the risk profile of tranches. This finding not only allows for seamless integration of structured and conventional exposures in a portfolio model, but also offers insights into the concentration effects of tranches.

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Recent Research: Highlights from September 2012

"The Most Successful Theory of Economics "
The Journal of Derivatives (Fall 2012)
Mark Kritzman

Ross has called options pricing theory “the most successful theory in all of economics.” Kritzman expands on Ross’s comment to justify this assertion and notes the role of The Journal of Derivatives in disseminating the benefits of this most successful of theories to the world at large.

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Recent Research: Highlights from August 2012

"Diversification Return and Leveraged Portfolio"
The Journal of Portfolio Management (Summer 2012)
Edward Qian

It is widely accepted that portfolio rebalancing adds diversification return to fixed-weight portfolios, but this is only true for long-only unleveraged portfolios. Qian provides analytical results regarding portfolio rebalancing and the associated diversification returns for different kinds of portfolios including long-only, long-short, and leveraged. He shows that portfolio rebalancing is linked to underlying portfolio dynamics. For long-only unleveraged portfolios, rebalancing amounts to a mean-reverting strategy, and the diversification return is always non-negative. But for short (or inverse) and leveraged portfolios, portfolio rebalancing on the top-down level amounts to a trend-following strategy that detracts from diversification return. Qian analyzes diversification returns of risk parity portfolios and shows that the diversification return of a leveraged long-only portfolio can generally be decomposed into two parts, both of which are related to a scaled unleveraged portfolio. The first part is the positive diversification return from rebalancing among individual assets at the bottom-up level, which is amplified by leverage. The second part is the negative diversification return caused by the leverage of the overall portfolio. His numerical examples show that diversification return is, in general, positive for leveraged risk parity portfolios when the leverage ratio is not too high. In addition, he shows that low correlations between different assets are crucial in achieving positive diversification return and reducing portfolio turnover for risk parity portfolios.

"The Rubber Starts to Meet the Road: Achievable Results in US Housing Finance Reform"
The Journal of Structured Finance (Summer 2012)
Chris DiAngelo

This article begins by noting that the US Congress and the Administration both remain stymied in the area of housing finance reform, notwithstanding numerous “white papers,” “requests for information,” “roundtables,” and the like. After almost four years, Fannie Mae and Freddie Mac remain in conservatorship, with no clear exit plan. Looking past the top level (Congress and the White House), however, one will see that the two government-sponsored enterprises (GSEs) themselves and their regulator/conservator, the Federal Housing Finance Agency, have begun to make real progress in several areas. In early 2012, the FHFA released a strategic plan for the GSEs and followed that up with a “scorecard” that sets forth in some detail a “to do” list of items that the FHFA intends to get done, along with target dates for those items. The article focuses on four items in particular: the REO disposition program, the “new securitization platform” initiative, the “single security” concept, and the possibility of privatizing the multifamily business. The conclusion is that more progress is being made than the public generally believes.

"Kicking the Habit: How Experience Determines Financial Risk Preferences"
The Journal of Wealth Management (Fall 2012)
Joachim Klement and Robin E. Miranda

Conventional explanations for the diversity of risk preferences among individual investors offer only limited insight. Recent research in neuroscience, genetics, and behavioral decision making underscore the importance of experience in financial risk taking. The authors review these findings and argue that not only does individual experience influence risk taking, so do the collective experiences of groups. Additionally, there seems to be a significant genetic component to financial risk taking, suggesting that “evolutionary experience” also needs to be considered when analyzing the risk preferences of individual investors. The authors introduce some simple tools to identify the influence of experience on financial risk preferences. These tools can help financial advisors to accurately assess investors’ risk preferences to help them achieve their goals at an acceptable level of risk.

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Recent Research: Highlights from July 2012

"Specification Risk and Calibration Effects of a Multifactor Credit Portfolio Model"
The Journal of Fixed Income (Summer 2012)
Gregor Dorfleitner, Matthias Fischer, and Marco Geidosch

This article examines a crucial source of specification risk when calibrating a typical industry-type, Merton-based credit portfolio model. It emerges from the necessity of having to choose a proxy for creditworthiness. In addition to equity prices and asset values, which are the classical choices, the authors consider credit default swap (CDS) spreads and expected default frequencies (EDF, from Moody’s KMV) as alternatives. Based on 40 large European companies from different industries, the authors calibrate a macroeconomic factor model with an OLS regression analysis for each specification and calculate the corresponding economic capital. Eighteen macroeconomic and financial variables are considered as risk factors. Their findings are: a) on average, 2 to 3 risk factors are needed to adequately model creditworthiness on the obligor level, b) stock market variables are the most important risk factors, c) model-implied credit correlation is extremely sensitive to the choice of the proxy for creditworthiness, and d) only the EDF specification leads to less economic capital compared with regulatory capital, according to Basel II, while it is exceeded substantially by all other specifications. In particular, credit correlation in the CDS specification by far exceeds any estimate mentioned in the literature. Most important, the authors show that the economic capital of their sample portfolio can be reduced by 78%, depending on which variable is chosen as a proxy for creditworthiness.

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Recent Research: Highlights from June 2012

"Some Like It Hot: The Role of Very Active Mandates across Equity Segments in a Core-Satellite Structure"
The Journal of Investing (Summer 2012)

Frank Nielsen, Giacomo Fachinotti, and Xiaowei Kang

This article reviews the active management opportunity in different market segments, and discusses the role of very active mandates across segments in a core–satellite portfolio structure. Research based on manager performance data over the last 10 years indicates that there is little evidence that average emerging market or small-cap managers have produced higher or more persistent risk-adjusted returns relative to their developed market large-cap peers. Therefore, institutional investors may consider active and passive management as complementary strategies across all equity segments. Due to the outperformance of high active risk mandates over the analyzed period, a simulated core–satellite structure across different equity segments achieved a higher information ratio than a combination of low active risk managers. The outperformance of high active risk mandates may reflect links between higher manager skill, higher investment conviction, and/or fewer constraints. Depending on investment beliefs, institutional investors might explore such a core–satellite structure to implement the global equity allocation.

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Recent Research: Highlights from May 2012

"The Death of Diversification Has Been Greatly Exaggerated"
The Journal of Portfolio Management (Spring 2012)
Antti Ilmanen and Jared Kizer

Diversification is famously referred to as the only “free lunch” in investing, but it has been under assault since the 2007–2009 global financial crisis, when virtually all longonly asset classes moved down together. Ilmanen and Kizer argue that the attacks are undeserved. Most investors were never as diversified as they thought they were, and there is ample room for improvement by shifting the focus from asset class diversification to factor diversification. They show that diversification into and across factors has been much more effective in reducing portfolio volatility and market directionality than asset class diversification. The benefits are greatest for long–short investing, which requires shorting and leverage but are also meaningful in a long-only context.

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Recent Research: Highlights from April 2012

"Defending the “Endowment Model”: Quantifying Liquidity Risk in a Post–Credit Crisis World"
The Journal of Alternative Investments (Spring 2012)

Abdullah Z. Sheikh and Jianxiong Sun

This article sets forth the proposition that liquidity risk may be optimized in an attempt to forestall or minimize the impact of a liquidity crisis. For a generic (but typical) endowment asset allocation, the authors find that liquidity levels between 6% and 14% are optimal, all other things equal, because 95% of the time, an allocation in this range would obviate situations in which a portfolio’s payout rate exceeds its liquidity pool. The framework also provides insights for tail-risk events involving a particularly severe liquidity crisis. For a generic endowment portfolio, the analysis indicates that in order to reduce the severity of a liquidity crisis to zero (i.e., eliminate risk completely), the allocation to fixed income would have to be around 35% (close to seven times the payout rate of 5%). Such an allocation would entail a very significant opportunity cost in terms of forgone returns based solely on a desire to mitigate extreme liquidity events (the proverbial “100-year flood”). In the authors’ view, reducing the likelihood of a liquidity crisis to below 5%, may be undesirable for all but the most risk-averse and least return sensitive endowments.

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Recent Research: Highlights from March 2012

"Topics in Applied Investment Management: From a Bayesian Viewpoint"
The Journal of Investing (Spring 2012)
Harry M. Markowitz

When John Guerard, the special editor for this issue, was assembling the articles to be published, he asked Harry Markowitz to write the introduction. By the author’s own words, once he had completed that task he could see that his remarks were more like discussant comments than an introduction and could equally well be read after reading the articles.

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Recent Research: Highlights from February 2012

"Measuring and Modeling Execution Cost and Risk"
The Journal of Portfolio Management (Winter 2012)
Robert Engle, Robert Ferstenberg, and Jeffrey Russell

Financial markets are considered to be liquid if a large quantity can be traded quickly and with minimal price impact. Although the idea of a liquid market involves both a cost as well as a time component, most measures of execution costs tend to focus on only a single number that reflects average costs and do not explicitly account for the temporal dimension of liquidity. In practice, trading takes time because larger orders are often broken up into smaller transactions or because of price limits. Recent work shows that the time taken to transact introduces a risk component in execution costs. In this setting, the decision can be viewed as a risk–reward trade-off faced by the investor who can solve for a mean-variance utility-maximizing trading strategy. Engle, Ferstenberg, and Russell introduce an econometric method to jointly model the expected cost and risk of the trade, thereby characterizing the mean-variance tradeoffs associated with different trading approaches, given market and order characteristics. They apply their methodology to a novel dataset and show that the risk component is a nontrivial part of the transaction decision.

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Recent Research: Highlights from January 2012

"Optimal Hedge Fund Allocation with Improved Estimates for Coskewness and Cokurtosis Parameters"
The Journal of Alternative Investments (Winter 2012)
Asmerilda Hitaj, Lionel Martellini, and Giovanni Zambruno

Since hedge fund returns are not normally distributed, mean–variance optimization techniques are not appropriate and should be replaced by optimization procedures incorporating higher-order moments of portfolio returns. In this context, optimal portfolio decisions involving hedge funds require not only estimates for covariance parameters but also estimates for coskewness and cokurtosis parameters. This is a formidable challenge that severely exacerbates the dimensionality problem already present with mean–variance analysis. This article presents an application of the improved estimators for higher-order co-moment parameters, in the context of hedge fund portfolio optimization. The authors find that the use of these enhanced estimates generates a significant improvement for investors in hedge funds. The authors also find that it is only when improved estimators are used and the sample size is sufficiently large that portfolio selection with higher-order moments consistently dominates mean–variance analysis from an out-of-sample perspective. Their results have important potential implications for hedge fund investors and hedge fund of funds managers who routinely use portfolio optimization procedures incorporating higher moments.

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Recent Research: Highlights from December 2011

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.

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Recent Research: Highlights from November 2011

"Breadth, Skill, and Time"
The Journal of Portfolio Management (Fall 2011)
Richard C. Grinold and Ronald N. Kahn

The information ratio determines the potential of an investment process to add value, and according to the fundamental law of active management, adding value depends on a combination of skill and breadth. Grinold and Kahn use an equilibrium dynamic model to provide insight into the concept of breadth, as well as a refined notion of skill. In equilibrium, the arrival rate of new information exactly balances the decay rate of old information. Grinold and Kahn denote the information turnover rate g. It is relatively easy to measure for any investment process. If the investment process forecasts returns on N assets, the breadth of the strategy i is g · N. Skill—the correlation of forecasts and returns—increases with the return horizon for small horizons, but then asymptotically decays to zero for very long horizons. The authors’ main result is that the ex ante information ratio is Breadth, Skill, and Time , where κ is a measure of skill.

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Recent Research: Highlights from September 2011

"Contingent-Capital Solutions for Mitigating the Investment Risks of a Private Placement Stock.The Journal of Investing (Fall 2011). C.B. Garcia.

The final negotiations between angel investors and a company following a thorough due diligence usually involve the following impasse: The angel investors on one side and the company on the other are in disagreement regarding the company's valuation because the company's expectations are more optimistic than the investors'. There is no feasible solution. In this article, the author proposes a model that a mediator may use to help the two parties come to a settlement. For the model, we show why traditional instruments of equity or notes are oftentimes infeasible and how feasible solutions—solutions that are currently not considered in negotiations—may be uncovered. With this model, a mediator may at least get one side to understand the implication of the terms to his or her future ownership of the firm, the (in)feasibility of the offering, and more importantly, where the other side is coming from. Better yet, with the model, the mediator may be able to persuade the contending parties to jointly consider alternate feasible solutions, to add their own constraints, or to move their expectations (which are functions of their beliefs about capital needs, risk profiles, intellectual property, etc.) closer to each other in order to get to a quicker settlement.

"The Performance of Johnson Distributions for Computing Value at Risk and Expected Shortfall." The Journal of Derivatives (Fall 2011). Jean-Guy Simonato.

Option pricing plainly depends on the probability distribution of the underlying asset return, at least the portion of the distribution for which the option is in the money. Risk management also depends on the return distribution, but standard risk measures like value at risk (VaR) and expected shortfall (ES) concentrate only on its tails. While the lognormal may be (arguably) adequate for modeling option values, empirically, "risk" is inherently tied up with fat-tailed return processes. This result has led to interest in methods to approximate an unknown distribution by matching its first four moments. The Cornish–Fisher and Gram–Charlier expansions are frequent choices. Simonato argues, however, that these techniques do not actually work very well because the range of densities for which the approximations are valid is quite limited. For example, the density approximation may have negative portions, even when skewness and kurtosis seem quite reasonable. He proposes adopting the Johnson family of densities instead, which also uses four parameters to match the first four moments of an empirical distribution. A simulation study shows that with Johnson distributions, tail fitting is accurate and available over the full range of parameter values.

"How Do Private Equity Investors Create Value?  A Summary of Findings from Ernst & Young's Extensive Research in North America over the Past Four Years." The Journal of Private Equity (Fall 2011). John Vester.

For the past four years, Ernst & Young has conducted in-depth annual surveys in North America on the largest private equity (PE) investment exits, to enable disciplined quantitative analyses for the purpose of identifying the major drivers of investment return. The results have been published and presented regularly in various forums, and each edition of the annual E&Y PE Value Creation Study (as it has become known) delves into new areas of investigation to keep the current findings innovative and fresh. This article presents for the first time a coherent and cumulative summary of the major findings from all of the editions of this substantive PE exit research and analyses over exit years from 2006 to 2009 for the largest PE exits in North America.

"The FTSE StableRisk Indices." The Journal of Index Investing (Fall 2011). Jeremiah H. Chafkin, Andrew W. Lo, and Robert W. Sinnott.

Implicit in most asset-allocation policies is the statistical assumption of "stationarity," which means that the means, variances, and covariances of asset returns are assumed to be constant over time. This assumption is a reasonable approximation during normal market conditions but fails dramatically during periods of market turmoil and dislocation. In such periods, market volatility is highly dynamic, correlations can jump to 100% in a matter of days, and risk premia can become negative for months at a time. FTSE and AlphaSimplex Group have developed a family of rule-driven (passive), transparent, and high-capacity indices whose volatilities are rescaled as often as daily with the goal of maintaining more stable risk levels. By stabilizing the risk of each asset class over time, the FTSE StableRisk Indices have the potential to capture the long-term risk premia of asset classes and simple strategies with less severe maximum drawdowns than those of traditional indices, which have no risk controls.

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Recent Research: Highlights from August 2011

Risk-Based Asset Allocation: A New Answer to an Old Question? The Journal of Portfolio Management (Summer 2011). Wai Lee.

In recent years, we have witnessed an alarmingly large and growing amount of literature on portfolio construction approaches focused on risks and diversification rather than on estimating expected returns. Numerous simulations applied to different universes have been documented in support of these approaches based on their apparent outperformance versus passive market capitalization–weighted or static fixed-weight portfolios. Many studies attribute the better performance of these risk-based asset allocation approaches to superior diversification. Given the absence of clearly defined investment objective functions behind these approaches as well as the metrics used by these studies to evaluate ex post performance, Lee puts these approaches into the same context of mean-variance efficiency in an attempt to understand their theoretical underpinnings. In doing so, he hopes to shed some light on what these approaches attempt to achieve and on the characteristics of the investment universe, if indeed these approaches are meant to approximate mean-variance efficiency. Rather than adding to the already large collection of simulation results, Lee uses some simple examples to compare and contrast the portfolio and risk characteristics of these approaches. He also reiterates that any portfolio which deviates from the market capitalization–weighted portfolio is an active portfolio. He concludes that there is no theory to predict, ex ante, that any of these risk-based approaches should outperform.

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Recent Research: Highlights from July 2011

The Role of Speculators During Times of Financial Distress.” The Journal of Alternative Investments (Summer 2011). Naomi E. Boyd, Jeffrey H. Harris, and Arkadiusz Nowak.

One of the best-known and largest hedge fund failures was the 2006 failure of Amaranth Advisors, LLC. The authors use detailed, trader-level data to examine the role of speculators during times of financial distress—in this case, the failure of Amaranth. They find that speculators served as a stabilizing force during the period by maintaining or increasing long positions, even while prices fell. The authors develop two testable propositions regarding liquidation versus transfer of positions and conclude that the probability of transfer was more likely for distant contract expirations and for contracts more dominantly held by the distressed trader. The article also examines the role of speculators in providing liquidity and mitigating the effects of liquidity risk by evaluating the change in the number of traders, the size and time between trades, and a Herfindahl measure of speculative trader concentration during the crisis period.

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Recent Research: Highlights from June 2011

Futures-Based Commodity ETFs.” The Journal of Index Investing (Summer 2011). Ilan Guedj, Guohua Li, and Craig McCann.

Exchange-traded funds (ETFs) have become popular investments since first introduced in 2004. These funds offer investors a simple way to gain exposure to commodities, which are thought of as an asset class suitable for diversification in investment portfolios and as a hedge against economic downturns. However, returns of futures-based commodity ETFs have deviated significantly from the changes in the prices of their underlying commodities. The pervasive underperformance of futures-based commodity ETFs compared to changes in commodity prices calls into question the usefulness of these ETFs for diversification or hedging. This article examines the sources of the deviation between futures-based commodity ETF returns and the changes in commodity prices using crude oil ETFs. The authors show that the deviation in returns is serially correlated and that a significant portion of this deviation can be predicted by the term structure of the oil futures market. They conclude that only investors sophisticated enough to understand and actively monitor commodity futures market conditions should use these ETFs.

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Do CEOs Get Penalized for Reporting Losses?

The decision to replace a CEO is probably one of the most important decisions made by the board of directors. The decision has long-term implications for a firm’s investment, operating, and financing decisions. CEO turnover was around 10% per year during the 1970s and 1980s and 11% in the 1990s. However, between 1992 and 2005, annual CEO turnover jumped to 15%. In the more recent years since 1998, CEO turnover is around 16.5%, implying that the average CEO tenure is just over six years. More importantly, boards have become more sensitive to firm performance and are acting decisively in response to poor performance. Overall, the results suggest that the CEO’s job is more precarious than previously thought.

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Recent Research: Highlights from May 2011

The Clash of the Cultures.” The Journal of Portfolio Management (Spring 2011). John C. Bogle.

During the recent era, the culture of short-term speculation has come to overwhelm the culture of long-term investment. The volume of transaction activity in the secondary financial markets has dwarfed the activity in the primary market where capital formation—once considered to be the principal economic mission of Wall Street—takes place. This change has been driven by many forces, including the institutionalization of stock ownership; the self-interested behavior of the financial agents who now hold 70% of all shares of U.S. stocks; the virtual disappearance of frictional trading costs (largely commissions and taxes); and the focus on the momentary illusion of stock prices rather than the eternal reality of intrinsic corporate values. The shift in the balance of mutual fund culture—from stewardship toward salesmanship—illustrates these trends and their negative impact on investors and on participation in corporate governance. Drawing on the timeless wisdom of Benjamin Graham, John Maynard Keynes, and Henry Kaufman, Bogle provides a range of recommendations that could likely foster the return to a financial system where the culture of speculation plays only a supporting role, with the starring role again played by the culture of investment.

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Liquidity Level or Liquidity Risk? Evidence from the Financial Crisis

CFA InstituteAlthough generally considered safe assets, liquid stocks underperformed illiquid stocks during the financial crisis of 2008–2009. The performance of stocks during the crisis can be better explained by their historical liquidity betas (risk) than by their historical liquidity levels. Stocks with different historical liquidity levels did not experience different returns after controlling for liquidity risk. The authors’ findings highlight the importance of accounting for both liquidity level and liquidity risk in risk management applications.

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Recent Research: Highlights from April 2011

The Impact of Illiquidity and Higher Moments of Hedge Fund Returns on Their Risk-Adjusted Performance and Diversification Potential.” The Journal of Alternative Investment (Spring 2011). Laurent Cavenaile, Alain Coën, and Georges Hübner.

This article studies the joint impact of smoothing and fat tails on the risk–return properties of hedge fund strategies. First, the authors adjust risk and performance measures for illiquidity and the non-Gaussian distribution of hedge funds returns. They use two risk metrics: the Modified Value-at-Risk and a preference-based measure retrieved from the linear exponential utility function. Second, they revisit the hedge fund diversification effect with these adjustments for illiquidity. Their results report similar fund performance rankings and optimal hedge fund strategy allocations for both adjusted metrics. They also show that the benefits of hedge funds in portfolio diversification persist but tend to weaken after adjustments for illiquidity are made.

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Recent Research: Highlights from March 2011

Capturing Alpha in the Alpha Capture System: Do Trade Ideas Generate Alpha?The Journal of Investing (Spring 2011). Jean W. Thomas.

In the wake of recent failures of such factors as price momentum and estimate revision to generate excess returns to traditional and quantitative strategies, this study explores the potential for using Trade Ideas as a new source of alpha in long-only and hedge strategies.

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Recent Research: Highlights from February 2011

Policy Portfolios and Rebalancing Behavior.” The Journal of Portfolio Management (Winter 2011). Martin L. Leibowitz and Anthony Bova.

An institutional fund typically has a multi-asset allocation—the policy portfolio—that is maintained over time. When allocations shift, the fund rebalances back to the policy portfolio. The discipline of the policy portfolio has many benefits: simplicity, convenient benchmarking, and a minimum of organizational frictions. Its very routine nature can lead, however, to an overemphasis on relative returns and an insensitivity to fundamental changes in fund status and market structure. In 2003, the late Peter Bernstein questioned whether rigid adherence to the policy portfolio made sense, given frequent market dislocations and high levels of volatility. In this article, Liebowitz and Bova attempt to shed further light on the Bernstein question by analyzing the risk tolerance and return assumptions of a basic two-asset (equity and cash) fund. One key finding is that policy portfolio rebalancing implicitly assumes that the risk tolerance and return premiums remain fixed over time. But few funds have the sponsorship, liquidity, or organizational conviction to keep such a constant risk tolerance in the face of severely adverse markets. One argument for the policy portfolio rebalancing is that assets become “cheaper” after a decline, but this is inconsistent with a constant return premium. Moreover, “cheaper” assets should actually call for rebalancing beyond the original policy portfolio to a more aggressive allocation. One idea for a more pro-active, market-sensitive process is to develop pre-planned contingency actions for various market scenarios.

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Recent Research: Highlights from January 2011

The StressVaR: A New Risk Concept for Extreme Risk and Fund Allocation.” The Journal of Alternative Investments (Winter 2011). Cyril Coste, Raphaël Douady, and Ilija I Zovko.

In this article the authors introduce an approach to risk estimation based on nonlinear factor–models—the “StressVaR” (SVaR). Developed to evaluate the risk of hedge funds, the SVaR appears to be applicable to a wide range of investments. The computation of the StressVaR is a three-step procedure whose main component is to use the fairly short and sparse history of the hedge fund returns to identify relevant risk factors among a very broad set of possible risk sources. This risk profile is obtained by calibrating a polymodel, which is a collection of nonlinear single-factor models, as opposed to a single multi-factor model. The authors then use the risk profile and the very long and rich history of the factors to assess the possible impact of known past crises on the funds, unveiling their hidden risks and so called “black swans.”

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Recent Research: Highlights from December 2010

An Empirical Investigation of the Performance of Commodity-Based Leveraged ETFs.” The Journal of Index Investing (Winter 2010). Robert Murphy.

The authors investigate the ability of 12 commodity-based leveraged ETFs in the ProShares family to achieve their stated investment objectives.They find that these 12 ETFs generate average daily returns that are not statistically significantly different from their stated objectives.They also find evidence that over their entire lives these ETFs generally underperform expectations when considering their exposure (long vs. short), desired leverage, and expense ratios. Despite this general underperformance relative to expectations, the authors also find that roughly 1/3 of the ETFs outperform expectations. They also report that over their entire lives the 12 leveraged ETFs in their sample struggle mightily to beat the performance of their corresponding unlevered commodities or indices. Their general inability to beat their corresponding unlevered commodities or indices over the long run is demonstrated to be a function of the price volatility of the commodities and indices. The authors conclude that these commodity-based leveraged ETFs are effective ways to gain double and double inverse exposure to the corresponding commodities and indices on a daily basis.However, they advise against using these ETFs in any sort of buy-and-hold investment program.


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Behavioral Finance: Theories and Evidence

CFA Institute That behavioral finance has revolutionized the way we think about investments cannot be denied. But its intellectual appeal may lie in its cross-disciplinary nature, marrying the field of investments with biology and psychology. This literature review discusses the relevant research in each component of what is known collectively as behavioral finance.

Click here to read the full literature review, written by Alistair Byrne, CFA, and Mike Brooks


Recent Research: Highlights from November 2010

Is Patience a Virtue? The Unsentimental Case for the Long View in Evaluating Returns.” The Journal of Portfolio Management (Fall 2010). David L Donoho, Robert A Crenian, and Matthew H Scanlan.

In this article, Donoho, Crenian, and Scanlan report the results of their study into the cost of institutional investor impatience. Using Monte Carlo simulation techniques, the authors construct an idealized world with a universe of investment managers of precisely quantified skill, with skill levels varying among the managers. Although many institutions base manager hiring decisions heavily on the manager’s performance in the most recent months or years, the authors’ simulations show that institutions that rely on longer performance horizons of 5–10 years are more likely to find and stick with the better managers. This happens because on shorter time scales, the relatively few highly skilled managers are often temporarily outperformed by one of the many lesser-skilled managers, specifically, unskilled managers who have recently happened to simply be lucky. Hence, if a plan that previously was long-term oriented starts to hire managers based on short-term results, it will often find that the newly chosen manager underperforms both his own previous performance and also the manager previously managing the plan’s funds. It can, however, truly take patience to keep a skilled manager in a fund portfolio. In the authors’ simulations, skilled managers have deeper, longer, and more frequent drawdowns than many investors would expect.

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Recent Research: Highlights from October 2010

An Examination of Traditional Style Indices.” The Journal of Index Investing (Fall 2010). Jason Hsu, Vitali Kalesnik, and Himanshu Surti.

For investors using a core–satellite approach to strategic asset allocation, traditional style indices, such as value and smallcap indices, represent convenient passive vehicles for achieving strategic or even tactical portfolio tilts. In this article, the authors examine traditional style indices using the Fama–French three-factor analysis. They find that most of the style indices exhibit a negative Fama–French alpha and statistically conclude that traditional style indices are suboptimal means for creating style tilts in portfolios. They posit that the source of the sub-optimality comes from the capweighted construction methodology, which these indices are rooted in and demonstrate that using a simple non-priceweighted approach for creating the style indices would result in more efficient exposures.

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Recent Research: Highlights from September 2010

Are Vanguard’s ETFs Cannibalizing the Firm’s Index Funds?The Journal of Index Investing (Summer 2010). Anna Agapova.

Existing literature on ETFs and conventional index mutual funds suggests that the two fund types are substitutes for each other in terms of attracting investors’ money. Vanguard is an industry-leading index fund provider that offers both conventional index mutual funds and ETFs. The question is whether Vanguard experiences a substitution effect between its index funds and ETFs to the same degree as is observed in the industry in general. The examination of the substitutability of the two fund types can help explain Vanguard’s decision to offer ETFs that could cannibalize the firm’s existing products. Results of the article show that contrary to the initial expectations, Vanguard’s ETFs and corresponding index funds are not substitutes but rather complements. The flows of ETFs and index funds positively affect each other. Positive spillover effects, such as ETF tax efficiency, may help explain the synergy between Vanguard index products. The results can help fund families take advantage of similar efficiency spillover effects when structuring new products.

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Recent Research: Highlights from August 2010

Celebrating 10 Years of ETFs in Europe.” The Journal of Index Investing (Summer 2010). Deborah Fuhr, Shane Kelly.

This article is a comprehensive report on the history and outlook for the exchange-traded fund industry in Europe. It covers both ETFs and exchange-traded products (ETPs). ETFs are open-end index funds that provide daily portfolio transparency, are listed and traded on exchanges like stocks on a secondary basis, and utilize a unique creation and redemption process for primary transactions. ETPs are products that have similarities to ETFs in the way they trade and settle, but they do not use a mutual fund structure. The use by ETPs of other structures, including grantor trusts, partnerships, notes, and commodity pools, can create different tax and regulatory implications for investors when compared to ETFs.

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