Financial Analysts Journal

Published by Chartered Financial Analysts Institute
Online ISSN: 0015-198X
Publications
Article
Does asset allocation policy explain 40 percent, 90 percent, or 100 percent of performance? According to some well-known studies, more than 90 percent of the variability of a typical plan sponsor's performance over time is attributable to asset allocation. However, few people want to explain variability over time. Instead, an analyst might want to know how important it is in explaining the differences in return from one fund to another, or what percentage of the level of a typical fund's return is the result of asset allocation. To address these aspects of the role of asset allocation policy, we investigated these three questions. 1. How much of the variability of returns across time is explained by asset allocation policy? 2. How much of the variation of returns among funds is explained by differences in asset allocation policy? 3. What portion of the return level is explained by returns to asset allocation policy? We examined 10 years of monthly returns to 94 balanced mutual funds and 5 years of quarterly returns to 58 pension funds. For the mutual funds, we used return-based style analysis for the entire 120-month period to estimate policy weights for each fund. We carried out the same type of analysis on quarterly returns of 58 pension funds for the five-year 1993-97 period. For the pension funds, rather than estimated policy weights, we used the actual policy weights and asset-class benchmarks of the pension funds. We answered the three questions as follows: In summary, our analysis shows that asset allocation explains about 90 percent of the variability of a fund's returns over time but explains only about 40 percent of the variation of returns among funds. Furthermore, on average across funds, asset allocation policy explains slightly more than 100 percent of the levels of returns. Thus, the answer to the question of whether asset allocation policy explains 40 percent, 90 percent, 100 percent of performance, depends on how the question is interpreted.
 
Article
With the recent flurry of articles declaiming the death of the rational markets hypothesis, it is well to pause and recall the very sound reasons this hypothesis was once so widely accepted at least in academic circles. Although academic models often assume that all investors are rational, this is clearly an expository device not to be taken seriously. However, what is in contention is whether markets are "rational" in the sense that prices are set as if all investors are rational. Even if markets are not rational in this sense, there may still not be abnormal profits opportunities. In that case, we say the markets are "minimally rational". This article maintains that developed financial markets are minimally rational and, with two qualifications, even achieve the higher standard of rationality. In particular, it contends that realistically, market rationality needs to be defined so as to allow investors to be uncertain about the characteristics of other investors in the market. It also argues that investor irrationality, to the extent it affects prices, is particularly likely to be manifest through overconfidence, which in turn is likely to make the market in an important sense hyper-rational. To illustrate, the paper ends by re-examining some of the most serious evidence against market rationality: excess volatility, the risk premium puzzle, the size anomaly, closed-end fund discounts, calendar effects and the 1987 stock market crash.
 
Article
This paper contains three parts: a discussion of the tax advantages of household capital (owner-occupied housing and consumer durables) relative to business capital (structures and producers durables) ,an analysis of alternative mechanisms for reducing these advantages (including the use of the mechanisms since 1965) ,and a brief enumeration of various attempts to lower the residential mortgage rate relative to other debt yields that have been employed during the past two decades or are currently being advocated.
 
Article
U.S. investors hold much less international stock than is optimal according to mean–variance portfolio theory applied to historical data. We investigated whether this home bias can be explained by Bayesian approaches to international asset allocation. In comparison with mean–variance analysis, Bayesian approaches use different techniques for obtaining the set of expected returns by shrinking the sample means toward a reference point that is inferred from economic theory. Applying the Bayesian approaches to the field of international diversification, we found that a substantial home bias can be explained when a U.S. investor has a strong belief in the global mean–variance efficiency of the U.S. market portfolio, and in this article, we show how to quantify the strength of this belief. We also found that one of the Bayesian approaches leads to the same implications for asset allocation as the mean–variance/tracking-error criterion. In both cases, the optimal portfolio is a combination of the U.S. market portfolio and the mean–variance-efficient portfolio with the highest Sharpe ratio.
 
Article
Chicago-based Morningstar Inc. rates the investment performance of mutual funds using a rating system of one to five stars. This article first documents the method Morningstar uses in assigning these widely circulated ratings. It then establishes that (1) a fund with a long history is less likely to receive the top rating of five stars than a fund with a short history and (2) nearly half of the no-load, diversified, domestic equity funds receive an overall Morningstar rating of four or five stars whereas slightly more than a quarter of these funds receive one or two stars. The disproportionate number of high ratings for these funds is a result of the interaction between the broad comparison group Morningstar uses in its rankings and the handicaps it gives to load and specialized equity funds.
 
Article
There are no established benchmarks for evaluating currency investment manager performance. Some analysts have suggested that known investing styles like momentum, purchasing power parity, and carry serve as benchmarks. Challenges for this approach include: there is no market portfolio; there are many alternative generic factor constructions; different constructions of the same factor may have low correlations; the 3 factors may not provide diversification; and there is no “buy and hold” in the FX market. An evaluation of professional currency managers’ returns indicates that they are often generated independently from the generic style factors. Skill in timing is what investors should pay for and some managers demonstrate superior skill in timing the factors. Managers are also skilled at minimizing drawdowns relative to the generic factors. The use of generic style factors may be a worst case scenario instead of returns to which an FX investor may aspire.
 
Article
The no arbitrage relation between futures and spot prices implies an analogous relation between futures and spot volatilities as measured by daily range. Long memory features of the range-based volatility estimators of the two series are analyzed, and their joint dynamics are modeled via a fractional vector error correction model (FVECM), in order to explicitly consider the no arbitrage constraints. We introduce a two-step estimation procedure for the FVECM parameters and we show the properties by a Monte Carlo simulation. The out-of-sample forecasting superiority of FVECM, with respect to competing models, is documented. The results highlight the importance of giving fully account of long-run equilibria in volatilities in order to obtain better forecasts.
 
Article
A study of one brokerage house's recommendations to its individual customers during the 1960s suggests that they were genuinely valuable, even after allowing for transactions costs and risk. On the other hand, the recommendations were useful in selection, rather than in market timing: The ratio of buys to sells varied little over the period studied. Abnormal returns were associated primarily with buy, rather than sell, recommendations. Positive in the six months prior to the recommendation, they peaked in the month of recommendation and remained essentially zero thereafter. One possible explanation is that, in the months prior to being recommended, companies enjoyed abnormal prosperity accompanied by a series of favorable news items. Their prosperity caught the attention of the brokerage house, whose research staff than uncovered additional positive news, encapsulating in recommendations to customers what might otherwise have been several more months of slowly emerging information. If large positive returns in the month of the recommendation were merely the result of trading pressure induced by the recommendation, those returns would have been followed by reversals. The absence of such reversals suggests that the brokerage house's recommendations were associated with genuine changes in the value of the securities.
 
Article
"Nowhere does history indulge in repetitions so often or so uniformly as in Wall Street," observed legendary speculator Jesse Livermore. History tells us that periods of major technological innovation are typically accompanied by speculative bubbles as economic agents overreact to genuine advancements in productivity. Excessive run-ups in asset prices can have important consequences for the economy as firms and investors respond to the price signals, resulting in capital misallocation. On the one hand, speculation can magnify the volatility of economic and financial variables, thus harming the welfare of those who are averse to uncertainty and fluctuations. But on the other hand, speculation can increase investment in risky ventures, thus yielding benefits to a society that suffers from an underinvestment problem.
 
Chapter
This paper proposes a scalable heuristic for portfolio selection problems in which investments are illiquid and return distributions change over time.
 
Article
Historically, commodity futures have had excess returns similar to those of equities. But what should we expect in the future? The usual risk factors are unable to explain the time-series variation in excess returns. In addition, our evidence suggests that commodity futures are an inconsistent, if not tenuous, hedge against unexpected inflation. Further, the historically high average returns to a commodity futures portfolio are largely driven by the choice of weighting schemes. Indeed, an equally weighted long-only portfolio of commodity futures returns has approximately a zero excess return over the past 25 years. Our portfolio analysis suggests that the a long-only strategic allocation to commodities as a general asset class is a bet on the future term structure of commodity prices, in general, and on specific portfolio weighting schemes, in particular. In contrast, we provide evidence that there are distinct benefits to an asset allocation overlay that tactically allocates using commodity futures exposures. We examine three trading strategies that use both momentum and the term structure of futures prices. We find that the tactical strategies provide higher average returns and lower risk than a long-only commodity futures exposure.
 
Article
Diversification return is an incremental return earned by a rebalanced portfolio of assets. The diversification return of a rebalanced portfolio is often incorrectly ascribed to a reduction in variance. We argue that the underlying source of the diversification return is the rebalancing, which forces the investor to sell assets that have appreciated in relative value and buy assets that have declined in relative value, as measured by their weights in the portfolio. In contrast, the incremental return of a buy-and-hold portfolio is driven by the fact that the assets that perform the best become a greater fraction of the portfolio. We use these results to resolve two puzzles associated with the Gorton and Rouwenhorst index of commodity futures, and thereby obtain a clear understanding of the source of the return of that index. Diversification return can be a significant source of return for any rebalanced portfolio of volatile assets.
 
Article
We construct an equally-weighted index of commodity futures monthly returns over the period between July of 1959 and March of 2004 in order to study simple properties of commodity futures as an asset class. Fully-collateralized commodity futures have historically offered the same return and Sharpe ratio as equities. While the risk premium on commodity futures is essentially the same as equities, commodity futures returns are negatively correlated with equity returns and bond returns. The negative correlation between commodity futures and the other asset classes is due, in significant part, to different behavior over the business cycle. In addition, commodity futures are positively correlated with inflation, unexpected inflation, and changes in expected inflation.
 
Article
This paper traces the evolution of the concept of "mortgage yield", starting with the yield to prepayment which held sway until the mid-seventies, to the cash flow yield which dominated until the late eighties, to the option adjusted yield which is intellectually dominant today. It is argued that while each of these concepts represented an improvement over the one that preceded it, the cash flow yield should have given way to the holding period yield, and then to an option adjusted holding period yield of which the (currently fashionable) option adjusted yield is merely a special case. The holding period yield is the ideal tool for scenario analysis because of its sensitivity to the particular circumstances of the user, and the option adjusted variant provides better information about whether a security is correctly priced because it does not prejudge the market’s consensus holding period.
 
Article
We develop a model for pricing risky debt and valuing credit derivatives that is easily calibrated to existing variables. Our approach is based on expanding the Heath-Jarrow-Morton (1990) term-structure model and its extension, the Das-Sundaram (2000) model to allow for defaultable debt with rating transitions. The framework has two salient features, comprising extensions over the earlier work: (i) it employs a rating transition matrix as the driver for the default process, and (ii) the entire set of rating categories is calibrated jointly, allowing, with minimal assumptions, arbitrage-free restrictions across rating classes, as a bond migrates amongst them. We provide an illustration of the approach by applying it to price credit sensitive notes that have coupon payments that are linked to the rating of the underlying credit.
 
Article
Changes in variance, or volatility, over time can be modeled using the approach based on autoregressive conditional heteroscedasticity. Another approach is to model variance as an unobserved stochastic process. Although it is not easy to obtain the exact likelihood function for such stochastic variance models, they tie in closely with developments in finance theory and have certain statistical attractions. This article sets up a multivariate model, discusses its statistical treatment, and shows how it can be modified to capture common movements in volatility in a very natural way. The model is then fitted to daily observations on exchange rates.
 
Article
Previous research suggests that the market for index-linked bonds is not entirely efficient and that these inefficiencies can be exploited by including inflation forecasts in trades on break-even inflation. Inspired by those results, we test the informational content of inflation expectations using survey data generated by the Survey of Professional Forecasters. We develop trading strategies speculating on the movement of break-even inflation. The results indicate that the market for US inflation-indexed government bonds offers the possibility to obtain excess returns. These results are fairly consistent regardless of market frictions introduced in the return calculation.
 
Article
There exists a widespread consensus among mainstream academics and investors that socially responsible investing (SRI) leads to inferior, rather than superior, portfolio performance. Using Innovest’s well-established corporate ecoefficiency scores, we provide evidence to the contrary. We compose two equity portfolios that differ in eco-efficiency characteristics and find that our highranked portfolio provided substantially higher average returns compared to its low-ranked counterpart over the period 1995-2003. Using a wide range of performance attribution techniques to address common methodological concerns, we show that this performance differential cannot be explained by differences in market sensitivity, investment style, or industry-specific components. We finally investigate whether this eco-efficiency premium puzzle withstands the inclusion of transaction costs scenarios, and evaluate how excess returns can be earned in a practical setting via a best-in-class stock selection strategy. The results remain significant under all levels of transactions costs, thus suggesting that the incremental benefits of SRI can be substantial.
 
Article
In the study reported here, we estimated the forward-looking long-term equity risk premium by extrapolating the way it has participated in the real economy. We decomposed the 1926–2000 historical equity returns into supply factors-inflation, earnings, dividends, the P/E, the dividend-payout ratio, book value, return on equity, and GDP per capita. Key findings are the following. First, the growth in corporate productivity measured by earnings is in line with the growth of overall economic productivity. Second, P/E increases account for only a small portion of the total return of equity. The bulk of the return is attributable to dividend payments and nominal earnings growth (including inflation and real earnings growth). Third, the increase in the equity market relative to economic productivity can be more than fully attributed to the increase in the P/E. Fourth, a secular decline has occurred in the dividend yield and payout ratio, rendering dividend growth alone a poor measure of corporate profitability and future growth. Our forecast of the equity risk premium is only slightly lower than the pure historical return estimate. We estimate the expected long-term equity risk premium (relative to the long-term government bond yield) to be about 6 percentage points arithmetically and 4 percentage points geometrically.
 
Article
U.S. Treasury Inflation Protection Securities (TIPs) were first issued in January 1997. Through the end of 2002, eleven TIPs have been issued with maturities ranging from a few years through thirty years. One TIP bond has already matured. Returns on TIPs have been positively correlated with returns on nominal bonds and negatively correlated with equity returns over the past five years. TIPs real durations are longer than nominal bonds because their real yields are low. However, their effective nominal durations are much shorter because they are not as sensitive to changes in expected inflation. TIPs volatility has displayed marked variation over time. It was relatively low during 1999- 2000 and considerably higher during 2001-2002. This suggests that real interest rate volatility has increased recently. TIPs can be used to estimate the real yield curve. The real and nominal yield curves can then be combined to estimate the term structure of anticipated inflation. Because of their taxation, TIPs yields may not be entirely independent of inflation. Given plausible assumptions about future expected returns, an investment portfolio diversified across equities and nominal bonds would be improved by the addition of TIPs.
 
Article
This article takes a critical look at the equity premium puzzle the inability of standard intertemporal economic models to rationalize the statistics that have characterized U.S. financial markets over the past century. A summary of historical returns for the United States and other industrialized countries and an overview of the economic construct itself are provided. The intuition behind the discrepancy between model prediction and empirical data is explained. After detailing the research efforts to enhance the model's ability to replicate the empirical data, I argue that the proposed resolutions fail along crucial dimensions
 
Article
Presented are an overview of the findings from the recent literature on the cost of U.S. equity trades for institutional investors and new evidence on trading costs from a large sample of institutional trades. The findings discussed have important implications for policymakers and investors: Implicit trading costs are economically significant; equity trading costs vary considerably and vary systematically with trade difficulty and order-placement strategy; and whether a trade price represents "best execution" depends on detailed data for the trade's entire order-submission process, especially information on pretrade decision variables, such as the trading horizon.
 
Article
Constructing a data base that is relatively free of bias, this paper provides measures of the returns of hedge fund s as well as the distinctly non-normal characteristics of the data. We provide risk-adjusted measures of performance as well as tests of the degree to which hedge funds live up to their claim of market neutrality. We also examine the substantial attrition of hedge funds and analyze the determinants of hedge fund survival as well as perform tests of return persistence. Finally, we examine the claims of the managers of “funds of funds” that they can form portfolios of “the best” hedge funds and that such funds provide useful instruments for individual investors. We conclude that hedge funds are far riskier and provide much lower returns than is commonly supposed.
 
Article
We study the relation between gender and job performance among brokerage firm equity analysts. Women's representation in analyst positions drops from 16% in 1995 to 13% in 2005. We find women cover roughly 9 stocks on average compared to 10 for men. Women's earnings estimates tend to be less accurate. After controlling for forecast characteristics, the difference in accuracy is roughly equivalent to four years of experience. Despite reduced coverage and lower forecast accuracy, we find women are significantly more likely to be designated as All-Stars, which suggests they outperform at other aspects of the job such as client service.
 
Article
Record low dividend yields and record high market-to-book ratios in recent months have led many market watchers to conclude that these indicators now behave differently from how they have in the past. This paper examines the relationship between traditional market indicators and stock performance, and then addresses two popular claims that the meaning of these indicators has changed in recent years. The first is that dividend yields are permanently lower now than in the past because firms have increased their use of share repurchases as a tax-advantaged substitute for dividends. The second claim is that the implementation of Financial Accounting Standard (FAS) 106 for retiree health liabilities has seriously depressed the reported book values of many companies since the early 1990s, artificially raising their market-to-book ratios. We conclude that, even after adjusting for these factors, the current level of market indicators is a cause for concern.
 
Article
This paper explains why investors are likely to be overconfident and how this behavioral bias affects investment decisions. Our analysis suggests that investor overconfidence can potentially generate stock return momentum and that this momentum effect is likely to be the strongest in those stocks whose valuation requires the interpretation of ambiguous information. Consistent with this, we find that momentum effects are stronger for growth stocks than value stocks. A portfolio strategy based on this hypothesis generates strong abnormal returns that do not appear to be attributable to risk. Although these results violate the traditional efficient markets hypothesis, they do not necessarily imply that rational but uniformed investors, without the benefit of hindsight, could have actually achieved the returns. We argue that to examine whether unexploited profit opportunities exist, one must test for what we call adaptive-efficiency, which is a somewhat weaker form of market efficiency that allows for the appearance of profit opportunities in historical data, but requires these profit opportunities to dissipate when they become apparent. Our tests reject this notion of adaptive-efficiency.
 
Article
During the turmoil in financial markets in late 1998, financial institutions attempting to liquidate positions to meet capital requirements may have faced unexpectedly high bid-ask spreads. In this paper, we investigate the effect on key risk measures (such as the likelihood of insolvency, value at risk, and expected tail loss) of spreads that are likely to widen just when positions must be liquidated in order to maintain capital ratios. Our results show that illiquidity causes significant increases in risk measures, especially with fat-tailed returns. A potential strategy to address this problem is for financial institutions to sell illiquid assets first, keeping a "cushion" of cash and liquid assets for "rainy days". According to a simple model presented in this paper, such a strategy, while increasing expected transaction costs, may significantly decrease tail losses and, especially, the probability of insolvency. In light of our results, it seems wise for financial institutions to carefully examine their strategies for liquidation during periods of severe stress.
 
Mean and standard deviation of returns and return forecasting variables, 1952.Q2-2002.Q4. (All variables except the log dividend yield are in annualized percentage units.)
VAR estimation results, 1952.Q2-2002.Q4.
Tangency portfolio implied by VAR estimation and risk-free rate equal to mean real T-bill rate.
Article
The US economy is arguably following an unsustainable trajectory. The main indicators of this are a large current account deficit, a large federal budget deficit and trend-wise increasing costs of Social Security and Medicare. In this chapter, we will discuss these observations and to what extent the financial and economic crisis may have changed the outlook. Before this, we need to define what we mean by sustainability. An often used definition of sustainability is that the inter-temporal budget restriction is satisfied.
 
Article
this article, we quantified the benefits of loss harvesting and highest in, first out accounting by using Monte Carlo simulations, and we investigated the robustness of these strategies in various markets and with various cash flows and tax rates. We concluded that a market with high stockspecific risk, low average return, and high dividend yield provides more opportunities to harvest losses. In addition, a steady stream of contributions refreshes a portfolio and allows the benefits of loss harvesting to remain strong over time. Conversely, withdrawals reduce the advantages of realizing losses. Our findings show that no matter what market environment occurs in the future, managing a portfolio in a tax-efficient manner gives substantially better after-tax performance than a simple index fund, both before and after liquidation of the portfolio
 
Article
The management of an educational endowment or other income-producing portfolio involves two strategic decisions at the fund level: asset allocation and choice of a spending rule. Traditionally, these two decisions are linked, for example, to preserve capital on average, but the optimal link would be more dynamic. This article describes a new protective strategy that links spending and asset allocation in a way that preserves spending power in down markets but participates significantly in up markets. The strategy is similar to constant proportions portfolio insurance, in that part of the fund is maintained in safe assets to preserve the value needed for continued expenditures. Like portfolio insurance, the strategy outperforms traditional strategies when markets are persistently up or persistently down but underperforms when portfolios are whipsawed by alternating ups and downs.
 
Article
Covered S&P 500 Index call strategies have, on average, outperformed the S&P 500 Index over the past 15+ years while realizing lower standard deviations of returns. This analysis dissects the strategy underlying the BuyWrite Monthly Index on the S&P 500. The BXM is the most broadly quoted benchmark for index call-selling strategies. Also discussed are alternative structured S&P 500 option-overwriting strategies, which have even more attractive risk-return trade-offs than the BXM because they take advantage of the implicit positive risk premium of equities and potentially adjust the strike price of the call sold on the basis of the volatility environment.
 
Article
The purpose of the study reported here was to investigate how characteristics of analysts affect their forecast errors. Previous research has found positive serial correlation in forecast errors, which can be attributed to underreaction to new information, especially to bad news. The relationship between an analyst's behavior and that analyst's characteristics is not clear, however, because most previous work was based solely on consensus estimates. By using detailed historical data, I found a stronger serial correlation among the herd-to-consensus analysts (that is, the group with a small average distance between their forecasts and the consensus forecast) than among other analysts. Moreover, average distance to consensus itself has a positive serial correlation, and it may be attributed to an analyst's personality (optimistic or pessimistic). I found strong positive serial correlation in the average distance to consensus among the herd-to-consensus analysts. These results show that herd-to-consensus analysts submit earnings estimates that are not only close to the consensus but are also strongly affected by their personalities.
 
IRS Suggested Guidelines for Crediting Rates 
Article
Controversy about the fairness of early transitions from traditional definedbenefit plans to cash-balance plans may have over-shadowed the subtleties of funding a cash-balance pension liability. Because crediting rates of cashbalance liabilities float with market rates, the same techniques used to value and hedge floating-rate bonds provide the present-value cost and e#ective duration of a cash-balance liability. The present-value cost of funding a liability varies dramatically across the menu of IRS-sanctioned crediting alternatives; the present value per $1.00 of cash balance of funding a liability paying o# 30 years from now varies between $0.90 and $1.48, given the yield curve from November 15, 1999. The e#ective duration of a cash-balance liability also varies dramatically across di#erent crediting rates; the e#ective duration is typically positive but much shorter than the expected time until retirement or other payment and can vary by a factor of five or so depending on the choi...
 
Article
this approach believed, on theoretical grounds, that cognitive biases could not affect asset prices. Why Behavioral Finance Cannot Be Dismissed Modern financial economic theory is based on the assumption that the "representative agent" in the economy is rational in two ways: The representative agent (1) makes decisions according to the axioms of expected utility theory and (2) makes unbiased forecasts about the future. An extreme version of this theory assumes that every agent behaves in accordance with these assumptions. Most economists recognize this extreme version as unrealistic; they concede that many of their relatives and acquaintances---spouses, students, deans, government leaders, and so on---are hopeless decision makers. Still, defenders of the traditional model argue that it is not a problem for some agents in the economy to make suboptimal decisions as long as the "marginal investor," that is, the investor who is making the specific investment decision a
 
Article
This paper addresses the risk analysis and market valuation of collateralized debt obligations (CDOs). We illustrate the effects of correlation and prioritization for the market valuation, diversity score, and risk of CDOs, in a simple jump-diffusion setting for correlated default intensities.
 
Article
Two old friends ruminate about insider trading. Treynor points out that the purposes of the U.S. insider trading laws are (1) to protect dealers and (2) to give investors the feeling that they are protected from people who know more than they do. He concludes that insider trading laws probably make capitalist societies healthier. LeBaron argues that when insiders are restricted, markets become less informed. He proposes that insider trading be encouraged at all times - but with the proviso that insiders be required to identify their market orders.
 
Article
In this article, we apply real options theory and modern capital budgeting to the problem of valuing an Internet company. We formulate the model in continuous time, form a discrete time approximation, estimate the model parameters, solve the model by simulation, and then perform sensitivity analysis. Depending on the parameters chosen, we find that the value of an Internet stock may be rational given high enough growth rates in revenues. Even with a very real chance that a firm may go bankrupt, if the initial growth rates are sufficiently high, and if there is enough volatility in this growth rate over time, then valuations can be what would otherwise appear to be dramatically high. In addition, we find a large sensitivity of the valuation to initial conditions and exact specification of the parameters. This is also consistent with the observation that the returns of Internet stocks have been strikingly volatile. 3 RATIONAL PRICING OF INTERNET COMPANIES 1. INTRODUCTION It is diffic...
 
Article
Many past studies have found that currencies trend, so technical trading rules produced statistically and economically significant profits. In other words, foreign exchange markets were weak-form inefficient. The study reported here reexamined this phenomenon with use of a new database of currency futures for 1975-2006 that includes old and newly liquid currencies. The findings from the recent data are contradictory. The profitability of trend following eroded for major currencies and their associated cross exchange rates around the mid-1990s. Newly liquid currencies after 2000 do trend, however, just as major currencies did in earlier years. The evidence is consistent with early weak-form inefficiency followed by vanishing trends as traders learn and adapt their strategies.
 
Article
Portfolio rebalancing strategies involve trading tracking error off against the transaction costs of frequent trading to avoid tracking error. Existing analytical work derives optimal rebalancing strategies that result in minimal expected transactions required to achieve a given level of tracking error. Employing the strategies described in the literature can obtain the same level of tracking error as naïve strategies often observed in practice with much lower transaction costs. We show that further (and substantial) reductions in expected transaction costs can be obtained by using derivatives to synthetically rebalance a portfolio. However, the design of an efficient synthetic rebalancing program is complicated. We show the key elements of the design of an efficient synthetic rebalancing program. Finally, we show how a rebalancing strategy should be designed when a portfolio experiences cash inflows and outflows.
 
Article
Divergence of opinions among investors, manifested in the dispersion of analysts' earnings forecasts, may play an important role in asset pricing. This article reports tests of whether disagreement can explain the cross-sectional return difference between value and growth (or glamour) stocks in the U.S. market over the 1983-2001 period. Consistent with the theoretical proposition that stocks subject to greater investor disagreement earn higher returns, the tests found value stocks to be exposed to greater investor disagreement than growth stocks. This finding suggests that the return advantage of value strategies is a reward for the greater disagreement about their future growth in earnings. Alternative multifactor asset-pricing tests supported the proposition that investor disagreement plays an important role in explaining the superior return of value stocks.
 
Article
Financial planners assume that retirees have a strong preference for consistent, predictable spending. Their widely used rule of thumb, the 4% rule, was developed to identify the maximum spending level that could be maintained throughout retirement. In stark contrast, the standard advice from financial economist may result in large fluctuations in spending. We reconcile these disparate views by augmenting the utility maximization framework of financial economists with the strong preference for consistent spending identified by financial planners. The resulting optimal strategies allocate a significant portion of retirement wealth to a floor portfolio invested in high-grade bonds to guarantee the current level of spending. All remaining wealth, the surplus portfolio, is invested in a leveraged equity position. If equities perform well, spending increases and money is transferred from the surplus portfolio to the floor portfolio. Surprisingly, we find that an 85% floor allocation and a 3x leveraged surplus portfolio is near-optimal across a wide range of retirement case studies. We refer to this general strategy as the Floor-Leverage rule for retirement.
 
Summary Statistics
Article
Recent literature has found some evidence of performance persistence in hedge funds. This study investigated whether this persistence varies with fund characteristics, such as size and age. Previous research has found that funds face capacity constraints, that investment flows chase past performance, and that as funds age, they become more passively managed, which reduces the likelihood of performance persistence as funds grow older and larger. Consistent with this model, this study found that performance persistence is strongest among small, young funds. A portfolio of these funds with prior good performance outperformed a portfolio of large, mature funds with prior poor performance by 9.6 percent per year.
 
Article
We study how migration of firms across size and value portfolios contributes to the size and value premiums in average stock returns. The size premium is almost entirely due to the small stocks that earn extreme positive returns and as a result become big stocks. The value premium has three sources: (i) value stocks that improve in type either because they are acquired by other firms or because they earn high returns and so migrate to a neutral or growth portfolio; (ii) growth stocks that earn low returns and as a result move to a neutral or value portfolio; and (iii) slightly higher returns on value stocks that remain in the same portfolio compared to growth stocks that do not migrate.
 
Article
Recent research suggests a persistent empirical relation between U.S. monetary policy and stock returns since the mid-1980s. The findings seem questionable and incomplete, however, for at least three reasons. First, the results are sensitive to sample selection. Second, this research does not distinguish between anticipated and unanticipated monetary policy decisions. Third, such analysis does not satisfactorily consider that returns and policy are probably determined simultaneously because prices contain information about market expectations for the economy and, in turn, policy. Together, these issues suggest that investors are unlikely to profit from strategies based on past or anticipated Federal Reserve decisions.
 
Article
The authors found that news related to the financial crisis and sovereign wealth fund investments in U.S. and European firms not only affected returns on U.S. money market instruments and U.S. firms’ common stock but also created negative “spillover” effects on Canadian money markets and Canadian firms’ equity returns.
 
Article
Enhanced active equity strategies, including 120-20 and 130-30 long-short portfolios, have become increasingly popular as managers and investors search for new ways to expand the alpha opportunities available from active management. But these strategies are not always well understood by the financial community. How do such strategies increase investors' flexibility both to underweight and to overweight securities? How do they compare with market-neutral long-short strategies? Are they significantly riskier than traditional, long-only strategies because they use short positions and leverage? This article sheds light on some common myths regarding enhanced active equity strategies.
 
Article
If the U.S. federal government properly accounted for its explicit and promised liabilities, it would record a national debt of $64 trillion and a national deficit of $2.4 trillion in 2006. Although capital markets seem to care about the officially reported budget deficit — a metric that is backward looking and quite misleading — the markets have done little more than yawn at the federal government's mammoth, and growing, forward-looking budget imbalance. Are investors uninformed? They should remember that the common belief that capital markets cannot fail is precisely the reason why they can.
 
Top-cited authors
Meir Statman
  • Santa Clara University
Claude Erb
  • Bloomberg BNA
Campbell Harvey
  • Duke University
Bruno Solnik
  • The Hong Kong University of Science and Technology
Andrew W Lo
  • Massachusetts Institute of Technology