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# input file: UFAJ_A_12046918_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Brian O'Neil
Author-X-Name-First: Brian
Author-X-Name-Last: O'Neil
Title: Death of the General Account
Abstract: 
 Life insurance in the United States has primarily been a general-account-based vehicle. A combination of developments in the financialmarkets and in insurance regulation are about to produce majorchanges in the investment characteristics and providers of life insurance and annuity products. Funds are moving out of the general account into separate accounts, in which the policyholders bear the investment risk, and in the near future, into synthetic general accounts, whichare provided by nonlife insurance companies. This process could forcea major consolidation in the life insurance industry. 
Journal: Financial Analysts Journal
Pages: 5-7
Issue: 1
Volume: 52
Year: 1996
Month: 1
X-DOI: 10.2469/faj.v52.n1.1960
File-URL: http://hdl.handle.net/10.2469/faj.v52.n1.1960
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# input file: UFAJ_A_12046919_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rex A. Sinquefield
Author-X-Name-First: Rex A.
Author-X-Name-Last: Sinquefield
Title: Where Are the Gains from International Diversification?
Abstract: 
 EAFE and international marketlike mandates are popular with U.S. institutional fund sponsors. The rationale seems to be that the international equity market has higher expected returns than the U.S. equity market and can substantially diversify U.S. portfolios. The empirical evidence for the 1970–94 period does not support either claim. Nor does theory help. Asset pricing models do not argue that risk factors have geographically different expected returns. Recent research for the U.S. market shows that two risk factors, value and size, explain differences in expected returns across equity portfolios. Preliminary evidence suggests that the same factors work in foreign markets, as well. International value stocks and international small stocks diversify U.S. portfolios more than EAFE. In fact, a sensible reason to diversify internationally is to “load up” on value stocks and small stocks without concentrating in one geographic region. If one does not wish to concentrate in such stocks, then international diversification for U.S. sponsors may be unnecessary. 
Journal: Financial Analysts Journal
Pages: 8-14
Issue: 1
Volume: 52
Year: 1996
Month: 1
X-DOI: 10.2469/faj.v52.n1.1961
File-URL: http://hdl.handle.net/10.2469/faj.v52.n1.1961
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# input file: UFAJ_A_12046920_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: John Kihn
Author-X-Name-First: John
Author-X-Name-Last: Kihn
Title: The Effect of Embedded Options on the Financial Performance of Convertible Bond Funds
Abstract: 
 This study is the first to analyze the pricing of convertible bonds by examining the financial performance of open-end convertible bond funds. The findings indicate that (1) in general, convertible bonds did not outperform straight low-grade corporate bonds during the study period, January 1962 through September 1994; (2) convertible bonds are significantly more equitylike and significantly less bondlike than low-grade bonds; and (3) convertible bonds display a strong January effect. The results suggest that the equity call option embedded in convertible bonds was appropriately priced during the study period. 
Journal: Financial Analysts Journal
Pages: 15-26
Issue: 1
Volume: 52
Year: 1996
Month: 1
X-DOI: 10.2469/faj.v52.n1.1962
File-URL: http://hdl.handle.net/10.2469/faj.v52.n1.1962
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# input file: UFAJ_A_12046921_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert A. Haugen
Author-X-Name-First: Robert A.
Author-X-Name-Last: Haugen
Author-Name: Philippe Jorion
Author-X-Name-First: Philippe
Author-X-Name-Last: Jorion
Title: The January Effect: Still There after All These Years
Abstract: 
 The year-end disturbance in the prices of small stocks that has come to be known as the January effect is arguably the most celebrated of the many stock market anomalies discovered during the past two decades. If this anomaly is exploitable and if the stock market is reasonably efficient, one would expect that opportunity would have been priced away by now. Evidence indicates, however, that the January effect is still going strong 17 years after its discovery. The magnitude of the effect has not changed significantly, and no significant trend portends its eventual disappearance. Because the anomaly can be inexpensively exploited, its persistence has implications for the theory of efficient markets and for the persistence of anomalies in general. 
Journal: Financial Analysts Journal
Pages: 27-31
Issue: 1
Volume: 52
Year: 1996
Month: 1
X-DOI: 10.2469/faj.v52.n1.1963
File-URL: http://hdl.handle.net/10.2469/faj.v52.n1.1963
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# input file: UFAJ_A_12046922_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Philip H. Dybvig
Author-X-Name-First: Philip H.
Author-X-Name-Last: Dybvig
Author-Name: William J. Marshall
Author-X-Name-First: William J.
Author-X-Name-Last: Marshall
Title: Pricing Long Bonds: Pitfalls and Opportunities
Abstract: 
 Valuing long claims has always been important for immunizing portfolios used to find long obligations such as certain defined-benefit pension payments. Recent bond issues such as Disney's 100-year bonds emphasize the need to value long-maturity fixed claims accurately. Because of the subtleties of convexity, parameter uncertainty, and the impact of default risk, the value of long-maturity bonds is easy to underestimate. Formal analysis of the pitfalls in pricing long bonds and the correct pricing that points to investment opportunities reveals large errors that can arise from the usual intuitive arguments using the expectations hypothesis and point estimates of unknown parameters. 
Journal: Financial Analysts Journal
Pages: 32-39
Issue: 1
Volume: 52
Year: 1996
Month: 1
X-DOI: 10.2469/faj.v52.n1.1964
File-URL: http://hdl.handle.net/10.2469/faj.v52.n1.1964
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# input file: UFAJ_A_12046923_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Lawrence D. Brown
Author-X-Name-First: Lawrence D.
Author-X-Name-Last: Brown
Title: Analyst Forecasting Errors and Their Implications for Security Analysis: An Alternative Perspective
Abstract: 
 Dreman and Berry, in the May/June 1995 Financial Analysts Journal, offered a perspective on analyst earnings forecast errors and their implications for security analysis. Among other arguments, they contended that the errors are too large to be reliably used by investors, the forecasts are less accurate than forecasts by time-series models, the errors are increasing over time, the analysts' forecasts are too optimistic, and the investment community relies too heavily on analyst forecasts. This article provides an alternative perspective on these issues. The argument is that analysts' forecast errors are within 3 percent of an appropriate benchmark (namely, stock price), that their forecasts generally are significantly more accurate than forecasts by naive or sophisticated time-series models, that analyst forecast errors have not been increasing over time, that analysts have been too pessimistic in recent years, and that the investment community, by placing too much weight on forecasts made by time-series models, relies too little on analysts' forecasts. 
Journal: Financial Analysts Journal
Pages: 40-47
Issue: 1
Volume: 52
Year: 1996
Month: 1
X-DOI: 10.2469/faj.v52.n1.1965
File-URL: http://hdl.handle.net/10.2469/faj.v52.n1.1965
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# input file: UFAJ_A_12046924_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Peter Carayannopoulos
Author-X-Name-First: Peter
Author-X-Name-Last: Carayannopoulos
Title: A Seasoning Process in the U.S. Treasury Bond Market: The Curious Case of Newly Issued Ten-Year Notes
Abstract: 
 The pricing behavior of new Treasury notes and bonds issued during the Treasury's regular refunding operations suggest the existence of a seasoning process: Prices of new issues are generally higher than prices of equivalent seasoned issues. Although overpricing for issues with original maturities of 3, 5, and 30 years persists for approximately two to three months after issuance, the seasoning process for Treasury notes with original maturity of 10 years is more pronounced and lengthier. On average, the prices of these notes take approximately 20 months to adjust and become comparable to the prices of seasoned issues. To a lesser extent, this overpricing is present in the prices of the principal strips derived from the newly issued ten-year notes. 
Journal: Financial Analysts Journal
Pages: 48-55
Issue: 1
Volume: 52
Year: 1996
Month: 1
X-DOI: 10.2469/faj.v52.n1.1966
File-URL: http://hdl.handle.net/10.2469/faj.v52.n1.1966
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# input file: UFAJ_A_12046925_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Piet M.A. Eichholtz
Author-X-Name-First: Piet M.A.
Author-X-Name-Last: Eichholtz
Title: Does International Diversification Work Better for Real Estate than for Stocks and Bonds?
Abstract: 
 International diversification is now an established fact for stock and bond portfolios. For real estate shares, however, this acceptance has so far not been the case. This study is an investigation of the effectiveness of international real estate diversification relative to international diversification of stock and bond portfolios. Tests of international correlation matrixes of real estate returns, common stock returns, and bond returns indicate significantly lower correlations between national real estate returns than between common stock or bond returns. The implication is that international diversification reduces the risk of a real estate portfolio more than that of common stock and bond portfolios. 
Journal: Financial Analysts Journal
Pages: 56-62
Issue: 1
Volume: 52
Year: 1996
Month: 1
X-DOI: 10.2469/faj.v52.n1.1967
File-URL: http://hdl.handle.net/10.2469/faj.v52.n1.1967
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# input file: UFAJ_A_12046926_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: White-Collar Crime Reconsidered (a review)
Abstract: 
 These 14 papers presented at a 1990 Indiana University conference provide a description of compliance practices and regulatory policy but are focused on a rich catalog of malfeasance and questions of moral ambiguity. 
Journal: Financial Analysts Journal
Pages: 63-64
Issue: 1
Volume: 52
Year: 1996
Month: 1
X-DOI: 10.2469/faj.v52.n1.1968
File-URL: http://hdl.handle.net/10.2469/faj.v52.n1.1968
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# input file: UFAJ_A_12046928_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Blind Hog: Memoirs of a Wall Street Maverick (a review)
Abstract: 
 The pseudonymous investment banker who wrote this book provides, perhaps inadvertently, useful insights into deal making and underwriting, and his descriptions can inspire investors to dig deep when trying to spot flawed transactions. 
Journal: Financial Analysts Journal
Pages: 79-80
Issue: 2
Volume: 52
Year: 1996
Month: 3
X-DOI: 10.2469/faj.v52.n2.1970
File-URL: http://hdl.handle.net/10.2469/faj.v52.n2.1970
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# input file: UFAJ_A_12046929_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Anthony T. Cope
Author-X-Name-First: Anthony T.
Author-X-Name-Last: Cope
Author-Name: L. Todd Johnson
Author-X-Name-First: L. Todd
Author-X-Name-Last: Johnson
Author-Name: Cheri L. Reither
Author-X-Name-First: Cheri L.
Author-X-Name-Last: Reither
Title: The Call for Reporting Comprehensive Income
Abstract: 
 Largely in response to AIMR's urging in Financial Reporting in the 1990s and Beyond, the Financial Accounting Standards Board decided to add to its technical agenda in September 1995 a project on reporting comprehensive income. This article discusses the concept of comprehensive income and explains why the project was added to FASB's agenda. It also outlines the project's scope and indicates ways in which the input of analysts and other users can be helpful to FASB during the course of the project. 
Journal: Financial Analysts Journal
Pages: 7-12
Issue: 2
Volume: 52
Year: 1996
Month: 3
X-DOI: 10.2469/faj.v52.n2.1975
File-URL: http://hdl.handle.net/10.2469/faj.v52.n2.1975
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# input file: UFAJ_A_12046930_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard W. Sias
Author-X-Name-First: Richard W.
Author-X-Name-Last: Sias
Title: Volatility and the Institutional Investor
Abstract: 
 Inconsistent with the relationship predicted by most academic theory, a positive contemporaneous association is documented between the level of institutional ownership and security return volatility after accounting for capitalization. This relationship is consistent with two stories: Either riskier securities attract institutional investors, or an increase in institutional holdings results in an increase in volatility. These empirical results are consistent with the latter interpretation. 
Journal: Financial Analysts Journal
Pages: 13-20
Issue: 2
Volume: 52
Year: 1996
Month: 3
X-DOI: 10.2469/faj.v52.n2.1976
File-URL: http://hdl.handle.net/10.2469/faj.v52.n2.1976
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# input file: UFAJ_A_12046931_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David P. Brown
Author-X-Name-First: David P.
Author-X-Name-Last: Brown
Title: Why Do We Need Stock Brokers?
Abstract: 
 The current and future states of the stock-brokerage industry are affected by the SEC's recent proposal for direct registration and by recent innovations in technology. Direct registration allows for book-entry shares registered in the names of corporate issuers as an alternative to the current practice of street-name registration. Enactment of this proposal will shorten the time required for transfer of book-entry shares between street names or from directly registered form to street-name form. This change, in turn, will lead to the unbundling of many of the services brokers now provide. Furthermore, brokers perform a number of functions that appear to be obsolete, given these innovations. The pressure on brokerage commission rates that initially began in the United States during the 1970s is likely to continue. In the extreme, stock exchanges could be organized to accommodate retail customers in the total absence of brokerage services. 
Journal: Financial Analysts Journal
Pages: 21-30
Issue: 2
Volume: 52
Year: 1996
Month: 3
X-DOI: 10.2469/faj.v52.n2.1977
File-URL: http://hdl.handle.net/10.2469/faj.v52.n2.1977
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# input file: UFAJ_A_12046932_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Stan Beckers
Author-X-Name-First: Stan
Author-X-Name-Last: Beckers
Author-Name: Gregory Connor
Author-X-Name-First: Gregory
Author-X-Name-Last: Connor
Author-Name: Ross Curds
Author-X-Name-First: Ross
Author-X-Name-Last: Curds
Title: National versus Global Influences on Equity Returns
Abstract: 
 Simple factor models of worldwide equity returns are used to explore the level and trend in international capital market integration. Global influences and national influences are of roughly equal importance in explaining the common movements in equity returns. Significant evidence indicates a trend toward increasing integration within the European Union, but not worldwide. 
Journal: Financial Analysts Journal
Pages: 31-39
Issue: 2
Volume: 52
Year: 1996
Month: 3
X-DOI: 10.2469/faj.v52.n2.1978
File-URL: http://hdl.handle.net/10.2469/faj.v52.n2.1978
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# input file: UFAJ_A_12046933_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Masasuke Ide
Author-X-Name-First: Masasuke
Author-X-Name-Last: Ide
Title: Corporate Profitability and Stock Valuation in Japan
Abstract: 
 The coexistence of low corporate profitability and high valuations in the Japanese stock market is seemingly contradictory. The Japanese financial system, which provided low-cost debt and equity capital as a package to major corporations through stable, interlocking relationships between large financial institutions and borrowing companies was, in fact, a hidden key factor for the unprecedented economic success of Japan after World War II. As Japan's economy successfully completes its catch-up phase and enters a mature stage, the traditional financial system is becoming more of a liability than an asset for achieving new economic priorities. Pressures are building to transform the system into one based on purely financial investment emphasizing management efficiency and profitability of borrowing companies. How soon and in what form this transformation will take place remains to be seen. 
Journal: Financial Analysts Journal
Pages: 40-55
Issue: 2
Volume: 52
Year: 1996
Month: 3
X-DOI: 10.2469/faj.v52.n2.1979
File-URL: http://hdl.handle.net/10.2469/faj.v52.n2.1979
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# input file: UFAJ_A_12046934_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: William C. Barbee
Author-X-Name-First: William C.
Author-X-Name-Last: Barbee
Author-Name: Sandip Mukherji
Author-X-Name-First: Sandip
Author-X-Name-Last: Mukherji
Author-Name: Gary A. Raines
Author-X-Name-First: Gary A.
Author-X-Name-Last: Raines
Title: Do Sales–Price and Debt–Equity Explain Stock Returns Better than Book–Market and Firm Size?
Abstract: 
 During the 1979–91 period, the sales–price ratio and the debt–equity ratio had greater explanatory power for stock returns than either the book–market value of equity ratio or the market value of equity. Furthermore, the sales–price ratio captures the role of the debt–equity ratio in explaining stock returns. Neither the book–market value of equity ratio nor the market value of equity has consistent explanatory power for stock returns, and the sales–price ratio is a more reliable explanatory factor. 
Journal: Financial Analysts Journal
Pages: 56-60
Issue: 2
Volume: 52
Year: 1996
Month: 3
X-DOI: 10.2469/faj.v52.n2.1980
File-URL: http://hdl.handle.net/10.2469/faj.v52.n2.1980
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Author-Name: M. A. J. Bharadia
Author-X-Name-First: M. A. J.
Author-X-Name-Last: Bharadia
Author-Name: N. Christofides
Author-X-Name-First: N.
Author-X-Name-Last: Christofides
Author-Name: G. R. Salkin
Author-X-Name-First: G. R.
Author-X-Name-Last: Salkin
Title: A Quadratic Method for the Calculation of Implied Volatility Using the Garman–Kohlhagen Model
Abstract: 
 Conventional techniques for evaluating the implied volatility from option prices involve iterative methods. The analytical algorithm presented in this article provides a simple, fairly accurate, and intuitive way of determining implied volatility. The discussion of this method is with reference to the Garman–Kohlhagen model for currency options, but the analysis is applicable to all options that can be priced using the Black–Scholes model. An improvement on a closed-form solution for implied volatility that is computationally more efficient is also presented. 
Journal: Financial Analysts Journal
Pages: 61-64
Issue: 2
Volume: 52
Year: 1996
Month: 3
X-DOI: 10.2469/faj.v52.n2.1981
File-URL: http://hdl.handle.net/10.2469/faj.v52.n2.1981
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# input file: UFAJ_A_12046936_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert Ferguson
Author-X-Name-First: Robert
Author-X-Name-Last: Ferguson
Author-Name: Dean Leistikow
Author-X-Name-First: Dean
Author-X-Name-Last: Leistikow
Title: On the Risk of Stocks in the Long Run: A Comment
Abstract: 
 Diametrically opposite conclusions about stocks' long-term risk follow from Bodie's methodology (see Financial Analysts Journal, May/June 1995). Bodie's conclusion that stocks' risk increases monotonically with the investment horizon is incorrect. Conventional wisdom about the long-term risk of stocks has not been refuted. 
Journal: Financial Analysts Journal
Pages: 67-68
Issue: 2
Volume: 52
Year: 1996
Month: 3
X-DOI: 10.2469/faj.v52.n2.1982
File-URL: http://hdl.handle.net/10.2469/faj.v52.n2.1982
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# input file: UFAJ_A_12046937_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard Taylor
Author-X-Name-First: Richard
Author-X-Name-Last: Taylor
Author-Name: Donald J. Brown
Author-X-Name-First: Donald J.
Author-X-Name-Last: Brown
Title: On the Risk of Stocks in the Long Run: A Note
Abstract: 
 In a recent article in this journal, Zvi Bodie used a simplified Black–Scholes model to prove that the cost of insuring a long-term stock portfolio against earning less than the risk-free rate increases over time. Bodie believes that this means the risk of investing in common stocks increases over time and that the conventional wisdom of the investment community concerning time diversification is a fallacy. Bodie's proof relies on a constant standard deviation for common stock over all holding periods. This assumption, however, may not be appropriate for long-term stock portfolios. This article is not available online.
Journal: Financial Analysts Journal
Pages: 69-71
Issue: 2
Volume: 52
Year: 1996
Month: 3
X-DOI: 10.2469/faj.v52.n2.1983
File-URL: http://hdl.handle.net/10.2469/faj.v52.n2.1983
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Author-Name: George M. Cohen
Author-X-Name-First: George M.
Author-X-Name-Last: Cohen
Title: Long-Run Risk in Stocks
Abstract: 
 This material comments on “Long-Run Risk in Stocks”.
Journal: Financial Analysts Journal
Pages: 72-76
Issue: 2
Volume: 52
Year: 1996
Month: 3
X-DOI: 10.2469/faj.v52.n2.1984
File-URL: http://hdl.handle.net/10.2469/faj.v52.n2.1984
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:2:p:72-76




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# input file: UFAJ_A_12046943_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street (a review)
Abstract: 
 This book is a fine biography of a remarkable man and a less-than-satisfying exegesis of his investment philosophy. 
Journal: Financial Analysts Journal
Pages: 77-79
Issue: 2
Volume: 52
Year: 1996
Month: 3
X-DOI: 10.2469/faj.v52.n2.1989
File-URL: http://hdl.handle.net/10.2469/faj.v52.n2.1989
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:2:p:77-79




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# input file: UFAJ_A_12046944_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Harry S. Marmer
Author-X-Name-First: Harry S.
Author-X-Name-Last: Marmer
Title: Visions of the Future: The Distant Past, Yesterday, Today, and Tomorrow
Abstract: 
 This article summarizes 30 years of investment management history andprovides some vision of the future. The investment management industryhas evolved from the dark age of the past to the information age of today.Tomorrow, the investment industry will consist of investment factories andsmall boutiques. The pension sponsor mantra of the future will reflect thebasic economic principal of value for service from money managers and consultants. 
Journal: Financial Analysts Journal
Pages: 9-12
Issue: 3
Volume: 52
Year: 1996
Month: 5
X-DOI: 10.2469/faj.v52.n3.1990
File-URL: http://hdl.handle.net/10.2469/faj.v52.n3.1990
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# input file: UFAJ_A_12046945_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Craig Merrill
Author-X-Name-First: Craig
Author-X-Name-Last: Merrill
Author-Name: Steven Thorley
Author-X-Name-First: Steven
Author-X-Name-Last: Thorley
Title: Time Diversification: Perspectives from Option Pricing Theory
Abstract: 
 Despite repeated theoretical arguments to the contrary, many investment professionals subscribe to the principle of time diversification. This principle states that equity investments become less risky if held for longer periods of time. We apply option pricing theory to the question of how the investment horizon affects equity risk. Financially engineered securities that guarantee a minimum return allow for greater equity market participation if the investor commits to a longer time horizon. In other words, the fair cost of insuring a minimum return, in terms of foregone market participation, is lower for longer horizons. The lower cost of risk reduction suggests that risk itself is lower, consistent with the pervasive practitioner belief in time diversification. 
Journal: Financial Analysts Journal
Pages: 13-19
Issue: 3
Volume: 52
Year: 1996
Month: 5
X-DOI: 10.2469/faj.v52.n3.1991
File-URL: http://hdl.handle.net/10.2469/faj.v52.n3.1991
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:3:p:13-19




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# input file: UFAJ_A_12046946_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Yan Gao
Author-X-Name-First: Yan
Author-X-Name-Last: Gao
Title: Primary versus Secondary Pricing of High-Yield Bonds
Abstract: 
 Previous research has found systematic underpricing of newly floated securities vis-à-vis secondary market levels. This conclusion is based on the observation that primary issues provide superior risk-adjusted returns in the period immediately following issuance. Those returns, however, are not known at the time of pricing. To gauge whether a new issue is offered at a premium or a concession to the secondary market, investors must use standard valuation benchmarks. In the case of high-yield bonds, an analysis based on agency ratings and yields to maturity indicates that new issues are priced richer than seasoned issues in some periods and cheaper in other periods. Using regression analysis, the authors model the magnitude of the premium or concession prevailing in a given period. The regressions explain 64 percent of the variance in the primary/secondary yield spread through proxies for supply, demand, and liquidity of the high-yield sector. 
Journal: Financial Analysts Journal
Pages: 20-27
Issue: 3
Volume: 52
Year: 1996
Month: 5
X-DOI: 10.2469/faj.v52.n3.1992
File-URL: http://hdl.handle.net/10.2469/faj.v52.n3.1992
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:3:p:20-27




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# input file: UFAJ_A_12046947_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: John Kihn
Author-X-Name-First: John
Author-X-Name-Last: Kihn
Title: To Load or Not to Load? A Study of the Marketing and Distribution Charges of Mutual Funds
Abstract: 
 A mutual fund firm's ability to charge for marketing funds is a function of more than past financial performance. Front-end loads and annual fund marketing charges are in part determined by customer services, whether deferred marketing charges can be imposed, and financial performance. The results imply that, at least in the short run, mutual fund firms should focus relatively more on fund marketing and service-related characteristics of their funds than on financial performance. Mutual fund investors seem to demand high levels of services in exchange for high marketing charges. 
Journal: Financial Analysts Journal
Pages: 28-36
Issue: 3
Volume: 52
Year: 1996
Month: 5
X-DOI: 10.2469/faj.v52.n3.1993
File-URL: http://hdl.handle.net/10.2469/faj.v52.n3.1993
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:3:p:28-36




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# input file: UFAJ_A_12046948_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Alexandros Benos
Author-X-Name-First: Alexandros
Author-X-Name-Last: Benos
Author-Name: Michel Crouhy
Author-X-Name-First: Michel
Author-X-Name-Last: Crouhy
Title: Changes in the Structure and Dynamics of European Securities Markets
Abstract: 
 The European securities markets have undergone many structural changes during the past ten years. This article describes the essential features of the trading structures of six European stock and derivative markets, particularly emphasizing their newly acquired information technology infrastructures. Automated trade execution systems and market making are briefly discussed in order to examine the future of European organized capital markets in view of the possible European Monetary Union of 1999. In the meantime, the competition between exchanges will be tough, although the actual technologies and structures are converging faster than expected. To gain market power, institutions have to make strategic decisions. The ability to exploit them, however, depends ultimately on the self-interest of their members. 
Journal: Financial Analysts Journal
Pages: 37-50
Issue: 3
Volume: 52
Year: 1996
Month: 5
X-DOI: 10.2469/faj.v52.n3.1994
File-URL: http://hdl.handle.net/10.2469/faj.v52.n3.1994
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:3:p:37-50




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# input file: UFAJ_A_12046949_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ira G. Kawaller
Author-X-Name-First: Ira G.
Author-X-Name-Last: Kawaller
Author-Name: John F. Marshall
Author-X-Name-First: John F.
Author-X-Name-Last: Marshall
Title: Deriving Zero-Coupon Rates: Alternatives to Orthodoxy
Abstract: 
 The bootstrapping method for deriving zero-coupon rates from par yield curves implicitly assumes a specific forecast of prospective interest rate changes. In the event that market conditions reflect this standard methodology but, at the same time, individual practitioners reject the implicit forecast, contrarian opportunities will be present. Additionally, to the extent that zero-coupon discount rates are based on unacceptable assumptions, any subsequent present valuation calculation using these rates would be suspect. We propose two methodologies whereby any explicit interest rate forecast may be used for determining zero-coupon interest rates. “Backsliding” calculates zero-coupon returns by assuming interim interest cash flows are always rolled over into the longest maturity coupon-bearing instruments available; “frontsliding” requires rolling these cash flows over into the shortest maturity vehicles. The choice of methodology should be driven by rate forecasts, as well as whether the objective is for funding or investment purposes. 
Journal: Financial Analysts Journal
Pages: 51-55
Issue: 3
Volume: 52
Year: 1996
Month: 5
X-DOI: 10.2469/faj.v52.n3.1995
File-URL: http://hdl.handle.net/10.2469/faj.v52.n3.1995
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:3:p:51-55




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Author-Name: Kevin Cole
Author-X-Name-First: Kevin
Author-X-Name-Last: Cole
Author-Name: Jean Helwege
Author-X-Name-First: Jean
Author-X-Name-Last: Helwege
Author-Name: David Laster
Author-X-Name-First: David
Author-X-Name-Last: Laster
Title: Stock Market Valuation Indicators: Is This Time Different?
Abstract: 
 Traditional market indicators have pointed to an overvalued stock market throughout the 1990s, because the dividend yield dropped to a record low and the market-to-book ratio reached a record high. Despite the indicators, the stock market has performed well, leading market watchers to question whether these indicators behave differently now than they have in the past. This article examines the predictive power of these measures and addresses the claim that the dividend yield and market-to-book ratio are no longer valid indicators. We find that share repurchase activity has not been especially high through most of the 1990s and that, adjusting for buybacks, the dividend yield remains low. Likewise, the market-to-book ratio remains at a record high once charges for retiree health liabilities have been taken into account. 
Journal: Financial Analysts Journal
Pages: 56-64
Issue: 3
Volume: 52
Year: 1996
Month: 5
X-DOI: 10.2469/faj.v52.n3.1996
File-URL: http://hdl.handle.net/10.2469/faj.v52.n3.1996
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# input file: UFAJ_A_12046951_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Moshe Levy
Author-X-Name-First: Moshe
Author-X-Name-Last: Levy
Author-Name: Haim Levy
Author-X-Name-First: Haim
Author-X-Name-Last: Levy
Title: The Danger of Assuming Homogeneous Expectations
Abstract: 
 The capital asset pricing model, the Black-Scholes option valuation model, and many other economic models rely on the assumption of homogeneous expectations. What are the effects of heterogeneous expectations on price determination? Are the homogeneous expectations models “approximately” correct? We compare stock price dynamics in models with homogeneous and heterogeneous expectations. Heterogeneous expectations appear to play a crucial role in risky asset price determination. When homogeneous expectations are assumed, unacceptable market inefficiencies are observed. The introduction of even a small degree of diversity of expectations changes the dynamics dramatically, and the result is a much more realistic market. These findings make one wonder how far the equilibrium prices of the CAPM and Black–Scholes model are from the true values in markets with heterogeneous expectations. 
Journal: Financial Analysts Journal
Pages: 65-70
Issue: 3
Volume: 52
Year: 1996
Month: 5
X-DOI: 10.2469/faj.v52.n3.1997
File-URL: http://hdl.handle.net/10.2469/faj.v52.n3.1997
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:3:p:65-70




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# input file: UFAJ_A_12046952_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robin L. Diamonte
Author-X-Name-First: Robin L.
Author-X-Name-Last: Diamonte
Author-Name: John M. Liew
Author-X-Name-First: John M.
Author-X-Name-Last: Liew
Author-Name: Ross L. Stevens
Author-X-Name-First: Ross L.
Author-X-Name-Last: Stevens
Title: Political Risk in Emerging and Developed Markets
Abstract: 
 Political risk represents a more important determinant of stock returns in emerging than in developed markets. Using analyst estimates of political risk, we show that average returns in emerging markets experiencing decreased political risk exceed those of emerging markets experiencing increased political risk by approximately 11 percent a quarter. In contrast, the difference is only 2.5 percent a quarter for developed markets. Furthermore, the difference between the impact of political risk in emerging and developed markets is statistically significant. We also document a global convergence in political risk. During the past 10 years, political risk has decreased in emerging markets and increased in developed markets. If this trend continues, the differential impact of political risk on returns in emerging and developed markets may narrow. 
Journal: Financial Analysts Journal
Pages: 71-76
Issue: 3
Volume: 52
Year: 1996
Month: 5
X-DOI: 10.2469/faj.v52.n3.1998
File-URL: http://hdl.handle.net/10.2469/faj.v52.n3.1998
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# input file: UFAJ_A_12046953_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David Dreman
Author-X-Name-First: David
Author-X-Name-Last: Dreman
Title: Analyst Forecasting Errors
Abstract: 
 This material comments on “Analyst Forecasting Errors and Their Imperfections for Security Analysis”.The views expressed in Letters to the Editor are those of the letter authors, not of CFA Institute or the Financial Analysts Journal.
Journal: Financial Analysts Journal
Pages: 77-80
Issue: 3
Volume: 52
Year: 1996
Month: 5
X-DOI: 10.2469/faj.v52.n3.1999
File-URL: http://hdl.handle.net/10.2469/faj.v52.n3.1999
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Author-Name: Russell J. Fuller
Author-X-Name-First: Russell J.
Author-X-Name-Last: Fuller
Title: Amos Tversky, Behavioral Finance, and Nobel Prizes
Abstract: 
 The death of Amos Tversky on June 2, 1996, brought an end to the distinguished career of one of the pioneers of behavioral finance. Tversky documented a number of systematic errors in judgment to which humans are prone—cognitive illusions being one of the best known. Tversky's work fit the pattern of Nobel Prize winners in economics in challenging conventional wisdom, being based on “simple” ideas, and spawning copious research by others. 
Journal: Financial Analysts Journal
Pages: 7-8
Issue: 4
Volume: 52
Year: 1996
Month: 7
X-DOI: 10.2469/faj.v52.n4.2005
File-URL: http://hdl.handle.net/10.2469/faj.v52.n4.2005
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# input file: UFAJ_A_12046955_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Philip Halpern
Author-X-Name-First: Philip
Author-X-Name-Last: Halpern
Author-Name: Nancy Calkins
Author-X-Name-First: Nancy
Author-X-Name-Last: Calkins
Author-Name: Tom Ruggels
Author-X-Name-First: Tom
Author-X-Name-Last: Ruggels
Title: Does the Emperor Wear Clothes or Not? The Final Word (or Almost) on the Parable of Investment Management
Abstract: 
 A goal of many institutional investors is hiring active managers that will consistently beat the market. The question is, how can such managers be identified in advance? This article documents one institutional investor's experience with manager selection and offers some thoughts about why successful manager selection is such a challenge. 
Journal: Financial Analysts Journal
Pages: 9-15
Issue: 4
Volume: 52
Year: 1996
Month: 7
X-DOI: 10.2469/faj.v52.n4.2006
File-URL: http://hdl.handle.net/10.2469/faj.v52.n4.2006
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# input file: UFAJ_A_12046956_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Alex Kane
Author-X-Name-First: Alex
Author-X-Name-Last: Kane
Author-Name: Alan J. Marcus
Author-X-Name-First: Alan J.
Author-X-Name-Last: Marcus
Author-Name: Jaesun Noh
Author-X-Name-First: Jaesun
Author-X-Name-Last: Noh
Title: The P/E Multiple and Market Volatility
Abstract: 
 The market multiple is highly sensitive to volatility. These empirical results suggest that a permanent 1 percentage point increase in market volatility can, over time, reduce the market multiple by 1.8. Hence, any assessment of market valuation that ignores the impact of volatility on the equilibrium P/E is inherently perilous. 
Journal: Financial Analysts Journal
Pages: 16-24
Issue: 4
Volume: 52
Year: 1996
Month: 7
X-DOI: 10.2469/faj.v52.n4.2007
File-URL: http://hdl.handle.net/10.2469/faj.v52.n4.2007
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# input file: UFAJ_A_12046957_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Emanuel Derman
Author-X-Name-First: Emanuel
Author-X-Name-Last: Derman
Author-Name: Iraj Kani
Author-X-Name-First: Iraj
Author-X-Name-Last: Kani
Author-Name: Joseph Z. Zou
Author-X-Name-First: Joseph Z.
Author-X-Name-Last: Zou
Title: The Local Volatility Surface: Unlocking the Information in Index Option Prices
Abstract: 
 The structure of listed index options prices, examined through the prism of the implied tree model, reveals the local volatility surface of the underlying index. In the same way as fixed-income investors analyze the yield curve in terms of forward rates, so index options investors should analyze the volatility smile in terms of local volatilities. This article explains the concept of local volatility and its use. It also presents three heuristic rules that relate local and implied volatilities. Local volatilities are used in markets with a pronounced smile to measure market sentiment, to compute the evolution of implied volatilities through time, to calculate the index exposure of standard index options, and to value and hedge exotic options. In markets with significant smiles, all of the results show large discrepancies from those of the standard Black–Scholes approach. 
Journal: Financial Analysts Journal
Pages: 25-36
Issue: 4
Volume: 52
Year: 1996
Month: 7
X-DOI: 10.2469/faj.v52.n4.2008
File-URL: http://hdl.handle.net/10.2469/faj.v52.n4.2008
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# input file: UFAJ_A_12046958_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert A. Olsen
Author-X-Name-First: Robert A.
Author-X-Name-Last: Olsen
Title: Implications of Herding Behavior for Earnings Estimation, Risk Assessment, and Stock Returns
Abstract: 
 Experts' earnings predictions exhibit positive bias and disappointing accuracy. These shortcomings are usually attributed to some combination of incomplete knowledge, incompetence, and/or misrepresentation. This article suggests that the human desire for consensus leads to herding behavior among earnings forecasters. Herding results in a reduction in the dispersion and an increase in the mean of the distribution of expert forecasts, creating positive bias and inaccuracy in published earnings estimates. Investors mistake reduced dispersion for reduced risk and positive bias for high future returns. These misperceptions lead to abnormally low returns from stocks with unpredictable earning streams. 
Journal: Financial Analysts Journal
Pages: 37-41
Issue: 4
Volume: 52
Year: 1996
Month: 7
X-DOI: 10.2469/faj.v52.n4.2009
File-URL: http://hdl.handle.net/10.2469/faj.v52.n4.2009
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:4:p:37-41




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Author-Name: Enrique R. Arzac
Author-X-Name-First: Enrique R.
Author-X-Name-Last: Arzac
Title: Valuation of Highly Leveraged Firms
Abstract: 
 The financial policy highly leveraged firms (HLFs) commonly follow implies uncertain leverage. Explicit allowance for this characteristic leads to two complementary pricing models. A recursive formula for the value of HLF follows from applying the adjusted present value (APV) approach to uncertain tax shields. This formula is used to evaluate the robustness of the simple APV rule and other valuation approaches used in practice. The HLF equity is also modeled as a call option with uncertain exercise price, which provides a natural way of dealing with uncertain leverage and complements the APV approach. Both models require inputs that are usually observable. The models developed in this article apply to the valuation of firms undergoing financial restructuring, as well as to leveraged buyouts and project financing. In all these situations, firms deploy all or a significant portion of their free cash flow to debt reduction and their leverage ratio is uncertain. 
Journal: Financial Analysts Journal
Pages: 42-50
Issue: 4
Volume: 52
Year: 1996
Month: 7
X-DOI: 10.2469/faj.v52.n4.2010
File-URL: http://hdl.handle.net/10.2469/faj.v52.n4.2010
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:4:p:42-50




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Author-Name: Michael A. Conte
Author-X-Name-First: Michael A.
Author-X-Name-Last: Conte
Author-Name: Joseph Blasi
Author-X-Name-First: Joseph
Author-X-Name-Last: Blasi
Author-Name: Douglas Kruse
Author-X-Name-First: Douglas
Author-X-Name-Last: Kruse
Author-Name: Rama Jampani
Author-X-Name-First: Rama
Author-X-Name-Last: Jampani
Title: Financial Returns of Public ESOP Companies: Investor Effects vs. Manager Effects
Abstract: 
 The financial returns of public companies that sponsor ESOPs are substantially and significantly higher than those of comparable non-ESOP companies. The returns are systematically different even after adjusting for risk, providing evidence of a positive investor effect. The analysis of pre- and postadoption returns of ESOP-sponsoring companies suggests that the adoption of an ESOP actually reduces financial returns, signifying the presence of a relatively large negative manager effect. These findings are consistent with the idea that most ESOPs in large publicly traded companies are adopted for defensive purposes. Even though ESOP adoption lowers financial returns in large companies and has no significant effect in smaller companies, the presence of an ESOP remains a good signal to buy the sponsor's stock. 
Journal: Financial Analysts Journal
Pages: 51-61
Issue: 4
Volume: 52
Year: 1996
Month: 7
X-DOI: 10.2469/faj.v52.n4.2011
File-URL: http://hdl.handle.net/10.2469/faj.v52.n4.2011
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# input file: UFAJ_A_12046961_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: William Ghee
Author-X-Name-First: William
Author-X-Name-Last: Ghee
Author-Name: William Reichenstein
Author-X-Name-First: William
Author-X-Name-Last: Reichenstein
Title: The After-Tax Returns from Different Savings Vehicles
Abstract: 
 When saving for retirement, investors' most important decision will probably be the choice of savings vehicles, that is, whether the funds are subject to the tax structure facing personal accounts, deferred annuities, or pensions. The pension tax structure has an overwhelming long-run advantage over the other two forms. A bond or stock fund held in a pension can expect to earn at least 2.5 percentage points a year more after taxes than the same fund held in a personal account. For the 1984–93 period, no bond fund could beat a bond index fund by 2.5 percentage points a year, and few stock funds could beat a stock index fund by 2.5 points a year. Thus, the choice of savings vehicles is more important to the long-run investor than the choice of bond and stock funds. 
Journal: Financial Analysts Journal
Pages: 62-72
Issue: 4
Volume: 52
Year: 1996
Month: 7
X-DOI: 10.2469/faj.v52.n4.2012
File-URL: http://hdl.handle.net/10.2469/faj.v52.n4.2012
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# input file: UFAJ_A_12046962_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rupert T. Cox
Author-X-Name-First: Rupert T.
Author-X-Name-Last: Cox
Title: Analyst Forecasting Errors
Abstract: 
 This material comments on “Analyst Forecasting Errors and Their Imperfections for Security Analysis”.
Journal: Financial Analysts Journal
Pages: 73-74
Issue: 4
Volume: 52
Year: 1996
Month: 7
X-DOI: 10.2469/faj.v52.n4.2013
File-URL: http://hdl.handle.net/10.2469/faj.v52.n4.2013
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# input file: UFAJ_A_12046963_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Derivatives Risk and Responsibility: The Complete Guide to Effective Derivatives Management (a review)
Abstract: 
 With contributions from academics, accountants, lawyers, portfolio managers, marketers, and consultants, this comprehensive volume provides a wealth of qualitative criteria as well as quantitative techniques for managing the risk of derivatives. 
Journal: Financial Analysts Journal
Pages: 75-76
Issue: 4
Volume: 52
Year: 1996
Month: 7
X-DOI: 10.2469/faj.v52.n4.2014
File-URL: http://hdl.handle.net/10.2469/faj.v52.n4.2014
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:4:p:75-76




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# input file: UFAJ_A_12046964_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Witch Doctor of Wall Street: A Noted Financial Expert Guides You Through Today's Voodoo Economics (a review)
Abstract: 
 Through the many incidents in his memoirs, the author demonstrates that economic straight talk is a scarcity in the market, in the government, and among economists. He provides insights into a variety of ethical issues, commercial considerations that may color research reports, and the hidden agenda behind many economic pronouncements. 
Journal: Financial Analysts Journal
Pages: 76-77
Issue: 4
Volume: 52
Year: 1996
Month: 7
X-DOI: 10.2469/faj.v52.n4.2015
File-URL: http://hdl.handle.net/10.2469/faj.v52.n4.2015
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:4:p:76-77




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# input file: UFAJ_A_12046965_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Arthur Zeikel
Author-X-Name-First: Arthur
Author-X-Name-Last: Zeikel
Title: The Future Before Us
Abstract: 
 This article, adapted from a keynote address at AIMR's 1996 Annual Conference, deals with the current state of the investment management business and the shape of things to come. The author presents six “points to ponder” regarding the future of the industry. 
Journal: Financial Analysts Journal
Pages: 8-16
Issue: 5
Volume: 52
Year: 1996
Month: 9
X-DOI: 10.2469/faj.v52.n5.2020
File-URL: http://hdl.handle.net/10.2469/faj.v52.n5.2020
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# input file: UFAJ_A_12046966_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bruno Solnik
Author-X-Name-First: Bruno
Author-X-Name-Last: Solnik
Author-Name: Cyril Boucrelle
Author-X-Name-First: Cyril
Author-X-Name-Last: Boucrelle
Author-Name: Yann Le Fur
Author-X-Name-First: Yann
Author-X-Name-Last: Le Fur
Title: International Market Correlation and Volatility
Abstract: 
 International correlations for stocks and bonds fluctuate widely over time. As previous studies have found, volatility appears to be contagious across markets. In addition, international correlation increases in periods of high market volatility. Although the correlation of individual foreign stock markets with the U.S. stock market has generally increased slightly over the past 37 years, it has not increased during the past 10 years. Similarly, the international correlation of bond markets increased in the early 1980s, but it has had no discernible trend in the past 10 years. The fairly low levels of international correlation among stocks or bonds suggests that national factors still strongly affect local asset prices. The link between correlation and market volatility is bad news for global money managers because when the domestic market is subject to a strong negative shock is when the benefits of international risk diversification are needed most. 
Journal: Financial Analysts Journal
Pages: 17-34
Issue: 5
Volume: 52
Year: 1996
Month: 9
X-DOI: 10.2469/faj.v52.n5.2021
File-URL: http://hdl.handle.net/10.2469/faj.v52.n5.2021
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:5:p:17-34




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# input file: UFAJ_A_12046967_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Thomas S.Y. Ho
Author-X-Name-First: Thomas S.Y.
Author-X-Name-Last: Ho
Author-Name: David M. Pfeffer
Author-X-Name-First: David M.
Author-X-Name-Last: Pfeffer
Title: Convertible Bonds: Model, Value Attribution, and Analytics
Abstract: 
 Convertible bonds provide investors an option to convert the bond into the underlying equity. For this reason, a convertible bond is exposed to both equity and interest rate risk. Incorporating these two sources of risk into the model is particularly important for callable issues. In this study, a two-factor model is used to analyze a sample of bonds. The model shows that the correlation of stock risk and interest rate risk may affect convertible bond prices significantly. The bond pricing model also provides portfolio analytics and can decompose a convertible bond into its basic components—the stock and bonds with different maturities. This approach enables an investor to implement a more precise hedging strategy than is possible using only delta. 
Journal: Financial Analysts Journal
Pages: 35-44
Issue: 5
Volume: 52
Year: 1996
Month: 9
X-DOI: 10.2469/faj.v52.n5.2022
File-URL: http://hdl.handle.net/10.2469/faj.v52.n5.2022
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:5:p:35-44




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# input file: UFAJ_A_12046968_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Leland E. Crabbe
Author-X-Name-First: Leland E.
Author-X-Name-Last: Crabbe
Title: Estimating the Credit-Risk Yield Premium for Preferred Stock
Abstract: 
 The credit risk of preferred stock is not simply the probability of default. Because preferred stock is legally an equity security, issuers may omit dividends without triggering default or bankruptcy. Historical data suggest that about 6.1 percent of a-rated preferred issuers pass on dividends or default over a 10-year period. For corporate bonds, by contrast, the 10-year default rate for A-rated issuers is about 2 percent. Using a risk-neutral pricing model, this paper shows that the yield spread between corporate bonds and preferred stock depends on the probability of receiving scheduled cash flows and on the price of the security in the event of a default or omission. In practical terms, a-rated preferred stock should trade at a minimum tax-adjusted spread of 26 basis points above A-rated corporate bonds; the minimum spread between b-rated preferred and B-rated bonds should be 517 basis points. 
Journal: Financial Analysts Journal
Pages: 45-56
Issue: 5
Volume: 52
Year: 1996
Month: 9
X-DOI: 10.2469/faj.v52.n5.2023
File-URL: http://hdl.handle.net/10.2469/faj.v52.n5.2023
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:5:p:45-56




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# input file: UFAJ_A_12046969_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mike Dempsey
Author-X-Name-First: Mike
Author-X-Name-Last: Dempsey
Author-Name: Robert Hudson
Author-X-Name-First: Robert
Author-X-Name-Last: Hudson
Author-Name: Kevin Littler
Author-X-Name-First: Kevin
Author-X-Name-Last: Littler
Author-Name: Kevin Keasey
Author-X-Name-First: Kevin
Author-X-Name-Last: Keasey
Title: On the Risk of Stocks in the Long Run: A Resolution to the Debate?
Abstract: 
 In response to the ongoing debate in this journal about whether the risk of investments in the stock market is increased or decreased by lengthening the investment period, we show that Bodie's attempt to identify market risk with the price of “put” options leads to a circular argument within the workings of arbitrage-free option pricing models. Thus, Bodie failed to rebut the conventional view that longer investment horizons may be thought of as less risky. Bodie's put option prices are relevant, however, to determining “market” prices of stock investment insurance. 
Journal: Financial Analysts Journal
Pages: 57-62
Issue: 5
Volume: 52
Year: 1996
Month: 9
X-DOI: 10.2469/faj.v52.n5.2024
File-URL: http://hdl.handle.net/10.2469/faj.v52.n5.2024
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:5:p:57-62




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# input file: UFAJ_A_12046970_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Brent Ambrose
Author-X-Name-First: Brent
Author-X-Name-Last: Ambrose
Author-Name: Arthur Warga
Author-X-Name-First: Arthur
Author-X-Name-Last: Warga
Title: Yield Bogeys
Abstract: 
 The term “bogey” refers to a target portfolio. In the fixed-income world, it is usually a published index based on some comprehensive list of traded securities. Bogey yields are almost always calculated as the market-value-weighted average of individual component bond yields, but such averages often do a poor job of approximating the actual portfolio yield. Commonly published bogey features such as duration and convexity also are calculated using value-weighted averages, and these measures more nearly approximate the corresponding portfolio values. Thus, the various published bogey characteristics inherently are mismatched. The purpose of this article is to quantify deviations of market-value-weighted bogey yields from actual yield. In some periods, conventionally reported yields have deviated from actual yields by more than 90 basis points. 
Journal: Financial Analysts Journal
Pages: 63-68
Issue: 5
Volume: 52
Year: 1996
Month: 9
X-DOI: 10.2469/faj.v52.n5.2025
File-URL: http://hdl.handle.net/10.2469/faj.v52.n5.2025
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:5:p:63-68




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# input file: UFAJ_A_12046971_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Sanjay K. Nawalkha
Author-X-Name-First: Sanjay K.
Author-X-Name-Last: Nawalkha
Author-Name: Donald R. Chambers
Author-X-Name-First: Donald R.
Author-X-Name-Last: Chambers
Title: An Improved Immunization Strategy: M-Absolute
Abstract: 
 Current immunization models have limited power in interest rate risk protection. A new approach, entitled M-Absolute, is designed to provide powerful and practical single-risk-measure immunization in particular circumstances. M-Absolute is similar to M-Square but is derived as a first-order lower bound immunization risk model. Like duration, M-Absolute can be implemented as a simple, single-risk-measure immunization model. M-Absolute of a bond is defined as the weighted average of the absolute distances of the bond's cash flows from a horizon point. Even though it is a single-risk measure, M-Absolute can act effectively to reduce the impacts of several types of interest rate risks rather than hedge against only a single type of term structure shift. Empirical tests show that M-Absolute reduces the interest rate risk inherent in the traditional duration model by more than half. These results are independent of the particular time period chosen. 
Journal: Financial Analysts Journal
Pages: 69-76
Issue: 5
Volume: 52
Year: 1996
Month: 9
X-DOI: 10.2469/faj.v52.n5.2026
File-URL: http://hdl.handle.net/10.2469/faj.v52.n5.2026
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:5:p:69-76




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# input file: UFAJ_A_12046972_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jakob Sidenius
Author-X-Name-First: Jakob
Author-X-Name-Last: Sidenius
Title: Warrant Pricing—Is Dilution a Delusion?
Abstract: 
 The textbook treatment of warrants takes as a state variable the total equity value of the firm and makes explicit allowance for the effects of equity “dilution” when warrants are exercised. Warrant pricing, however, could just as well be based on the process the stock price follows. This approach leads to a much simpler pricing model into which dilution does not enter, and in fact, a warrant has a value identical to that of the corresponding option. Moreover, valuations based on stock prices are fully consistent with those obtained using the standard equity value approach. In fact, when the comparison is made in a consistent fashion, the warrant prices obtained using the stock price method are identical to the results arising from the textbook method. 
Journal: Financial Analysts Journal
Pages: 77-80
Issue: 5
Volume: 52
Year: 1996
Month: 9
X-DOI: 10.2469/faj.v52.n5.2027
File-URL: http://hdl.handle.net/10.2469/faj.v52.n5.2027
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:5:p:77-80




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# input file: UFAJ_A_12046973_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bruce I. Jacobs
Author-X-Name-First: Bruce I.
Author-X-Name-Last: Jacobs
Author-Name: Kenneth N. Levy
Author-X-Name-First: Kenneth N.
Author-X-Name-Last: Levy
Title: 20 Myths about Long–Short
Abstract: 
 Popular conceptions of long–short investing are distorted by a number of myths, many of which appear to result from viewing long–short from a conventional investment perspective. Long–short portfolios differ fundamentally from long-only portfolios in construction, in the measurement of their risk and return, and in their implementation costs. Furthermore, long–short portfolios allow greater flexibility in security selection, asset allocation, and overall plan structure. 
Journal: Financial Analysts Journal
Pages: 81-85
Issue: 5
Volume: 52
Year: 1996
Month: 9
X-DOI: 10.2469/faj.v52.n5.2028
File-URL: http://hdl.handle.net/10.2469/faj.v52.n5.2028
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:5:p:81-85




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# input file: UFAJ_A_12046974_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Trillion Dollar Promise (a review)
Abstract: 
 Subtitled "An Inside Look at Corporate Pension Money, How It's Managed and for Whose Benefit," this book is a comprehensive presentation-in terms the average pension beneficiary can understand-of the critical issues facing defined-benefit plans. 
Journal: Financial Analysts Journal
Pages: 86-87
Issue: 5
Volume: 52
Year: 1996
Month: 9
X-DOI: 10.2469/faj.v52.n5.2029
File-URL: http://hdl.handle.net/10.2469/faj.v52.n5.2029
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:5:p:86-87




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# input file: UFAJ_A_12046975_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Market Unbound: Unleashing Global Capitalism (a review)
Abstract: 
 This “big-picture” approach to issues related to internationalizing the portfolio provides a wealth of provocative ideas on demographics, globalization of businesses, and integration of financial markets. 
Journal: Financial Analysts Journal
Pages: 87-88
Issue: 5
Volume: 52
Year: 1996
Month: 9
X-DOI: 10.2469/faj.v52.n5.2030
File-URL: http://hdl.handle.net/10.2469/faj.v52.n5.2030
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:5:p:87-88




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# input file: UFAJ_A_12046976_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to the article by Enrique R. Arzac, “Valuation of Highly Leveraged Firms,” which appeared in the July/August issue of this journal. 
Journal: Financial Analysts Journal
Pages: 6-6
Issue: 5
Volume: 52
Year: 1996
Month: 9
X-DOI: 10.2469/faj.v52.n5.2031
File-URL: http://hdl.handle.net/10.2469/faj.v52.n5.2031
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:5:p:6-6




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# input file: UFAJ_A_12046977_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Peter L. Bernstein
Author-X-Name-First: Peter L.
Author-X-Name-Last: Bernstein
Title: What Prompts Paradigm Shifts?
Abstract: 
 Unexpected paradigm shifts are a congenital disease of our economic system. When major business decisions are irreversible and financial markets are forward looking, forecasting is essential. Nevertheless, the future remains hidden. Forecast errors, in both the public and private sectors, are the raw material from which paradigm shifts are fashioned. 
Journal: Financial Analysts Journal
Pages: 7-13
Issue: 6
Volume: 52
Year: 1996
Month: 11
X-DOI: 10.2469/faj.v52.n6.2035
File-URL: http://hdl.handle.net/10.2469/faj.v52.n6.2035
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:6:p:7-13




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# input file: UFAJ_A_12046978_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Pamela A. Smith
Author-X-Name-First: Pamela A.
Author-X-Name-Last: Smith
Author-Name: Cheri L. Reither
Author-X-Name-First: Cheri L.
Author-X-Name-Last: Reither
Title: Comprehensive Income and the Effect of Reporting It
Abstract: 
 In June, the Financial Accounting Standards Board issued an exposure draft on reporting comprehensive income. This article describes components of comprehensive income and applies the provisions of the exposure draft to the 1995 financial information of the top 10 companies from seven industries chosen from the Fortune 1,000 industry listing. 
Journal: Financial Analysts Journal
Pages: 14-19
Issue: 6
Volume: 52
Year: 1996
Month: 11
X-DOI: 10.2469/faj.v52.n6.2036
File-URL: http://hdl.handle.net/10.2469/faj.v52.n6.2036
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:6:p:14-19




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# input file: UFAJ_A_12046979_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Wayne E. Ferson
Author-X-Name-First: Wayne E.
Author-X-Name-Last: Ferson
Author-Name: Vincent A. Warther
Author-X-Name-First: Vincent A.
Author-X-Name-Last: Warther
Title: Evaluating Fund Performance in a Dynamic Market
Abstract: 
 Previous studies show that interest rates, dividend yields, and other commonly available variables are useful market indicators, but until now, measures of fund performance have not used the information. This article modifies classical performance measures to take account of well-known market indicators. The conditional performance evaluation approach avoids some of the biases that plague traditional measures. Applied to a sample of mutual funds, the conditional measures make the funds' performance look better. 
Journal: Financial Analysts Journal
Pages: 20-28
Issue: 6
Volume: 52
Year: 1996
Month: 11
X-DOI: 10.2469/faj.v52.n6.2037
File-URL: http://hdl.handle.net/10.2469/faj.v52.n6.2037
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:6:p:20-28




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# input file: UFAJ_A_12046980_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Claude B. Erb
Author-X-Name-First: Claude B.
Author-X-Name-Last: Erb
Author-Name: Campbell R. Harvey
Author-X-Name-First: Campbell R.
Author-X-Name-Last: Harvey
Author-Name: Tadas E. Viskanta
Author-X-Name-First: Tadas E.
Author-X-Name-Last: Viskanta
Title: Political Risk, Economic Risk, and Financial Risk
Abstract: 
 Given the increasingly global nature of investment portfolios, an understanding of country risk is very important. This article addresses the economic content of five different measures of country risk: four measures from the International Country Risk Guide's political-, financial-, economic-, and composite-risk indexes and one from Institutional Investor's country credit ratings. We explored whether any of these measures contain information about future expected stock returns. We conducted time-series/cross-sectional analysis linking these risk measures to future expected returns. Finally, we analyzed the links between fundamental attributes such as book-to-price ratios within each economy and the risk measures. The results suggest that the country-risk measures are correlated with future equity returns. In addition, such measures are highly correlated with equity valuation measures. This finding provides some insight into the reason that value-oriented strategies generate high average returns. 
Journal: Financial Analysts Journal
Pages: 29-46
Issue: 6
Volume: 52
Year: 1996
Month: 11
X-DOI: 10.2469/faj.v52.n6.2038
File-URL: http://hdl.handle.net/10.2469/faj.v52.n6.2038
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:6:p:29-46




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# input file: UFAJ_A_12046981_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Philippe Jorion
Author-X-Name-First: Philippe
Author-X-Name-Last: Jorion
Title: Risk2: Measuring the Risk in Value at Risk
Abstract: 
 The recent derivatives disasters have focused the attention of the finance industry on the need to control financial risks better. This search has led to a uniform measure of risk called value at risk (VAR), which is the expected worst loss over a given horizon at a given confidence level. VAR numbers, however, are themselves affected by sampling variation, or “estimation risk”—thus, the risk in value at risk itself. Nevertheless, given these limitations, VAR is an indispensable tool to control financial risks. This article lays out the statistical methodology for analyzing estimation error in VAR and shows how to improve the accuracy of VAR estimates. 
Journal: Financial Analysts Journal
Pages: 47-56
Issue: 6
Volume: 52
Year: 1996
Month: 11
X-DOI: 10.2469/faj.v52.n6.2039
File-URL: http://hdl.handle.net/10.2469/faj.v52.n6.2039
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:6:p:47-56




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Author-Name: Edward I. Altman
Author-X-Name-First: Edward I.
Author-X-Name-Last: Altman
Author-Name: Vellore M. Kishore
Author-X-Name-First: Vellore M.
Author-X-Name-Last: Kishore
Title: Almost Everything You Wanted to Know about Recoveries on Defaulted Bonds
Abstract: 
 This study documents, for the first time, the severity of bond defaults stratified by Standard Industrial Classification sector and by debt seniority. The highest average recoveries came from public utilities (70 percent) and chemical, petroleum, and related products (63 percent). The differences between those sectors and all the rest are statistically significant, even when adjusted for seniority. The original rating of a bond issue as investment grade or below investment grade has virtually no effect on recoveries once seniority is accounted for. In addition, neither the size of the issue nor the time to default from its original date of issuance has any association with the recovery rate. These results should provide important information for investors as well as analysts. 
Journal: Financial Analysts Journal
Pages: 57-64
Issue: 6
Volume: 52
Year: 1996
Month: 11
X-DOI: 10.2469/faj.v52.n6.2040
File-URL: http://hdl.handle.net/10.2469/faj.v52.n6.2040
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:6:p:57-64




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# input file: UFAJ_A_12046983_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Lucie Chaumeton
Author-X-Name-First: Lucie
Author-X-Name-Last: Chaumeton
Author-Name: Gregory Connor
Author-X-Name-First: Gregory
Author-X-Name-Last: Connor
Author-Name: Ross Curds
Author-X-Name-First: Ross
Author-X-Name-Last: Curds
Title: A Global Stock and Bond Model
Abstract: 
 Six fundamental risk factors (four for stocks and two for bonds) explain most of the common volatility of individual stocks and bonds worldwide. Some of the risk factors have a strong international component, and others are more purely national. The cross-national component of the risk factors tends to be stronger within the European Union than worldwide. The model proposed in this article can be used for integration of worldwide asset selection and asset allocation decisions. 
Journal: Financial Analysts Journal
Pages: 65-74
Issue: 6
Volume: 52
Year: 1996
Month: 11
X-DOI: 10.2469/faj.v52.n6.2041
File-URL: http://hdl.handle.net/10.2469/faj.v52.n6.2041
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:6:p:65-74




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# input file: UFAJ_A_12046984_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Michael J. Barclay
Author-X-Name-First: Michael J.
Author-X-Name-Last: Barclay
Author-Name: Craig G. Dunbar
Author-X-Name-First: Craig G.
Author-X-Name-Last: Dunbar
Title: Private Information and the Costs of Trading around Quarterly Earnings Announcements
Abstract: 
 No one wants to trade with those who have better information. In markets where traders have asymmetric information, however, both informed and uninformed traders must make strategic trading decisions. Because public announcements can affect the information asymmetry between traders, these strategic decisions are likely to be most important around public announcements. How concerned should uninformed traders be about the potential information asymmetry when trading around public announcements? Surprisingly, whether for large-block trades or for the entire order flow, there is no evidence that the uninformed can trade on more favorable terms by varying the timing of their trades in relation to a quarterly earnings announcement. 
Journal: Financial Analysts Journal
Pages: 75-84
Issue: 6
Volume: 52
Year: 1996
Month: 11
X-DOI: 10.2469/faj.v52.n6.2042
File-URL: http://hdl.handle.net/10.2469/faj.v52.n6.2042
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:6:p:75-84




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# input file: UFAJ_A_12046985_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Howard M. Saunders
Author-X-Name-First: Howard M.
Author-X-Name-Last: Saunders
Title: Valuation Indicators
Abstract: 
 This material comments on “Stock Market Valuation Indicators: Is This Time Different?”.
Journal: Financial Analysts Journal
Pages: 85-87
Issue: 6
Volume: 52
Year: 1996
Month: 11
X-DOI: 10.2469/faj.v52.n6.2043
File-URL: http://hdl.handle.net/10.2469/faj.v52.n6.2043
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Handle: RePEc:taf:ufajxx:v:52:y:1996:i:6:p:85-87




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# input file: UFAJ_A_12046986_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Charles D. Ellis
Author-X-Name-First: Charles D.
Author-X-Name-Last: Ellis
Title: Small Slam!
Abstract: 
 Because a strong offense is the best defense in any free market, investment managers may be contributing inadvertently to their portfolios' disappointing performance through excessive diversification — and the consequent dispersion of attention that might achieve superior results if focused on playing to win instead of “playing to play.” 
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 1
Volume: 53
Year: 1997
Month: 1
X-DOI: 10.2469/faj.v53.n1.2050
File-URL: http://hdl.handle.net/10.2469/faj.v53.n1.2050
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# input file: UFAJ_A_12046987_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Michael S. Caccese
Author-X-Name-First: Michael S.
Author-X-Name-Last: Caccese
Title: Ethics and the Financial Analyst
Abstract: 
 Ethics is becoming an increasingly important aspect of our business and professional concerns. One reason is a growing emphasis on personal responsibility. Another is that ethical practices are good business. 
Journal: Financial Analysts Journal
Pages: 9-14
Issue: 1
Volume: 53
Year: 1997
Month: 1
X-DOI: 10.2469/faj.v53.n1.2051
File-URL: http://hdl.handle.net/10.2469/faj.v53.n1.2051
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:1:p:9-14




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# input file: UFAJ_A_12046988_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: John Dobson
Author-X-Name-First: John
Author-X-Name-Last: Dobson
Title: Ethics in Finance II
Abstract: 
 The best way to approach professional ethics, whether in the finance profession or elsewhere, is from the perspective of virtue-ethics theory. This theory places particular emphasis on the character and motivations of an individual professional and on the organizational community in which the individual acts. This article extends and clarifies the central argument of an earlier article on financial ethics. Several real-world examples illustrate the role of virtue ethics in professionalism. 
Journal: Financial Analysts Journal
Pages: 15-25
Issue: 1
Volume: 53
Year: 1997
Month: 1
X-DOI: 10.2469/faj.v53.n1.2052
File-URL: http://hdl.handle.net/10.2469/faj.v53.n1.2052
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:1:p:15-25




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# input file: UFAJ_A_12046989_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Maribeth Coller
Author-X-Name-First: Maribeth
Author-X-Name-Last: Coller
Author-Name: Julia L. Higgs
Author-X-Name-First: Julia L.
Author-X-Name-Last: Higgs
Title: Firm Valuation and Accounting for Employee Stock Options
Abstract: 
 The Financial Accounting Standards Board has issued a new standard changing the accounting treatment for employee stock options. For some firms, the new method may significantly affect the bottom line. Although seeking to require better recognition of an important item, the new standard also leaves much room for individual judgment in determining the amount of that item. We apply the new standard to six publicly traded corporations and demonstrate that, in some cases, significant differences in valuation may result when different, yet equally acceptable, calculation methods are used. As a result, financial statements of firms using the new standard should be interpreted with caution. 
Journal: Financial Analysts Journal
Pages: 26-34
Issue: 1
Volume: 53
Year: 1997
Month: 1
X-DOI: 10.2469/faj.v53.n1.2053
File-URL: http://hdl.handle.net/10.2469/faj.v53.n1.2053
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:1:p:26-34




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# input file: UFAJ_A_12046990_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David F. Babbel
Author-X-Name-First: David F.
Author-X-Name-Last: Babbel
Author-Name: Craig Merrill
Author-X-Name-First: Craig
Author-X-Name-Last: Merrill
Author-Name: William Panning
Author-X-Name-First: William
Author-X-Name-Last: Panning
Title: Default Risk and the Effective Duration of Bonds
Abstract: 
 Default risk creates difficulties for fixed-income portfolio managers in measuring a portfolio's exposure to interest rate risk. It also heightens the anxiety of traders and arbitragers who are hedging their investments, and it compounds financial institutions' problem of matching assets and liabilities. The consensus among researchers is that credit risk shortens the effective duration of corporate bonds. This paper provides estimates of how much shorter durations become because of credit risk. These estimates are based on observable data and easily estimated bond pricing parameters. Because the duration measures are taken with respect to movements in a common reference rate of interest, they can be used with greater confidence than can other measures when attempting to compute the duration of a portfolio of bonds subject to varying degrees of credit risk. 
Journal: Financial Analysts Journal
Pages: 35-44
Issue: 1
Volume: 53
Year: 1997
Month: 1
X-DOI: 10.2469/faj.v53.n1.2054
File-URL: http://hdl.handle.net/10.2469/faj.v53.n1.2054
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:1:p:35-44




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# input file: UFAJ_A_12046991_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: William H. Beaver
Author-X-Name-First: William H.
Author-X-Name-Last: Beaver
Author-Name: Stephen G. Ryan
Author-X-Name-First: Stephen G.
Author-X-Name-Last: Ryan
Author-Name: James M. Wahlen
Author-X-Name-First: James M.
Author-X-Name-Last: Wahlen
Title: When Is “Bad News” Viewed as “Good News”?
Abstract: 
 Recent research has shown that discretionary loan loss provisions are positively associated with bank stock returns and future earnings. The good news signaled by discretionary provisions is most prominent for banks with greater incentive to signal good news (e.g., low-regulatory-capital banks with potential loan default problems); for banks with greater degrees of accounting discretion over the loan loss provision (e.g., banks with portfolios with a high proportion of commercial loans); and for provisions in the fourth quarter, which is audited. Banks with low regulatory capital that record large fourth-quarter loan loss provisions adopt more-conservative future loan growth strategies and generate substantial improvement in future earnings. These results suggest that bank managers increase discretionary provisions to signal “good news” about future earnings and that increased discretionary provisions are associated with other, less observable management actions that increase the value of the bank. 
Journal: Financial Analysts Journal
Pages: 45-54
Issue: 1
Volume: 53
Year: 1997
Month: 1
X-DOI: 10.2469/faj.v53.n1.2055
File-URL: http://hdl.handle.net/10.2469/faj.v53.n1.2055
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:1:p:45-54




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# input file: UFAJ_A_12046992_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Shmuel Hauser
Author-X-Name-First: Shmuel
Author-X-Name-Last: Hauser
Author-Name: Beni Lauterbach
Author-X-Name-First: Beni
Author-X-Name-Last: Lauterbach
Title: The Relative Performance of Five Alternative Warrant Pricing Models
Abstract: 
 Five warrant pricing models are examined in this study: a pair based on the Black–Scholes model, a pair based on the constant elasticity of variance (CEV) modification, and an extendible-warrant model (à la Longstaff). Based on more than 20,000 warrant price observations, the flexible-exponent CEV model generates the lowest average absolute pricing error in most of the warrants examined. The dilution-adjusted Black–Scholes model, however, remains a reasonable, economical alternative in many cases. 
Journal: Financial Analysts Journal
Pages: 55-61
Issue: 1
Volume: 53
Year: 1997
Month: 1
X-DOI: 10.2469/faj.v53.n1.2056
File-URL: http://hdl.handle.net/10.2469/faj.v53.n1.2056
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:1:p:55-61




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# input file: UFAJ_A_12046993_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David R. Beaglehole
Author-X-Name-First: David R.
Author-X-Name-Last: Beaglehole
Author-Name: Philip H. Dybvig
Author-X-Name-First: Philip H.
Author-X-Name-Last: Dybvig
Author-Name: Guofu Zhou
Author-X-Name-First: Guofu
Author-X-Name-Last: Zhou
Title: Going to Extremes: Correcting Simulation Bias in Exotic Option Valuation
Abstract: 
 Monte Carlo simulation is widely used in practice to value exotic options for which analytical formulas are not available. When valuing those options that depend on extreme values of the underlying asset, convergence of the standard simulation is slow as the time grid is refined, and even a daily simulation interval produces unacceptable errors. This article suggests approximating the extreme value on a subinterval by a random draw from the known theoretical distribution for an extreme of a Brownian bridge on the same interval. This approach provides reliable option values and retains the flexibility of simulations, in that it allows great freedom in choosing a price process for the underlying asset or a joint process for the asset price, its volatility, and other asset prices. 
Journal: Financial Analysts Journal
Pages: 62-68
Issue: 1
Volume: 53
Year: 1997
Month: 1
X-DOI: 10.2469/faj.v53.n1.2057
File-URL: http://hdl.handle.net/10.2469/faj.v53.n1.2057
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:1:p:62-68




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# input file: UFAJ_A_12046994_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time (a review)
Abstract: 
 Through a systematic investigation of Compustat data, the author documents several anomalies in equity investing and in plain, no-nonsense prose, explores his essential assumption that history is a reliable guide to the future. 
Journal: Financial Analysts Journal
Pages: 69-70
Issue: 1
Volume: 53
Year: 1997
Month: 1
X-DOI: 10.2469/faj.v53.n1.2058
File-URL: http://hdl.handle.net/10.2469/faj.v53.n1.2058
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:1:p:69-70




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# input file: UFAJ_A_12046995_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Financial Services Revolution: Understanding the Changing Role of Banks, Mutual Funds, and Insurance Companies (a review)
Abstract: 
 Written primarily by lawyers, this overview gives an up-to-date report on the state of financial services-on the provider side and the regulatory side. It provides a clear understanding of the problems created or exacerbated by change and weighs the merits of proposed solutions. 
Journal: Financial Analysts Journal
Pages: 70-71
Issue: 1
Volume: 53
Year: 1997
Month: 1
X-DOI: 10.2469/faj.v53.n1.2059
File-URL: http://hdl.handle.net/10.2469/faj.v53.n1.2059
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:1:p:70-71




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# input file: UFAJ_A_12046996_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Don M. Chance
Author-X-Name-First: Don M.
Author-X-Name-Last: Chance
Title: A Derivative Alternative as Executive Compensation
Abstract: 
 Forward contracts are superior to options as executive compensation. Forward contracts require the executive to purchase the stock, have no value when issued, and are easily valued during their lives. They provide the same incentives as stock but without the right to vote, which limits the executive's influence over the board. 
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 2
Volume: 53
Year: 1997
Month: 3
X-DOI: 10.2469/faj.v53.n2.2065
File-URL: http://hdl.handle.net/10.2469/faj.v53.n2.2065
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:2:p:6-8




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# input file: UFAJ_A_12046997_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Michael S. Caccese
Author-X-Name-First: Michael S.
Author-X-Name-Last: Caccese
Title: Insider Trading Laws and the Role of Securities Analysts
Abstract: 
 To maintain a fair and open market, the use of nonpublic material information is generally prohibited by law or regulation. Financial analysts, whose profession depends upon gathering and processing information about companies, need to scrupulously avoid receiving, communicating, and trading on “insider” information. 
Journal: Financial Analysts Journal
Pages: 9-12
Issue: 2
Volume: 53
Year: 1997
Month: 3
X-DOI: 10.2469/faj.v53.n2.2066
File-URL: http://hdl.handle.net/10.2469/faj.v53.n2.2066
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:2:p:9-12




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# input file: UFAJ_A_12046998_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Lawrence D. Brown
Author-X-Name-First: Lawrence D.
Author-X-Name-Last: Brown
Title: Earnings Surprise Research: Synthesis and Perspectives
Abstract: 
 An investigation of the relation between earnings surprise and three empirical anomalies—the P/E effect, the size effect, and the Value Line enigma—indicates that the standardized unexpected earnings (SUE) effect appears to be separate and distinct from each of the three. The relations between the SUE phenomenon and firm risk, the appropriateness of the earnings expectations model, and the role of transaction costs are also investigated. The SUE phenomenon is not attributable to inappropriate risk adjustment, use of the “wrong” earnings expectations model, or ignoring transaction costs. The SUE effect may be partly explained by analysts' behavior and is both predictable and profitable. The SUE effect has also been observed in Japan. 
Journal: Financial Analysts Journal
Pages: 13-19
Issue: 2
Volume: 53
Year: 1997
Month: 3
X-DOI: 10.2469/faj.v53.n2.2067
File-URL: http://hdl.handle.net/10.2469/faj.v53.n2.2067
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:2:p:13-19




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# input file: UFAJ_A_12046999_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Peter L. Bernstein
Author-X-Name-First: Peter L.
Author-X-Name-Last: Bernstein
Title: What Rate of Return Can You Reasonably Expect… or What Can the Long Run Tell Us about the Short Run?
Abstract: 
 Conventional studies of long-run returns on capital market assets, because of changes in valuation between the starting date and the ending date, obscure the basic return each asset earns. Consequently, both absolute returns and measured risk premiums are distorted. The basic return can be extracted by selecting widely separated dates with identical valuation levels. Over nearly 200 years, the analysis for equities produced 63 episodes averaging 35 years with a mean nominal basic return of 9.6 percent and standard deviation of 1.6 percent; 63 bond episodes averaging 43 years produced a mean nominal basic return of 4.9 percent and standard deviation of 2.3 percent. Equities revealed a tendency to regress to the mean over time, but no such tendency was apparent in the bond data. Thus, long-run equity returns were more predictable than long-run bond returns. This conclusion applies with even greater force to real returns. 
Journal: Financial Analysts Journal
Pages: 20-28
Issue: 2
Volume: 53
Year: 1997
Month: 3
X-DOI: 10.2469/faj.v53.n2.2068
File-URL: http://hdl.handle.net/10.2469/faj.v53.n2.2068
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:2:p:20-28




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Author-Name: Clifford S. Asness
Author-X-Name-First: Clifford S.
Author-X-Name-Last: Asness
Title: The Interaction of Value and Momentum Strategies
Abstract: 
 Value and momentum strategies both have demonstrated power to predict the cross-section of stock returns, but are these strategies related? Measures of momentum and value are negatively correlated across stocks, yet each is positively related to the cross-section of average stock returns. We examine whether the marginal power of value or momentum differs depending upon the level of the other variable. Value strategies work, in general, but are strongest among low-momentum (loser) stocks and weakest among high-momentum (winner) stocks. The momentum strategy works, in general, but is particularly strong among low-value (expensive) stocks. These results hold despite finding comparable spreads in value measures among stocks with different levels of momentum and comparable spreads in the momentum measure among stocks with different levels of value. Any explanation for why value and momentum work must explain this interaction. 
Journal: Financial Analysts Journal
Pages: 29-36
Issue: 2
Volume: 53
Year: 1997
Month: 3
X-DOI: 10.2469/faj.v53.n2.2069
File-URL: http://hdl.handle.net/10.2469/faj.v53.n2.2069
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:2:p:29-36




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# input file: UFAJ_A_12047001_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Edward S. O'Neal
Author-X-Name-First: Edward S.
Author-X-Name-Last: O'Neal
Title: How Many Mutual Funds Constitute a Diversified Mutual Fund Portfolio?
Abstract: 
 Can investors receive diversification benefits from holding more than a single mutual fund in their portfolios? Simulation analysis shows that the time-series diversification benefits are minimal but that the expected dispersion in terminal-period wealth can be substantially reduced by holding multiple funds. Portfolios with as few as four growth funds halve the dispersion in terminal-period wealth for 5- to 19-year holding periods. In addition, downside risk measures decline as funds are added to portfolios. These advantages to multiple-fund portfolios are especially meaningful for investors funding fixed-horizon investment goals such as retirement or college savings. 
Journal: Financial Analysts Journal
Pages: 37-46
Issue: 2
Volume: 53
Year: 1997
Month: 3
X-DOI: 10.2469/faj.v53.n2.2070
File-URL: http://hdl.handle.net/10.2469/faj.v53.n2.2070
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:2:p:37-46




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# input file: UFAJ_A_12047002_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark L. Gold
Author-X-Name-First: Mark L.
Author-X-Name-Last: Gold
Author-Name: Chad A. Leat
Author-X-Name-First: Chad A.
Author-X-Name-Last: Leat
Author-Name: Michel Perrin
Author-X-Name-First: Michel
Author-X-Name-Last: Perrin
Title: Senior Secured Floating-Rate Bank Loans for Life Insurance Company Investment Portfolios
Abstract: 
 The historical perception by life insurance companies has been that spreads obtained in the senior secured loan market have tended to be insufficient on a credit spread basis to justify the investment. An analysis based solely on credit spreads, however, would be insufficient. The return impact on a portfolio with respect to the inclusion of senior secured loans must include an analysis of credit risk in the context of change in interest rates, which may more than offset yield shortfall. An asset/liability efficient frontier technique is used to compare the return and risk characteristics of fixed-income investment strategies with a blend of senior secured bank loans and fixed-income investments. Cash flows were projected across stochastic interest rate scenarios, and a generic single-premium deferred annuity product was modeled as the liability. The quantitative analysis conforms to intuitive expectations and illustrates that using senior secured loans in an investment portfolio tends to reduce financial risk for life insurance companies. 
Journal: Financial Analysts Journal
Pages: 47-54
Issue: 2
Volume: 53
Year: 1997
Month: 3
X-DOI: 10.2469/faj.v53.n2.2071
File-URL: http://hdl.handle.net/10.2469/faj.v53.n2.2071
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:2:p:47-54




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Author-Name: Stephen R. Mull
Author-X-Name-First: Stephen R.
Author-X-Name-Last: Mull
Author-Name: Luc A. Soenen
Author-X-Name-First: Luc A.
Author-X-Name-Last: Soenen
Title: U.S. REITs as an Asset Class in International Investment Portfolios
Abstract: 
 An examination of U.S. real estate investment trust (REIT) efficiency as a portfolio component from the perspective of all G-7 countries for the period 1985 through 1994 indicates that U.S. REITs offer both an inflation hedge and diversification. Nevertheless, including REITs in test portfolios did not yield statistically significant increases in risk-adjusted return over the period as a whole. Subperiod analyses indicated large temporal differences in REIT efficiency as a portfolio component. 
Journal: Financial Analysts Journal
Pages: 55-61
Issue: 2
Volume: 53
Year: 1997
Month: 3
X-DOI: 10.2469/faj.v53.n2.2072
File-URL: http://hdl.handle.net/10.2469/faj.v53.n2.2072
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Author-Name: Robert A. Olsen
Author-X-Name-First: Robert A.
Author-X-Name-Last: Olsen
Title: Investment Risk: The Experts' Perspective
Abstract: 
 Investment management requires managers and their clients to share a general definition of investment risk. Professional portfolio managers and individual investors also seem to share a common conception of investment risk. Specifically, investment risk, as well as risk in other decision domains, appears to be a function of four attributes: the potential for a large loss, the potential for a below-target return, the feeling of control, and the perceived level of knowledge. Based on a survey study, these risk factors explained approximately 77 percent of the variation in security returns between 1965 and 1990. 
Journal: Financial Analysts Journal
Pages: 62-66
Issue: 2
Volume: 53
Year: 1997
Month: 3
X-DOI: 10.2469/faj.v53.n2.2073
File-URL: http://hdl.handle.net/10.2469/faj.v53.n2.2073
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Author-Name: Edward Renshaw
Author-X-Name-First: Edward
Author-X-Name-Last: Renshaw
Title: Will Stocks Continue to Outperform Bonds in the Future?
Abstract: 
 Valuation of the earnings and dividends associated with the S&P 500 Composite Stock Price Index has changed over time. These changes, in conjunction with record amounts of retirement money that are now being funneled into mutual funds and wider fluctuations in the price of corporate bonds, suggest that the earnings and dividend price ratios for representative stock market averages may someday be reduced to the point where the before-tax returns on equities will not be greater than the returns on corporate bonds. 
Journal: Financial Analysts Journal
Pages: 67-73
Issue: 2
Volume: 53
Year: 1997
Month: 3
X-DOI: 10.2469/faj.v53.n2.2074
File-URL: http://hdl.handle.net/10.2469/faj.v53.n2.2074
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# input file: UFAJ_A_12047006_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Against the Gods: The Remarkable Story of Risk (a review)
Abstract: 
 This fascinating book recounts the long history of miscalculations in dealing with risk. 
Journal: Financial Analysts Journal
Pages: 74-74
Issue: 2
Volume: 53
Year: 1997
Month: 3
X-DOI: 10.2469/faj.v53.n2.2075
File-URL: http://hdl.handle.net/10.2469/faj.v53.n2.2075
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# input file: UFAJ_A_12047007_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin F. Fridson
Author-X-Name-First: Martin F.
Author-X-Name-Last: Fridson
Title: Fat and Mean: The Corporate Squeeze of Working Americans and the Myth of Managerial Downsizing (a review)
Abstract: 
 This book defines and measures the problem of unproductive bureaucracy in businesses. 
Journal: Financial Analysts Journal
Pages: 75-75
Issue: 2
Volume: 53
Year: 1997
Month: 3
X-DOI: 10.2469/faj.v53.n2.2076
File-URL: http://hdl.handle.net/10.2469/faj.v53.n2.2076
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:2:p:75-75




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Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Title: Reclaiming Shareholder Power
Abstract: 
 A new approach to empowering shareholders relies on control of the corporate purse strings rather than the proxy ballot. Corporations would be taxed on the conduit principle; that is, they would pay no taxes providing they distributed all of their earnings to shareholders, who after paying taxes on them, could reinvest them wherever they chose. 
Journal: Financial Analysts Journal
Pages: 7-10
Issue: 3
Volume: 53
Year: 1997
Month: 5
X-DOI: 10.2469/faj.v53.n3.2080
File-URL: http://hdl.handle.net/10.2469/faj.v53.n3.2080
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Author-Name: Jeffrey M. Bacidore
Author-X-Name-First: Jeffrey M.
Author-X-Name-Last: Bacidore
Author-Name: John A. Boquist
Author-X-Name-First: John A.
Author-X-Name-Last: Boquist
Author-Name: Todd T. Milbourn
Author-X-Name-First: Todd T.
Author-X-Name-Last: Milbourn
Author-Name: Anjan V. Thakor
Author-X-Name-First: Anjan V.
Author-X-Name-Last: Thakor
Title: The Search for the Best Financial Performance Measure
Abstract: 
 Refined economic value added (REVA) provides an analytical framework for evaluating operating performance measures in the context of shareholder value creation. Economic value added (EVA) performs quite well in terms of its correlation with shareholder value creation, but REVA is a theoretically superior measure for assessing whether a firm's operating performance is adequate from the standpoint of compensating the firm's financiers for the risk to their capital. In this article, comprehensive statistical analysis of both REVA and EVA is used to estimate their correlation with and their ability to predict shareholder value creation. REVA statistically outperforms EVA in this regard. Moreover, the realized returns for the 1988–92 period for the top 25 REVA firms were higher than the realized returns for the top 25 EVA firms. 
Journal: Financial Analysts Journal
Pages: 11-20
Issue: 3
Volume: 53
Year: 1997
Month: 5
X-DOI: 10.2469/faj.v53.n3.2081
File-URL: http://hdl.handle.net/10.2469/faj.v53.n3.2081
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Author-Name: Daniel C. Quan
Author-X-Name-First: Daniel C.
Author-X-Name-Last: Quan
Author-Name: Sheridan Titman
Author-X-Name-First: Sheridan
Author-X-Name-Last: Titman
Title: Commercial Real Estate Prices and Stock Market Returns: An International Analysis
Abstract: 
 The movement toward globalization of institutional investments requires an understanding of the historical relationship between international commercial real estate price changes and stock returns. Previous studies have focused on the time series of stock and real estate returns, using data from a single country. By necessity, these studies examined returns and price changes over short intervals, creating a bias when property values are smoothed from year to year. This study examines the relation between stock returns and changes in property values and rents based on data from 17 countries. Although we find no relation between real estate values and rents and stock returns in the United States, we find significant relations in a number of other countries. When the data are pooled, the relation between stock returns and both value changes and changes in rental rates is very strong. 
Journal: Financial Analysts Journal
Pages: 21-34
Issue: 3
Volume: 53
Year: 1997
Month: 5
X-DOI: 10.2469/faj.v53.n3.2082
File-URL: http://hdl.handle.net/10.2469/faj.v53.n3.2082
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Author-Name: Gailen Hite
Author-X-Name-First: Gailen
Author-X-Name-Last: Hite
Author-Name: Arthur Warga
Author-X-Name-First: Arthur
Author-X-Name-Last: Warga
Title: The Effect of Bond-Rating Changes on Bond Price Performance
Abstract: 
 The price reaction of publicly traded industrial bonds to Moody's Investors Service and Standard & Poor's bond-rating changes is investigated using a database of month-end trader quotes from Lehman Brothers for March 1985 through March 1995. All Standard & Poor's and Moody's rating changes are studied in a period from up to 12 months before the rating change to 12 months after. A unique feature of this study is the use of a data set containing recent firm-specific information that also provides a long event window. Downgraded firms reveal a significant announcement effect in both the announcement month and preannouncement period. The magnitude of downgrading effects increases dramatically as the sample moves from investment-grade to non-investment-grade firms. Samples that are restricted to rating changes that are not preceded by any rerating within six months reveal that the market reacts reliably as much as six months before an event. Upgrade effects are much weaker in magnitude and significance. 
Journal: Financial Analysts Journal
Pages: 35-51
Issue: 3
Volume: 53
Year: 1997
Month: 5
X-DOI: 10.2469/faj.v53.n3.2083
File-URL: http://hdl.handle.net/10.2469/faj.v53.n3.2083
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:3:p:35-51




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Author-Name: Joseph R. Gordon
Author-X-Name-First: Joseph R.
Author-X-Name-Last: Gordon
Author-Name: Myron J. Gordon
Author-X-Name-First: Myron J.
Author-X-Name-Last: Gordon
Title: The Finite Horizon Expected Return Model
Abstract: 
 The finite horizon expected return model (FHERM), a new method for estimating the expected return on a share, states that (1) forecasts of abnormal performance have a finite horizon, N, beyond which investors expect a corporation to earn for all future time a return on equity investment equal to the expected return on its shares; and (2) the expected return on a share is the discount rate that equates the share's current price with a dividend expectation for which the dividend in each period from 1 to N is equal to its forecast and the dividend in each period from N + 1 to infinity is equal to the forecast for normalized earnings in Period N + 1. The capital asset pricing model (CAPM) states that the expected return on a share varies with beta and dividend yield, but empirical tests of the CAPM using previous methods for estimating expected return have failed. Empirical evidence strongly supports the joint hypothesis that the FHERM and the CAPM are both true. 
Journal: Financial Analysts Journal
Pages: 52-61
Issue: 3
Volume: 53
Year: 1997
Month: 5
X-DOI: 10.2469/faj.v53.n3.2084
File-URL: http://hdl.handle.net/10.2469/faj.v53.n3.2084
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:3:p:52-61




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Author-Name: Ajay Khorana
Author-X-Name-First: Ajay
Author-X-Name-Last: Khorana
Author-Name: Edward Nelling
Author-X-Name-First: Edward
Author-X-Name-Last: Nelling
Title: The Performance, Risk, and Diversification of Sector Funds
Abstract: 
 Sector funds' self-imposed limits on diversification have both costs and benefits. Sector funds tend to perform as well as other equity funds, but their performance tends to be sensitive to the benchmark that is used. In addition, sector-fund managers do not exhibit any significant persistence in performance. Although sector funds tend to be moderately less diversified than other equity funds, they do not entail greater systematic risk. Sector funds exhibit larger total risk than the control sample, but they are not any riskier than small-cap and aggressive-growth funds. Factor analysis results provide evidence that variation in sector-fund returns can be attributed to two common underlying factors, and the primary factor appears to be the return on the market index. 
Journal: Financial Analysts Journal
Pages: 62-74
Issue: 3
Volume: 53
Year: 1997
Month: 5
X-DOI: 10.2469/faj.v53.n3.2085
File-URL: http://hdl.handle.net/10.2469/faj.v53.n3.2085
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:3:p:62-74




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Author-Name: Sandip Mukherji
Author-X-Name-First: Sandip
Author-X-Name-Last: Mukherji
Author-Name: Manjeet S. Dhatt
Author-X-Name-First: Manjeet S.
Author-X-Name-Last: Dhatt
Author-Name: Yong H. Kim
Author-X-Name-First: Yong H.
Author-X-Name-Last: Kim
Title: A Fundamental Analysis of Korean Stock Returns
Abstract: 
 Korea has one of the largest stock markets in the world and is in the process of being opened to foreign investors. In an investigation of the relations between stock returns and fundamental variables in Korea, annual stock returns during the 1982–93 period were positively related to book–market, sales–price, and debt–equity ratios, negatively related to firm size, and not significantly related to the earnings–price ratio or beta. These results add to the growing international evidence that value stocks outperform growth stocks over long periods. Also for Korean stocks, book–market and sales–price ratios are more efficient indicators of value than the earnings–price ratio, and the debt–equity ratio is a more reliable proxy for risk than beta. 
Journal: Financial Analysts Journal
Pages: 75-80
Issue: 3
Volume: 53
Year: 1997
Month: 5
X-DOI: 10.2469/faj.v53.n3.2086
File-URL: http://hdl.handle.net/10.2469/faj.v53.n3.2086
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:3:p:75-80




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Author-Name: John S. Brush
Author-X-Name-First: John S.
Author-X-Name-Last: Brush
Title: Comparisons and Combinations of Long and Long/Short Strategies
Abstract: 
 Market-neutral long/short strategies get their returns from alphas and short rebates; long strategies get their returns from alpha and the market. Differing return and risk sources complicate their comparison, partly because of the strong market-referenced focus of conventional performance analysis. Compelling theoretical advantages of active return per unit of active risk suggest that long/short strategies are better able to deliver excess return than are conventional institutional long strategies. Long/short strategies, even with tiny positive alphas, are seen to improve investors' efficient frontiers when added to a traditional T-bill/long portfolio mix, mostly because their risk sources are uncorrelated. Surprisingly, the improvement occurs even if long/short strategies are Sharpe-ratio inferior to long strategies. These results provide theoretical support for including long/short strategies in most investors' mix of assets. 
Journal: Financial Analysts Journal
Pages: 81-89
Issue: 3
Volume: 53
Year: 1997
Month: 5
X-DOI: 10.2469/faj.v53.n3.2087
File-URL: http://hdl.handle.net/10.2469/faj.v53.n3.2087
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:3:p:81-89




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# input file: UFAJ_A_12047016_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Financial Warnings (a review)
Abstract: 
 This book provides an encyclopedic checklist for the early detection of negative earnings surprises, including quantitative and time-tested qualitative danger signals. 
Journal: Financial Analysts Journal
Pages: 90-91
Issue: 3
Volume: 53
Year: 1997
Month: 5
X-DOI: 10.2469/faj.v53.n3.2088
File-URL: http://hdl.handle.net/10.2469/faj.v53.n3.2088
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:3:p:90-91




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# input file: UFAJ_A_12047017_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Institutional Investors and Corporate Governance (a review)
Abstract: 
 This book offers advice to corporate managers and investors on working together for their mutual benefit and describes the efforts of some giant institutional investors to transform the proxy system from a meaningless ritual to a mechanism for protecting stockholders' interests. 
Journal: Financial Analysts Journal
Pages: 91-93
Issue: 3
Volume: 53
Year: 1997
Month: 5
X-DOI: 10.2469/faj.v53.n3.2089
File-URL: http://hdl.handle.net/10.2469/faj.v53.n3.2089
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:3:p:91-93




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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: The Structure of the Investment-Management Industry: Revisiting the New Paradigm
Abstract: 
 Will a new paradigm of investment management lead to concentration of the money management business? Will the merger trend continue? Will fees decline? And what accounts for product proliferation in an industry that struggles to deliver on the implied promise of its products? Answers—some that may surprise—to these questions and more. 
Journal: Financial Analysts Journal
Pages: 6-13
Issue: 4
Volume: 53
Year: 1997
Month: 7
X-DOI: 10.2469/faj.v53.n4.2095
File-URL: http://hdl.handle.net/10.2469/faj.v53.n4.2095
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:4:p:6-13




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Author-Name: Claude B. Erb
Author-X-Name-First: Claude B.
Author-X-Name-Last: Erb
Author-Name: Campbell R. Harvey
Author-X-Name-First: Campbell R.
Author-X-Name-Last: Harvey
Author-Name: Tadas E. Viskanta
Author-X-Name-First: Tadas E.
Author-X-Name-Last: Viskanta
Title: Demographics and International Investments
Abstract: 
 Population demographics affect both the time-series and the cross-section of expected asset returns. A number of theories link the average age of a population to expected market returns. For example, Bakshi and Chen argue that an older population will demand a higher premium on equity investment because older people are more risk averse than younger people. We contend that, in an international context, population demographics are likely to reveal information about the risk exposure of a particular country. Our evidence supports the risk hypothesis. 
Journal: Financial Analysts Journal
Pages: 14-28
Issue: 4
Volume: 53
Year: 1997
Month: 7
X-DOI: 10.2469/faj.v53.n4.2096
File-URL: http://hdl.handle.net/10.2469/faj.v53.n4.2096
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:4:p:14-28




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Author-Name: Robert M. Conroy
Author-X-Name-First: Robert M.
Author-X-Name-Last: Conroy
Author-Name: Yujiro Fukuda
Author-X-Name-First: Yujiro
Author-X-Name-Last: Fukuda
Author-Name: Robert S. Harris
Author-X-Name-First: Robert S.
Author-X-Name-Last: Harris
Title: Securities Houses and Earnings Forecasts in Japan: What Makes for an Accurate Prediction?
Abstract: 
 Financial analysts' earnings forecasts in Japan show a steady improvement in accuracy as the year progresses. Moreover, echoing results in the United States, sell-side forecasts in Japan are overly optimistic. Although no single security house emerges clearly as the most accurate forecaster, Japanese houses produce more accurate forecasts than Western houses operating in Japan. The improved accuracy appears to result from a better gauge of company information at the end of the fiscal year and is not restricted to Japanese houses with investment banking links to the firm being forecast. Overly bullish forecasts seem to pervade both Japanese and Western houses, but if anything, Japanese houses are less optimistic than their Western counterparts. The evidence suggests a blend of informational and incentive effects. Incentives for sell-side analysts may contribute to overly optimistic forecasts and may be most pronounced for a security house that is a firm's main investment bank. In searching for accurate forecasts, using last year's forecast errors offers no significant advantages in picking a best forecaster for the current year. Moreover, a consensus average forecast does not yield significantly smaller mean forecast errors than a strategy of picking a single forecaster at random. This result suggests that forecasts in Japan contain a great deal of common, highly correlated information. Knowing more than a single forecast is still valuable because higher disagreement among analysts is a signal of increased uncertainty in forecasting. In addition, consensus forecasts provide a small forecasting advantage, especially in situations in which uncertainty is high. 
Journal: Financial Analysts Journal
Pages: 29-40
Issue: 4
Volume: 53
Year: 1997
Month: 7
X-DOI: 10.2469/faj.v53.n4.2097
File-URL: http://hdl.handle.net/10.2469/faj.v53.n4.2097
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:4:p:29-40




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Author-Name: Kenneth L. Fisher
Author-X-Name-First: Kenneth L.
Author-X-Name-Last: Fisher
Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: The Mean–Variance-Optimization Puzzle: Security Portfolios and Food Portfolios
Abstract: 
 The Markowitz mean–variance-optimization framework presents a puzzle. Although it is the standard model of portfolio construction, investors rarely use it and, when used, it is constrained so much that portfolios reflect the constraints more than the optimization. Why do investors dislike unadulterated optimized mean–variance portfolios? The typical answer focuses on biases introduced by estimation errors. More important is the fact that investors' goals are quite different from mean–variance optimization. People care about more than cost and nutrition when they construct their diets: They also care about palatability. Similarly, investors care about more than expected returns and variance as they construct their securities portfolios: They also care about the investment equivalent of palatability. We use an analogy between security portfolios and food portfolios to explore the nature of the gap between intuitively appealing portfolios and mean–variance-optimized portfolios. 
Journal: Financial Analysts Journal
Pages: 41-50
Issue: 4
Volume: 53
Year: 1997
Month: 7
X-DOI: 10.2469/faj.v53.n4.2098
File-URL: http://hdl.handle.net/10.2469/faj.v53.n4.2098
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:4:p:41-50




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# input file: UFAJ_A_12047022_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Gifford Fong
Author-X-Name-First: Gifford
Author-X-Name-Last: Fong
Author-Name: Oldrich A. Vasicek
Author-X-Name-First: Oldrich A.
Author-X-Name-Last: Vasicek
Title: A Multidimensional Framework for Risk Analysis
Abstract: 
 The variety and complexity of portfolio holdings have given rise to the need for additional analyses for purposes of risk management. A framework for risk analysis includes three dimensions: sensitivity analysis, value at risk (VAR), and stress testing. This article describes each dimension and suggests a procedure for achieving a VAR measure. Once individual holdings are analyzed, attention can be directed to portfolio-level analyses and the types of output suitable for monitoring purposes. In combination, this framework can capture the important features of portfolio risk. 
Journal: Financial Analysts Journal
Pages: 51-57
Issue: 4
Volume: 53
Year: 1997
Month: 7
X-DOI: 10.2469/faj.v53.n4.2099
File-URL: http://hdl.handle.net/10.2469/faj.v53.n4.2099
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:4:p:51-57




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# input file: UFAJ_A_12047023_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Thomas J. Healey
Author-X-Name-First: Thomas J.
Author-X-Name-Last: Healey
Author-Name: Donald J. Hardy
Author-X-Name-First: Donald J.
Author-X-Name-Last: Hardy
Title: Growth in Alternative Investments
Abstract: 
 The largest pension funds, endowments, and foundations in the United States and Canada had commitments to alternative investments of almost $70 billion in 1995—a 92 percent increase since 1992. Alternative investments composed an average of 5.5 percent of the total assets of funds that allocate dollars to this asset class, up from 3.6 percent in 1992. Public and corporate funds represented more than 86 percent of total dollar participation in alternative investments, while endowments and foundations, which commit a higher percentage of total assets than other funds, were relatively small in total dollars committed. Interest in international private equity has grown considerably and, along with venture capital, international private equity is identified as the most attractive alternative investment in the near future. The ability of alternative investments to outperform more traditional investments is the primary reason for participation in this asset class; perceived risk and lack of liquidity are the principal deterrents. Given the dynamism of the U.S. economy and growing demand for capital worldwide, a strong case can be made that alternative investments will become an even more important part of the capital markets. 
Journal: Financial Analysts Journal
Pages: 58-65
Issue: 4
Volume: 53
Year: 1997
Month: 7
X-DOI: 10.2469/faj.v53.n4.2100
File-URL: http://hdl.handle.net/10.2469/faj.v53.n4.2100
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:4:p:58-65




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# input file: UFAJ_A_12047024_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Grant McQueen
Author-X-Name-First: Grant
Author-X-Name-Last: McQueen
Author-Name: Kay Shields
Author-X-Name-First: Kay
Author-X-Name-Last: Shields
Author-Name: Steven R. Thorley
Author-X-Name-First: Steven R.
Author-X-Name-Last: Thorley
Title: Does the “Dow-10 Investment Strategy” Beat the Dow Statistically and Economically?
Abstract: 
 A comparison of returns from 1946 to 1995 on a portfolio of the 10 Dow Jones Industrial Average stocks with the highest dividend yields (the Dow-10) with those from a portfolio of all 30 stocks in the DJIA (the Dow-30) shows that the Dow-10 portfolio beats the Dow-30 statistically; that is, the Dow-10 has significantly higher average annual returns. After adjusting for the Dow-10 portfolio's higher risk, extra transaction costs, and unfavorable tax treatment, however, the Dow-10 does not beat the Dow-30 economically. In some subperiods, Dow-10 performance is economically superior, but the question is how to interpret this information in light of the potential for data mining and investor learning. 
Journal: Financial Analysts Journal
Pages: 66-72
Issue: 4
Volume: 53
Year: 1997
Month: 7
X-DOI: 10.2469/faj.v53.n4.2101
File-URL: http://hdl.handle.net/10.2469/faj.v53.n4.2101
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:4:p:66-72




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# input file: UFAJ_A_12047025_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Liang Zou
Author-X-Name-First: Liang
Author-X-Name-Last: Zou
Title: Investments with Downside Insurance and the Issue of Time Diversification
Abstract: 
 Of two insurance policies that guarantee the same minimum rate of return on a portfolio and differ only in their time horizons, which is riskier? This study shows that if the minimum rate is lower than the risk-free rate, and if the risk is measured by the cost of insurance, then the degree of risk is not a monotonic function of the policy's time horizon. For every positive level of concession rate—defined as the risk-free rate minus the insured rate—the cost of such insurance peaks at a finite time horizon. This peak cost horizon is typically between 5 and 15 years. The higher the concession rate (or the lower the volatility of the insured portfolio), the shorter this peak-cost time horizon is. Thus, although a 5-year insurance policy can be much riskier than a 1-year policy, it can also be riskier than a 30-year policy. 
Journal: Financial Analysts Journal
Pages: 73-79
Issue: 4
Volume: 53
Year: 1997
Month: 7
X-DOI: 10.2469/faj.v53.n4.2102
File-URL: http://hdl.handle.net/10.2469/faj.v53.n4.2102
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:4:p:73-79




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# input file: UFAJ_A_12047026_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Angelo Lobosco
Author-X-Name-First: Angelo
Author-X-Name-Last: Lobosco
Author-Name: Dan DiBartolomeo
Author-X-Name-First: Dan
Author-X-Name-Last: DiBartolomeo
Title: Approximating the Confidence Intervals for Sharpe Style Weights
Abstract: 
 Style analysis is a form of constrained regression that uses a weighted combination of market indexes to replicate, as closely as possible, the historical return pattern of an investment portfolio. The resulting coefficients, called Sharpe style weights, are used to form inferences about a portfolio's behavior and composition. This technique has been widely adopted in the investment industry, despite the fact that no explicit confidence interval measures have been available to describe the results. We derive an approximation for the confidence intervals of these weights and, using Monte Carlo simulation, verify its efficacy. The estimation of these confidence intervals can help practitioners assess the statistical significance of their results and aids in determining which indexes to include in the analysis. It may also encourage the use of daily return data to meaningfully reduce the size of the confidence intervals. 
Journal: Financial Analysts Journal
Pages: 80-85
Issue: 4
Volume: 53
Year: 1997
Month: 7
X-DOI: 10.2469/faj.v53.n4.2103
File-URL: http://hdl.handle.net/10.2469/faj.v53.n4.2103
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:4:p:80-85




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# input file: UFAJ_A_12047027_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Lee Shama
Author-X-Name-First: Lee
Author-X-Name-Last: Shama
Author-Name: Avraham Shama
Author-X-Name-First: Avraham
Author-X-Name-Last: Shama
Title: Russia's True Economy: More Inviting to Investors
Abstract: 
 Financial analysts' opinions about investing in Russia are often based on incomplete and misleading official Russian data and on observations made during short trips to Russia. In Russia, what you see is not what you get. This study provides an assessment of Russia's true economy and its attractiveness to foreign investment. Based on personal interviews with Russian managers and with experts working in Russia, investing in that country appears to be potentially twice as lucrative as previously thought. Russia's true economy may be twice as large as officially reported, because private-sector companies, which constitute more than half of Russia's economy, do not report 90 percent of their revenues and profits. Investors and mutual fund managers must find unconventional ways to interpret Russian data and supplement that information with additional primary research. 
Journal: Financial Analysts Journal
Pages: 86-93
Issue: 4
Volume: 53
Year: 1997
Month: 7
X-DOI: 10.2469/faj.v53.n4.2104
File-URL: http://hdl.handle.net/10.2469/faj.v53.n4.2104
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:4:p:86-93




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# input file: UFAJ_A_12047028_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Asset-Backed Securities (a review)
Abstract: 
 This volume accomplishes the difficult feat of bringing together the vast body of knowledge that an investment professional should have to be competent in dealing with asset-backed securities. 
Journal: Financial Analysts Journal
Pages: 94-94
Issue: 4
Volume: 53
Year: 1997
Month: 7
X-DOI: 10.2469/faj.v53.n4.2105
File-URL: http://hdl.handle.net/10.2469/faj.v53.n4.2105
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:4:p:94-94




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# input file: UFAJ_A_12047029_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Art of Short Selling (a review)
Abstract: 
 The author describes the stratagems and tactics of short sellers, provides a detailed catalog of recognizable errors in analysis that help create candidates for short selling, and presents a close-up perspective on market inefficiency.
Journal: Financial Analysts Journal
Pages: 94-95
Issue: 4
Volume: 53
Year: 1997
Month: 7
X-DOI: 10.2469/faj.v53.n4.2106
File-URL: http://hdl.handle.net/10.2469/faj.v53.n4.2106
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:4:p:94-95




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# input file: UFAJ_A_12047030_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bruno Solnik
Author-X-Name-First: Bruno
Author-X-Name-Last: Solnik
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Going Global with Equities (a review)
Abstract: 
 This far-ranging, enjoyable book on global equity investing is based on sound conceptual reasoning and provides the individual investor with practical advice and honest reviews of investment approaches.
Journal: Financial Analysts Journal
Pages: 95-96
Issue: 4
Volume: 53
Year: 1997
Month: 7
X-DOI: 10.2469/faj.v53.n4.2107
File-URL: http://hdl.handle.net/10.2469/faj.v53.n4.2107
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:4:p:95-96




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# input file: UFAJ_A_12047031_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ronald N. Kahn
Author-X-Name-First: Ronald N.
Author-X-Name-Last: Kahn
Title: Three Classic Errors in Statistics, from Baseball to Investment Research
Abstract: 
 Three classic errors—involving the “lunatic fringe,” data redlining, and burying mistakes—cloud our ability to interpret statistical arguments across many disparate fields. Identifying and understanding these errors clarifies arguments from baseball to investment research. 
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 5
Volume: 53
Year: 1997
Month: 9
X-DOI: 10.2469/faj.v53.n5.2110
File-URL: http://hdl.handle.net/10.2469/faj.v53.n5.2110
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:5:p:6-8




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# input file: UFAJ_A_12047032_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Beverly J. Bell
Author-X-Name-First: Beverly J.
Author-X-Name-Last: Bell
Title: Fischer's Files
Abstract: 
 In a three-line cover letter that accompanied his last submission to the Financial Analysts Journal in May 1995, Fischer Black noted the long and satisfying association that he had had with the publication. A copy of this letter is in one of the hundreds of files that Fischer kept, which span roughly the last 25 years of his career. The files show that his work hinged on his fierce devotion to the written word; they also give us an idea of how he set about doing his research and the pleasure it gave him. 
Journal: Financial Analysts Journal
Pages: 9-10
Issue: 5
Volume: 53
Year: 1997
Month: 9
X-DOI: 10.2469/faj.v53.n5.2111
File-URL: http://hdl.handle.net/10.2469/faj.v53.n5.2111
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:5:p:9-10




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# input file: UFAJ_A_12047033_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jonathan B. Berk
Author-X-Name-First: Jonathan B.
Author-X-Name-Last: Berk
Title: Does Size Really Matter?
Abstract: 
 If the size of firms is measured correctly, small firms do not necessarily earn higher returns than larger firms. Yet, this finding is not inconsistent with the empirical fact that firms with small market values earn higher returns. Modern financial theory predicts that when firm size is economically unrelated to return, the relation between firm market value and return will be negative; that is, firms with small market values will have higher expected returns than other firms. 
Journal: Financial Analysts Journal
Pages: 12-18
Issue: 5
Volume: 53
Year: 1997
Month: 9
X-DOI: 10.2469/faj.v53.n5.2112
File-URL: http://hdl.handle.net/10.2469/faj.v53.n5.2112
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:5:p:12-18




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# input file: UFAJ_A_12047034_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Craig G. Beard
Author-X-Name-First: Craig G.
Author-X-Name-Last: Beard
Author-Name: Richard W. Sias
Author-X-Name-First: Richard W.
Author-X-Name-Last: Sias
Title: Is There a Neglected-Firm Effect?
Abstract: 
 The “neglected-firm effect” suggests that securities that analysts ignore offer higher returns (a “neglect premium”) than securities that analysts follow and scrutinize heavily. Using a large and recent sample of securities, we reinvestigated the neglected-firm effect. Controlling for capitalization, we found no evidence of a neglect premium. Investors attempting to exploit the neglected-firm effect during the past 14 years are likely to have been disappointed. 
Journal: Financial Analysts Journal
Pages: 19-23
Issue: 5
Volume: 53
Year: 1997
Month: 9
X-DOI: 10.2469/faj.v53.n5.2113
File-URL: http://hdl.handle.net/10.2469/faj.v53.n5.2113
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:5:p:19-23




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# input file: UFAJ_A_12047035_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Zakri Y. Bello
Author-X-Name-First: Zakri Y.
Author-X-Name-Last: Bello
Author-Name: Vahan Janjigian
Author-X-Name-First: Vahan
Author-X-Name-Last: Janjigian
Title: A Reexamination of the Market-Timing and Security-Selection Performance of Mutual Funds
Abstract: 
 An extended and correctly specified version of the Treynor–Mazuy (TM) model is used to examine the market-timing and stock-selection abilities of domestic equity mutual funds. This extended model controls for the inclusion of non-S&P 500 assets in mutual fund portfolios. We document positive and significant market-timing abilities for 633 mutual funds during the 1984–94 period. This finding is in sharp contrast to the negative market-timing abilities found when using the original TM model, which does not control for non-S&P 500 assets. Security-selection abilities are significantly positive, and cross-sectional correlations between market timing and selectivity are significantly negative. The monotonic correlation between turnover and market timing is positive, and that between turnover and selectivity is negative. Neither of these findings is evident with the original TM model or with traditional linear parametric measures of correlation. 
Journal: Financial Analysts Journal
Pages: 24-30
Issue: 5
Volume: 53
Year: 1997
Month: 9
X-DOI: 10.2469/faj.v53.n5.2114
File-URL: http://hdl.handle.net/10.2469/faj.v53.n5.2114
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:5:p:24-30




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# input file: UFAJ_A_12047036_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Dan diBartolomeo
Author-X-Name-First: Dan
Author-X-Name-Last: diBartolomeo
Author-Name: Erik Witkowski
Author-X-Name-First: Erik
Author-X-Name-Last: Witkowski
Title: Mutual Fund Misclassification: Evidence Based on Style Analysis
Abstract: 
 An iterative application of William Sharpe's method of style analysis is applied to the classification of equity mutual funds. A new methodology for creating purified mutual fund style indexes is used to verify existing classifications. Results suggest that 9 percent of all equity funds are seriously misclassified and another 31 percent are somewhat misclassified. Two factors emerge as the most likely reasons for misclassification: (1) the ambiguity of the current classification system and (2) competitive pressures in the mutual fund industry and compensation structures that reward relative performance. Monte Carlo simulations on out-of-sample data show that this misclassification has a significant effect on investors' ability to build diversified portfolios of mutual funds. 
Journal: Financial Analysts Journal
Pages: 32-43
Issue: 5
Volume: 53
Year: 1997
Month: 9
X-DOI: 10.2469/faj.v53.n5.2115
File-URL: http://hdl.handle.net/10.2469/faj.v53.n5.2115
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:5:p:32-43




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Author-Name: Gregory Connor
Author-X-Name-First: Gregory
Author-X-Name-Last: Connor
Title: Sensible Return Forecasting for Portfolio Management
Abstract: 
 Black and Litterman showed that a Bayesian adjustment to expected-return forecasts makes them more suitable for use in portfolio management. A new adjustment applies directly to return-forecasting models rather than to the forecasts they produce. This approach eliminates the need for an arbitrary adjustment when forecasts are inserted into a portfolio-choice model and integrates the return-forecasting and portfolio-choice steps of quantitative investment management. 
Journal: Financial Analysts Journal
Pages: 44-51
Issue: 5
Volume: 53
Year: 1997
Month: 9
X-DOI: 10.2469/faj.v53.n5.2116
File-URL: http://hdl.handle.net/10.2469/faj.v53.n5.2116
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:5:p:44-51




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# input file: UFAJ_A_12047038_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Sangkyun Park
Author-X-Name-First: Sangkyun
Author-X-Name-Last: Park
Title: Rationality of Negative Stock-Price Responses to Strong Economic Activity
Abstract: 
 Monthly, quarterly, and annual data between 1956 and 1995 were used to examine the effects of real economic variables on stock returns, future corporate cash flows, and future inflation. In general, relative effects of various economic variables on stock returns are justified by their effects on future corporate cash flows and on inflation. In particular, employment growth shows the strongest negative effect on stock returns. Compared with other variables, employment growth is related more negatively with future corporate cash flows and more positively with future inflation. These effects are most pronounced in annual data, which reflect long-term relationships. Based on these results, negative stock-price responses to strong economic activity seem to be rational. 
Journal: Financial Analysts Journal
Pages: 52-56
Issue: 5
Volume: 53
Year: 1997
Month: 9
X-DOI: 10.2469/faj.v53.n5.2117
File-URL: http://hdl.handle.net/10.2469/faj.v53.n5.2117
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:5:p:52-56




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# input file: UFAJ_A_12047039_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Carr Bettis
Author-X-Name-First: Carr
Author-X-Name-Last: Bettis
Author-Name: Don Vickrey
Author-X-Name-First: Don
Author-X-Name-Last: Vickrey
Author-Name: Donn W. Vickrey
Author-X-Name-First: Donn W.
Author-X-Name-Last: Vickrey
Title: Mimickers of Corporate Insiders Who Make Large-Volume Trades
Abstract: 
 Most prior research shows that corporate insiders can systematically earn abnormal returns by buying or selling their own securities. Also, several studies have investigated whether outsiders can earn abnormal returns by mimicking the trades of insiders after the latter report their trades. The findings of these studies suggest that they cannot. In contrast, this study's results indicate that outsiders can earn significant abnormal returns by mimicking such trades. This conclusion is consistent with a growing body of empirical literature that suggests that the market is not efficient in the semistrong form (i.e., is not efficient with respect to all publicly available information). 
Journal: Financial Analysts Journal
Pages: 57-66
Issue: 5
Volume: 53
Year: 1997
Month: 9
X-DOI: 10.2469/faj.v53.n5.2118
File-URL: http://hdl.handle.net/10.2469/faj.v53.n5.2118
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:5:p:57-66




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# input file: UFAJ_A_12047040_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Sean Collins
Author-X-Name-First: Sean
Author-X-Name-Last: Collins
Author-Name: Phillip Mack
Author-X-Name-First: Phillip
Author-X-Name-Last: Mack
Title: The Optimal Amount of Assets under Management in the Mutual Fund Industry
Abstract: 
 Economies of scale for the mutual fund industry were estimated to determine the optimal amount of assets under management for a fund complex. Empirical results show that the optimal asset size for a multiproduct fund complex is between $20 billion and $40 billion and that the average fund complex could realize some efficiency gains by increasing its asset size. This finding suggests that in the near future, a fund complex with assets less than $20 billion may have difficulty surviving. A fund complex that offers just one kind of mutual fund could achieve economies of scale with far fewer assets under management but potentially could achieve additional cost efficiencies by adding new product lines. 
Journal: Financial Analysts Journal
Pages: 67-73
Issue: 5
Volume: 53
Year: 1997
Month: 9
X-DOI: 10.2469/faj.v53.n5.2119
File-URL: http://hdl.handle.net/10.2469/faj.v53.n5.2119
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:5:p:67-73




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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Small Slam Direct Hit
Abstract: 
 This material comments on “Small Slam!”.
Journal: Financial Analysts Journal
Pages: 74-74
Issue: 5
Volume: 53
Year: 1997
Month: 9
X-DOI: 10.2469/faj.v53.n5.2120
File-URL: http://hdl.handle.net/10.2469/faj.v53.n5.2120
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:5:p:74-74




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# input file: UFAJ_A_12047043_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Street Smarts: Linking Professional Conduct with Shareholder Value in the Securities Industry (a review)
Abstract: 
 Based on the finding that sound practices must be enforced from the top down, this book serves as a manager's manual for identifying inherent conflicts of interest, implementing control systems, and communicating ethical expectations. 
Journal: Financial Analysts Journal
Pages: 75-76
Issue: 5
Volume: 53
Year: 1997
Month: 9
X-DOI: 10.2469/faj.v53.n5.2122
File-URL: http://hdl.handle.net/10.2469/faj.v53.n5.2122
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:5:p:75-76




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Author-Name: Jack Gray
Author-X-Name-First: Jack
Author-X-Name-Last: Gray
Title: Overquantification
Abstract: 
 Data are our industry's raw material. Our challenge is to add value by transforming them into meaningful and actionable information. Too narrow a focus on a “scientific” approach exposes us to the risk of overquantification—when ever-more precise measurement and ever-more complex models and calculations become substitutes for human judgment. This risk is increasing as the information age envelops us. Effective hedging requires equal emphasis on a “humanist” approach that demands creative, qualitative, hermeneutic skills, such as the use of analogies and metaphors; an awareness of human and social psychology; and a contrarian style that forever seeks to falsify. 
Journal: Financial Analysts Journal
Pages: 5-12
Issue: 6
Volume: 53
Year: 1997
Month: 11
X-DOI: 10.2469/faj.v53.n6.2125
File-URL: http://hdl.handle.net/10.2469/faj.v53.n6.2125
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:6:p:5-12




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# input file: UFAJ_A_12047045_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Zvi Bodie
Author-X-Name-First: Zvi
Author-X-Name-Last: Bodie
Author-Name: Dwight B. Crane
Author-X-Name-First: Dwight B.
Author-X-Name-Last: Crane
Title: Personal Investing: Advice, Theory, and Evidence
Abstract: 
 Data from a unique survey containing information on the composition of the respondents' total asset holdings—both inside and outside their retirement accounts—shed light on individual asset-allocation behavior. Individual asset allocations are consistent with the recommendations of expert practitioners and with the prescriptions of economic theory. The survey respondents maintain in cash and near-cash investments a proportion of their wealth that declines as wealth increases. They hold these safe assets outside their retirement accounts. The proportion of total assets that they hold in equities declines with age and rises with wealth. They do not appear to manage their assets across retirement and nonretirement accounts to maximize tax efficiency. 
Journal: Financial Analysts Journal
Pages: 13-23
Issue: 6
Volume: 53
Year: 1997
Month: 11
X-DOI: 10.2469/faj.v53.n6.2126
File-URL: http://hdl.handle.net/10.2469/faj.v53.n6.2126
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:6:p:13-23




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# input file: UFAJ_A_12047046_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ross Jennings
Author-X-Name-First: Ross
Author-X-Name-Last: Jennings
Author-Name: Marc J. LeClere
Author-X-Name-First: Marc J.
Author-X-Name-Last: LeClere
Author-Name: Robert B. Thompson
Author-X-Name-First: Robert B.
Author-X-Name-Last: Thompson
Title: Evidence on the Usefulness of Alternative Earnings per Share Measures
Abstract: 
 In February 1997, the Financial Accounting Standards Board adopted new reporting rules for earnings per share. The new standard replaces “primary” EPS with “basic” EPS and makes a minor adjustment in the computation of “fully diluted” EPS. A comparison of the extent to which basic, primary, and fully diluted EPS explain variation in stock prices for a large sample of NYSE- and Amex-listed firms from 1989 to 1995 suggests that analysts and investors are likely to be no worse off under the new standard than under the old and may, in fact, have access to better information under the new standard because of its enhanced disclosure requirements. 
Journal: Financial Analysts Journal
Pages: 24-33
Issue: 6
Volume: 53
Year: 1997
Month: 11
X-DOI: 10.2469/faj.v53.n6.2127
File-URL: http://hdl.handle.net/10.2469/faj.v53.n6.2127
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:6:p:24-33




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Author-Name: Gerald R. Jensen
Author-X-Name-First: Gerald R.
Author-X-Name-Last: Jensen
Author-Name: Robert R. Johnson
Author-X-Name-First: Robert R.
Author-X-Name-Last: Johnson
Author-Name: Jeffrey M. Mercer
Author-X-Name-First: Jeffrey M.
Author-X-Name-Last: Mercer
Title: New Evidence on Size and Price-to-Book Effects in Stock Returns
Abstract: 
 Firm size and price-to-book-value ratio are prominent measures in explaining cross-sectional stock returns. Historically, average returns on shares of small-capitalization firms and low price-to-book firms have exceeded those on large-capitalization firms and high price-to-book firms. Recent evidence also shows that monetary policy developments significantly explain security returns. When we considered the influence on stock returns of the Federal Reserve's policy stance, we found that size and price-to-book effects depend largely on the monetary environment. Specifically, the small-firm and low price-to-book premiums are economically and statistically significant only in expansive monetary policy periods and are small, and in some instances negative, in restrictive policy periods. This evidence suggests that investors should consider the Fed's policy stance when using strategies that rely on size or price-to-book ratio. 
Journal: Financial Analysts Journal
Pages: 34-42
Issue: 6
Volume: 53
Year: 1997
Month: 11
X-DOI: 10.2469/faj.v53.n6.2128
File-URL: http://hdl.handle.net/10.2469/faj.v53.n6.2128
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:6:p:34-42




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# input file: UFAJ_A_12047048_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Title: Franchise Margins and the Sales-Driven Franchise Value
Abstract: 
 In a global environment, any one company's cost advantage from geographical locale, cheaper labor, or more-efficient production sites can always be replicated, in time, by a sufficiently strong competitor with access to today's free-flowing financial markets. Thus, the ultimate key to a superior margin will be price, not cost. High-value firms will be those that can develop and/or sustain a sales-driven franchise with premium pricing across a range of product markets. The incremental pricing margin beyond that available to a “new commodity competitor”—one who would be content to earn only the cost of capital—is the “franchise margin.” A sales-driven valuation model translates this pricing power into an estimate of capitalized firm value. 
Journal: Financial Analysts Journal
Pages: 43-53
Issue: 6
Volume: 53
Year: 1997
Month: 11
X-DOI: 10.2469/faj.v53.n6.2129
File-URL: http://hdl.handle.net/10.2469/faj.v53.n6.2129
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:6:p:43-53




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Author-Name: John R. Graham
Author-X-Name-First: John R.
Author-X-Name-Last: Graham
Author-Name: Campbell R. Harvey
Author-X-Name-First: Campbell R.
Author-X-Name-Last: Harvey
Title: Grading the Performance of Market-Timing Newsletters
Abstract: 
 Many investment newsletters offer market-timing advice; that is, they are supposed to recommend increased stock market weights before market appreciations and decreased weights before market declines. Examination of the performance of 326 newsletter asset-allocation strategies for the 1983–95 period shows that as a group, newsletters do not appear to possess any special information about the future direction of the market. Nevertheless, investment newsletters that are on a hot streak (have correctly anticipated the direction of the market in previous recommendations) may provide valuable information about future returns. 
Journal: Financial Analysts Journal
Pages: 54-66
Issue: 6
Volume: 53
Year: 1997
Month: 11
X-DOI: 10.2469/faj.v53.n6.2130
File-URL: http://hdl.handle.net/10.2469/faj.v53.n6.2130
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:6:p:54-66




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Author-Name: R. Douglas Van Eaton
Author-X-Name-First: R. Douglas
Author-X-Name-Last: Van Eaton
Author-Name: James A. Conover
Author-X-Name-First: James A.
Author-X-Name-Last: Conover
Title: Put Prices and PEN Participation Rates at Longer Horizons: Is Equity Risk in the Eye of the Beholder?
Abstract: 
 Two recent articles in the Financial Analysts Journal address the question of how equity risk changes as investment horizons grow longer. Both use analyses based on derivatives-pricing examples but draw exactly opposite conclusions. We reexamine these authors' arguments and find the logic of both analyses is flawed. We demonstrate that the use of specialized put option prices as proxies for equity risk yields ambiguous conclusions about equity risk changes at longer investment horizons. With added information about an investor's required minimum rate of return, however, we can specify the change in equity risk at longer horizons with these put prices. 
Journal: Financial Analysts Journal
Pages: 67-73
Issue: 6
Volume: 53
Year: 1997
Month: 11
X-DOI: 10.2469/faj.v53.n6.2131
File-URL: http://hdl.handle.net/10.2469/faj.v53.n6.2131
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:6:p:67-73




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# input file: UFAJ_A_12047051_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Charles W. Hodges
Author-X-Name-First: Charles W.
Author-X-Name-Last: Hodges
Author-Name: Walton R.L. Taylor
Author-X-Name-First: Walton R.L.
Author-X-Name-Last: Taylor
Author-Name: James A. Yoder
Author-X-Name-First: James A.
Author-X-Name-Last: Yoder
Title: Stocks, Bonds, the Sharpe Ratio, and the Investment Horizon
Abstract: 
 An investigation of the empirical relationship between the Sharpe ratio and the investment horizon for portfolios of small stocks, larger stocks, and bonds shows that the Sharpe ratio first increases and then decreases for each portfolio type as the investment horizon lengthens. Furthermore, the relative Sharpe ratio rankings of the portfolios change. Contrary to general belief, bonds outperform stocks, given sufficiently long holding periods. The Sharpe ratios computed by investment advisory services, such as Morningstar Mutual Funds, must be interpreted with care because the Sharpe ratio is dependent on the investment horizon. 
Journal: Financial Analysts Journal
Pages: 74-80
Issue: 6
Volume: 53
Year: 1997
Month: 11
X-DOI: 10.2469/faj.v53.n6.2132
File-URL: http://hdl.handle.net/10.2469/faj.v53.n6.2132
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:6:p:74-80




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Author-Name: Lawrence D. Brown
Author-X-Name-First: Lawrence D.
Author-X-Name-Last: Brown
Title: Analyst Forecasting Errors: Additional Evidence
Abstract: 
 Analyst forecasting errors are approximately as large as Dreman and Berry (1995) documented, and an optimistic bias is evident for all years from 1985 through 1996. In contrast to their findings, I show that analyst forecasting errors and bias have decreased over time. Moreover, the optimistic bias in quarterly forecasts was absent for S&P 500 firms from 1993 through 1996. Analyst forecasting errors are smaller for (1) S&P 500 firms than for other firms; (2) firms with comparatively large amounts of market capitalization, absolute value of earnings forecast, and analyst following; and (3) firms in certain industries. 
Journal: Financial Analysts Journal
Pages: 81-88
Issue: 6
Volume: 53
Year: 1997
Month: 11
X-DOI: 10.2469/faj.v53.n6.2133
File-URL: http://hdl.handle.net/10.2469/faj.v53.n6.2133
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:6:p:81-88




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Author-Name: Richard C. Schneider
Author-X-Name-First: Richard C.
Author-X-Name-Last: Schneider
Title: Unreality Check
Abstract: 
 This material comments on “Does the 'Dow-10 Investment Strategy' Beat the Dow Statistically and Economically?”.
Journal: Financial Analysts Journal
Pages: 89-89
Issue: 6
Volume: 53
Year: 1997
Month: 11
X-DOI: 10.2469/faj.v53.n6.2134
File-URL: http://hdl.handle.net/10.2469/faj.v53.n6.2134
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:6:p:89-89




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# input file: UFAJ_A_12047054_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Investor's Anthology: Original Ideas from the Industry's Greatest Minds (a review)
Abstract: 
 Most items in this collection of classic essays are indeed texts that one generation of financial professionals would commend to the next, and the whole will remind readers that the greatest ideas are simple insights that get discovered again and again. 
Journal: Financial Analysts Journal
Pages: 90-91
Issue: 6
Volume: 53
Year: 1997
Month: 11
X-DOI: 10.2469/faj.v53.n6.2135
File-URL: http://hdl.handle.net/10.2469/faj.v53.n6.2135
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Handle: RePEc:taf:ufajxx:v:53:y:1997:i:6:p:90-91




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# input file: UFAJ_A_12047055_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Edward I. Altman
Author-X-Name-First: Edward I.
Author-X-Name-Last: Altman
Author-Name: John B. Caouette
Author-X-Name-First: John B.
Author-X-Name-Last: Caouette
Author-Name: Paul Narayanan
Author-X-Name-First: Paul
Author-X-Name-Last: Narayanan
Title: Credit-Risk Measurement and Management: The Ironic Challenge in the Next Decade
Abstract: 
 Credit-risk management is the next great risk-management challenge for the coming years. 
Journal: Financial Analysts Journal
Pages: 7-11
Issue: 1
Volume: 54
Year: 1998
Month: 1
X-DOI: 10.2469/faj.v54.n1.2140
File-URL: http://hdl.handle.net/10.2469/faj.v54.n1.2140
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:1:p:7-11




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Author-Name: Michael J. Brennan
Author-X-Name-First: Michael J.
Author-X-Name-Last: Brennan
Title: Stripping the S&P 500 Index
Abstract: 
 A new market in S&P 500 Index dividend strips, which are claims to a year's dividend on the index, would not only improve risk sharing but, more importantly, would also serve to focus investor attention on the fundamentals that determine the value of the index rather than simply on the future resale value of the index. Such a market would also reveal the market assessment of certainty-equivalent growth rates in dividends and thus help to promote rational pricing. Calculations are presented to illustrate the prices at which the index strips might trade, the associated certainty-equivalent growth rates, and the expected returns for given expected dividend growth rates. 
Journal: Financial Analysts Journal
Pages: 12-22
Issue: 1
Volume: 54
Year: 1998
Month: 1
X-DOI: 10.2469/faj.v54.n1.2141
File-URL: http://hdl.handle.net/10.2469/faj.v54.n1.2141
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:1:p:12-22




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Author-Name: Roger D. Huang
Author-X-Name-First: Roger D.
Author-X-Name-Last: Huang
Author-Name: Hans R. Stoll
Author-X-Name-First: Hans R.
Author-X-Name-Last: Stoll
Title: Is It Time to Split the S&P 500 Futures Contract?
Abstract: 
 By October 1996, the value of the S&P 500 Index futures contract had grown to five times its value at its inception in April 1982. One way to make the contract more accessible to small investors and to smooth out trading is to split the contract. Splitting the contract could increase transaction costs, although competition would probably limit the amount of the increase. Less clear is the need for increasing the minimum percentage tick size. The current minimum tick size is small for S&P 500 futures compared with that of other futures and also common stocks. The larger tick size could affect volume, however, by increasing trading costs and reducing the willingness to trade. 
Journal: Financial Analysts Journal
Pages: 23-35
Issue: 1
Volume: 54
Year: 1998
Month: 1
X-DOI: 10.2469/faj.v54.n1.2142
File-URL: http://hdl.handle.net/10.2469/faj.v54.n1.2142
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:1:p:23-35




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Author-Name: Barrie A. Wigmore
Author-X-Name-First: Barrie A.
Author-X-Name-Last: Wigmore
Title: Revisiting the October 1987 Crash
Abstract: 
 The crash of 1987 reflected panic selling by the retail public, foreigners, and institutions in response to overvaluation, an effort by the U.S. Congress to restrict merger activity, rising interest rates, and international policy squabbles. Portfolio insurance overwhelmed the specialists, who were unable to handle the large index trades in the Designated Order Turnaround system. The credit crisis on the second day reflected justifiable worries about brokers' credit. With valuation and other indicators back to the record levels of 1987, could the U.S. market suffer a repeat of October 1987? 
Journal: Financial Analysts Journal
Pages: 36-48
Issue: 1
Volume: 54
Year: 1998
Month: 1
X-DOI: 10.2469/faj.v54.n1.2143
File-URL: http://hdl.handle.net/10.2469/faj.v54.n1.2143
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:1:p:36-48




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Author-Name: Michael J. Ho
Author-X-Name-First: Michael J.
Author-X-Name-Last: Ho
Author-Name: Robert S. Harris
Author-X-Name-First: Robert S.
Author-X-Name-Last: Harris
Title: Market Reactions to Messages from Brokerage Ratings Systems
Abstract: 
 One dimension of the strategies investment houses use to present investment advice is the number of categories in their rating systems. We studied three-, four-, and five-level systems and found that in all rating systems, upgrades outnumber downgrades. Price reactions are more pronounced to multiple-level than to single-level recommendation changes and to recommendation upgrades to the highest rating category. These price reactions confirm that the market gleans new information from analysts' research but suggest that investors, at least partially, recognize analysts' tendency toward optimism and thus react more strongly to downgrades. The price effects also show that adding more rating categories is not simply a way to portion out information in smaller bits. Some of the largest price reactions are to changes between the top two categories in a five-level system, even though the descriptions of the categories would not signal a portfolio action. Our results are consistent with the view that firms try to avoid issuing harshly worded recommendations, which might compromise revenue generation. A system with more rating categories provides for less-direct statements of bad news. 
Journal: Financial Analysts Journal
Pages: 49-57
Issue: 1
Volume: 54
Year: 1998
Month: 1
X-DOI: 10.2469/faj.v54.n1.2144
File-URL: http://hdl.handle.net/10.2469/faj.v54.n1.2144
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:1:p:49-57




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Author-Name: Maribeth Coller
Author-X-Name-First: Maribeth
Author-X-Name-Last: Coller
Author-Name: Teri Lombardi Yohn
Author-X-Name-First: Teri Lombardi
Author-X-Name-Last: Yohn
Title: Management Forecasts: What Do We Know?
Abstract: 
 Empirical research has addressed several issues related to management forecasts of earnings, including the motivations management may have to release forecasts voluntarily, bias in and accuracy of forecasts, and reactions to management forecasts. These issues are important to consider in order to interpret management forecasts properly. This article summarizes this body of research and concisely describes the findings. The discussion is intended to help analysts seeking to use the information in management forecasts in making their own assessments of a firm's future. 
Journal: Financial Analysts Journal
Pages: 58-62
Issue: 1
Volume: 54
Year: 1998
Month: 1
X-DOI: 10.2469/faj.v54.n1.2145
File-URL: http://hdl.handle.net/10.2469/faj.v54.n1.2145
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:1:p:58-62




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Author-Name: Brian D. Singer
Author-X-Name-First: Brian D.
Author-X-Name-Last: Singer
Author-Name: Kevin Terhaar
Author-X-Name-First: Kevin
Author-X-Name-Last: Terhaar
Author-Name: John Zerolis
Author-X-Name-First: John
Author-X-Name-Last: Zerolis
Title: Maintaining Consistent Global Asset Views (with a Little Help from Euclid)
Abstract: 
 Global economic and capital market integration has led to a host of new concerns for plan sponsors and money managers. In such an environment, ensuring consistent capital market expectations, policies, and strategies among different base currencies is important. A primary difficulty is translating risk and correlation estimates from the home currency into any other currency. We provide a method for converting risk and correlation views. The method makes use of a geometric interpretation of risks and correlations, dramatically simplifying the requisite calculations. 
Journal: Financial Analysts Journal
Pages: 63-71
Issue: 1
Volume: 54
Year: 1998
Month: 1
X-DOI: 10.2469/faj.v54.n1.2146
File-URL: http://hdl.handle.net/10.2469/faj.v54.n1.2146
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:1:p:63-71




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Author-Name: Christopher B. Barry
Author-X-Name-First: Christopher B.
Author-X-Name-Last: Barry
Author-Name: John W. Peavy
Author-X-Name-First: John W.
Author-X-Name-Last: Peavy
Author-Name: Mauricio Rodriguez
Author-X-Name-First: Mauricio
Author-X-Name-Last: Rodriguez
Title: Performance Characteristics of Emerging Capital Markets
Abstract: 
 Capital markets in developing countries have become an important asset class. These emerging markets are commonly associated with high returns, high volatility, and diversification benefits for investors in developed markets. We used the Emerging Markets Data Base provided by the International Finance Corporation to examine the risk and return characteristics of emerging markets. Contrary to the results often presented in the popular press, we found that these markets have not produced high levels of compound returns relative to U.S. stock markets for the 20-year time period ending in June 1995. They have experienced a high level of volatility, but they also have consistently provided diversification benefits when combined with developed market portfolios. 
Journal: Financial Analysts Journal
Pages: 72-80
Issue: 1
Volume: 54
Year: 1998
Month: 1
X-DOI: 10.2469/faj.v54.n1.2147
File-URL: http://hdl.handle.net/10.2469/faj.v54.n1.2147
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:1:p:72-80




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Author-Name: Robert Ferguson
Author-X-Name-First: Robert
Author-X-Name-Last: Ferguson
Author-Name: Dean Leistikow
Author-X-Name-First: Dean
Author-X-Name-Last: Leistikow
Title: Search for the Best Financial Performance Measure: Basics Are Better
Abstract: 
 Economic value added (EVA) is a well-known and widely used measure of operating performance. Bacidore, Boquist, Milbourn, and Thakor (1997) claimed in a recent Financial Analysts Journal article that a modified version of EVA, refined economic value added (REVA), is theoretically superior to EVA. Actually, EVA is theoretically superior to REVA. 
Journal: Financial Analysts Journal
Pages: 81-85
Issue: 1
Volume: 54
Year: 1998
Month: 1
X-DOI: 10.2469/faj.v54.n1.2148
File-URL: http://hdl.handle.net/10.2469/faj.v54.n1.2148
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:1:p:81-85




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Author-Name: Thomas Albrecht
Author-X-Name-First: Thomas
Author-X-Name-Last: Albrecht
Title: The Search for the Best Financial Performance Measure: A Comment
Abstract: 
 This material comments on “The Search for the Best Financial Performance Measure.”
Journal: Financial Analysts Journal
Pages: 86-87
Issue: 1
Volume: 54
Year: 1998
Month: 1
X-DOI: 10.2469/faj.v54.n1.2149
File-URL: http://hdl.handle.net/10.2469/faj.v54.n1.2149
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:1:p:86-87




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Author-Name: David Watkins
Author-X-Name-First: David
Author-X-Name-Last: Watkins
Author-Name: David Hartzell
Author-X-Name-First: David
Author-X-Name-Last: Hartzell
Title: U.S. REITs and Common Stock as an Inflation Hedge: A Response
Abstract: 
 This material comments on “U.S. REITs and Common Stock as an Inflation Hedge.”
Journal: Financial Analysts Journal
Pages: 87-88
Issue: 1
Volume: 54
Year: 1998
Month: 1
X-DOI: 10.2469/faj.v54.n1.2150
File-URL: http://hdl.handle.net/10.2469/faj.v54.n1.2150
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:1:p:87-88




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# input file: UFAJ_A_12047066_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Peter L. Bernstein
Author-X-Name-First: Peter L.
Author-X-Name-Last: Bernstein
Title: The Expected Return of the Security Analyst
Abstract: 
 In an update of a 1978 address, the author considers whether security analysts have a future and, if so, what they should (and should not) be doing. 
Journal: Financial Analysts Journal
Pages: 4-8
Issue: 2
Volume: 54
Year: 1998
Month: 3
X-DOI: 10.2469/faj.v54.n2.2160
File-URL: http://hdl.handle.net/10.2469/faj.v54.n2.2160
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:2:p:4-8




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# input file: UFAJ_A_12047067_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert A. Olsen
Author-X-Name-First: Robert A.
Author-X-Name-Last: Olsen
Title: Behavioral Finance and Its Implications for Stock-Price Volatility
Abstract: 
 An increasing number of academic and professional articles are being published about research on and potential applications of behavioral finance. This article offers a more complete picture of the origin, content, and rationale behind this emerging area of study than previously presented. In the process, the traditional dominance in finance of the economic concepts of subjective expected utility and rationality are discussed. In addition, the article argues that the newer theories of chaos and adaptive decision making, which have a place in behavioral finance, can help explain the puzzle of stock-price volatility. 
Journal: Financial Analysts Journal
Pages: 10-18
Issue: 2
Volume: 54
Year: 1998
Month: 3
X-DOI: 10.2469/faj.v54.n2.2161
File-URL: http://hdl.handle.net/10.2469/faj.v54.n2.2161
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:2:p:10-18




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Author-Name: Marshall E. Blume
Author-X-Name-First: Marshall E.
Author-X-Name-Last: Blume
Title: An Anatomy of Morningstar Ratings
Abstract: 
 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. 
Journal: Financial Analysts Journal
Pages: 19-27
Issue: 2
Volume: 54
Year: 1998
Month: 3
X-DOI: 10.2469/faj.v54.n2.2162
File-URL: http://hdl.handle.net/10.2469/faj.v54.n2.2162
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:2:p:19-27




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# input file: UFAJ_A_12047069_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Christopher M. Garman
Author-X-Name-First: Christopher M.
Author-X-Name-Last: Garman
Title: Determinants of Spreads on New High-Yield Bonds
Abstract: 
 Non-investment-grade debt offerings have a reputation as “story bonds” for which objective valuation criteria are difficult to establish. Nevertheless, 56 percent of the variance in risk premiums is explained by quantifiable factors, such as rating, term, and secondary-market spreads. At the same time, the underwriter's effectiveness in presenting the issuer to investors appears to materially influence pricing. 
Journal: Financial Analysts Journal
Pages: 28-39
Issue: 2
Volume: 54
Year: 1998
Month: 3
X-DOI: 10.2469/faj.v54.n2.2163
File-URL: http://hdl.handle.net/10.2469/faj.v54.n2.2163
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:2:p:28-39




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# input file: UFAJ_A_12047070_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bruce I. Jacobs
Author-X-Name-First: Bruce I.
Author-X-Name-Last: Jacobs
Author-Name: Kenneth N. Levy
Author-X-Name-First: Kenneth N.
Author-X-Name-Last: Levy
Author-Name: David Starer
Author-X-Name-First: David
Author-X-Name-Last: Starer
Title: On the Optimality of Long–Short Strategies
Abstract: 
 We consider the optimality of portfolios not subject to short-selling constraints and derive conditions that a universe of securities must satisfy for an optimal active portfolio to be dollar neutral or beta neutral. We find that following the common practice of constraining long–short portfolios to have zero net holdings or zero betas is generally suboptimal. Only under specific unlikely conditions will such constrained portfolios optimize an investor's utility function. We also derive precise formulas for optimally equitizing an active long–short portfolio using exposure to a benchmark security. The relative sizes of the active and benchmark exposures depend on the investor's desired residual risk relative to the residual risk of a typical portfolio and on the expected risk-adjusted excess return of a minimum-variance active portfolio. We demonstrate that optimal portfolios demand the use of integrated optimizations. 
Journal: Financial Analysts Journal
Pages: 40-51
Issue: 2
Volume: 54
Year: 1998
Month: 3
X-DOI: 10.2469/faj.v54.n2.2164
File-URL: http://hdl.handle.net/10.2469/faj.v54.n2.2164
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:2:p:40-51




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# input file: UFAJ_A_12047071_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: R. Douglas Van Eaton
Author-X-Name-First: R. Douglas
Author-X-Name-Last: Van Eaton
Author-Name: James A. Conover
Author-X-Name-First: James A.
Author-X-Name-Last: Conover
Title: Misconceptions about Optimal Equity Allocation and Investment Horizon
Abstract: 
 Our analysis and results offer some resolution to a debate that has continued for 30 years. We demonstrate that, in contrast to prior claims, no conflict exists between the implications of economic models of choice under uncertainty and a rational investor preference for larger equity allocations at longer investment horizons. Using examples of expected utility of wealth and mean–variance utility, we show that the effect of a longer horizon on risky-asset allocation is consistent with increasing or decreasing optimal equity allocations, even under the assumption of constant relative risk aversion. 
Journal: Financial Analysts Journal
Pages: 52-59
Issue: 2
Volume: 54
Year: 1998
Month: 3
X-DOI: 10.2469/faj.v54.n2.2165
File-URL: http://hdl.handle.net/10.2469/faj.v54.n2.2165
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:2:p:52-59




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Author-Name: Mark W. Griffin
Author-X-Name-First: Mark W.
Author-X-Name-Last: Griffin
Title: A Global Perspective on Pension Fund Asset Allocation
Abstract: 
 A comparison of pension fund asset allocations around the globe shows surprisingly wide variations. Closer study reveals some interesting relationships that help explain the variations. Outright allocation restrictions are numerous, but they appear to be constraining in only a few situations. Pension funds diversify internationally to a much greater degree in equities than in bonds. A positive relationship exists between a country's relative level of international trade and its average level of international diversification within equities. The most dramatic finding is that subtle accounting and regulatory differences between countries have a strong impact on the allocation between equities and bonds. 
Journal: Financial Analysts Journal
Pages: 60-68
Issue: 2
Volume: 54
Year: 1998
Month: 3
X-DOI: 10.2469/faj.v54.n2.2166
File-URL: http://hdl.handle.net/10.2469/faj.v54.n2.2166
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:2:p:60-68




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Author-Name: Jack Treynor
Author-X-Name-First: Jack
Author-X-Name-Last: Treynor
Title: Bulls, Bears, and Market Bubbles
Abstract: 
 According to some finance scholars, a securities market that does not exhibit a random walk cannot be rational. They point out that for a rational investor, changes in his or her expectations are entirely a surprise. The same is true for the consensus when investors share the same expectation. In real markets, however, investors disagree, and the equilibrium level reflects their wealth, as well as their expectations. When, for example, news raises the market level, the market rewards the bulls and penalizes the bears, leaving the bulls with more wealth, hence greater market impact, and the bears with less. The wealth shift causes an additional change in the equilibrium level and a further wealth shift. If investors' disagreement is large enough, the second change in equilibrium price can be bigger than the first and the third bigger than the second. Rational behavior by individual investors can cause a market bubble. 
Journal: Financial Analysts Journal
Pages: 69-74
Issue: 2
Volume: 54
Year: 1998
Month: 3
X-DOI: 10.2469/faj.v54.n2.2167
File-URL: http://hdl.handle.net/10.2469/faj.v54.n2.2167
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:2:p:69-74




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# input file: UFAJ_A_12047074_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: W. Scott Bauman
Author-X-Name-First: W. Scott
Author-X-Name-Last: Bauman
Author-Name: C. Mitchell Conover
Author-X-Name-First: C. Mitchell
Author-X-Name-Last: Conover
Author-Name: Robert E. Miller
Author-X-Name-First: Robert E.
Author-X-Name-Last: Miller
Title: Growth versus Value and Large-Cap versus Small-Cap Stocks in International Markets
Abstract: 
 Many studies have shown that value-stock strategies outperform growth-stock strategies in U.S. markets. For international stock markets, however, little published research exists on this subject. Using four valuation ratios to define value stocks and growth stocks for more than 28,000 return observations in 21 countries for a 10-year period, we found that value stocks generally outperformed growth stocks on a total-return basis and on a risk-adjusted basis for the period and in a majority of individual years as well as in a majority of the national markets. When the growth stocks outperformed, the margin of difference was small. We also found a strong firm-size effect. In addition, value stocks outperformed growth stocks in all firm capitalization-size categories except the smallest. 
Journal: Financial Analysts Journal
Pages: 75-89
Issue: 2
Volume: 54
Year: 1998
Month: 3
X-DOI: 10.2469/faj.v54.n2.2168
File-URL: http://hdl.handle.net/10.2469/faj.v54.n2.2168
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:2:p:75-89




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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Analysis and Use of Financial Statements, 2nd ed. (a review)
Abstract: 
 This immense work not only provides descriptions of essential analytical techniques and quirky accounting methods but also contains an excellent section on the relationship between financial statements and securities valuation. 
Journal: Financial Analysts Journal
Pages: 90-91
Issue: 2
Volume: 54
Year: 1998
Month: 3
X-DOI: 10.2469/faj.v54.n2.2169
File-URL: http://hdl.handle.net/10.2469/faj.v54.n2.2169
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:2:p:90-91




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# input file: UFAJ_A_12047076_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Malek Lashgari
Author-X-Name-First: Malek
Author-X-Name-Last: Lashgari
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Inflation-Protection Bonds (a review)
Abstract: 
 Most useful for investment professionals and public officials, this book provides a history of inflation-indexed bonds in and outside the United States and describes potential advantages and pitfalls of these fixed-income investments. 
Journal: Financial Analysts Journal
Pages: 91-92
Issue: 2
Volume: 54
Year: 1998
Month: 3
X-DOI: 10.2469/faj.v54.n2.2170
File-URL: http://hdl.handle.net/10.2469/faj.v54.n2.2170
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:2:p:91-92




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# input file: UFAJ_A_12047077_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard A. Weiss
Author-X-Name-First: Richard A.
Author-X-Name-Last: Weiss
Title: Global Sector Rotation: New Look at an Old Idea
Abstract: 
 An investment product that capitalizes on the rising importance of the industry
                    factor in increasingly integrated global markets should have a bright future.
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 3
Volume: 54
Year: 1998
Month: 5
X-DOI: 10.2469/faj.v54.n3.2175
File-URL: http://hdl.handle.net/10.2469/faj.v54.n3.2175
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Author-Name: Lee N. Price
Author-X-Name-First: Lee N.
Author-X-Name-Last: Price
Title: Globalization of Performance Presentation Standards
Abstract: 
 Made available for public comment in March 1997, GIPS establish a much-needed
                    framework for standardizing the presentation of investment performance on a
                    global basis. 
Journal: Financial Analysts Journal
Pages: 10-12
Issue: 3
Volume: 54
Year: 1998
Month: 5
X-DOI: 10.2469/faj.v54.n3.2176
File-URL: http://hdl.handle.net/10.2469/faj.v54.n3.2176
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# input file: UFAJ_A_12047079_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: John Byrd
Author-X-Name-First: John
Author-X-Name-Last: Byrd
Author-Name: Robert Parrino
Author-X-Name-First: Robert
Author-X-Name-Last: Parrino
Author-Name: Gunnar Pritsch
Author-X-Name-First: Gunnar
Author-X-Name-Last: Pritsch
Title: Stockholder–Manager Conflicts and Firm Value
Abstract: 
 The separation of ownership and control in a modern corporation often requires
                    the delegation of significant decision-making authority to professional
                    managers, which introduces the possibility that managers will have incentives to
                    make decisions that benefit them at the expense of stockholders. We discuss the
                    theory and empirical evidence on stockholder–manager conflicts, provide an
                    overview of the problems that can arise in U.S. corporations, summarize recent
                    empirical evidence on the effectiveness of the various mechanisms that can
                    control these problems, and alert investors to global variations in problems and
                    controls. 
Journal: Financial Analysts Journal
Pages: 14-30
Issue: 3
Volume: 54
Year: 1998
Month: 5
X-DOI: 10.2469/faj.v54.n3.2177
File-URL: http://hdl.handle.net/10.2469/faj.v54.n3.2177
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Author-Name: Allen Michel
Author-X-Name-First: Allen
Author-X-Name-Last: Michel
Author-Name: Israel Shaked
Author-X-Name-First: Israel
Author-X-Name-Last: Shaked
Author-Name: Christopher McHugh
Author-X-Name-First: Christopher
Author-X-Name-Last: McHugh
Title: After Bankruptcy: Can Ugly Ducklings Turn into Swans?
Abstract: 
 Before they emerge from bankruptcy, U.S. debtor companies are required to provide
                    financial and operational projections to the Bankruptcy Court. The projections
                    are of interest to numerous parties—analysts, advisors, creditors, and
                    securityholders—but the results of this study suggest that the projections
                    are frequently (and often, greatly) overstated. 
Journal: Financial Analysts Journal
Pages: 31-40
Issue: 3
Volume: 54
Year: 1998
Month: 5
X-DOI: 10.2469/faj.v54.n3.2178
File-URL: http://hdl.handle.net/10.2469/faj.v54.n3.2178
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# input file: UFAJ_A_12047081_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Peter Best
Author-X-Name-First: Peter
Author-X-Name-Last: Best
Author-Name: Alistair Byrne
Author-X-Name-First: Alistair
Author-X-Name-Last: Byrne
Author-Name: Antti Ilmanen
Author-X-Name-First: Antti
Author-X-Name-Last: Ilmanen
Title: What Really Happened to U.S. Bond Yields
Abstract: 
 Analysts have been able to say surprisingly little about the sources of the very
                    volatile yields of long-term U.S. bonds in recent decades. We used surveys of
                    economists' forecasts to decompose long-term bond yields into expectations of
                    future inflation, expected real short-term interest rates, and the expected bond
                    risk premium. Variation in the bond risk premium accounts for most of the
                    variation in yields from period to period, but declines in all three components
                    have contributed to the decline in yields of the past decade and a half. 
Journal: Financial Analysts Journal
Pages: 41-49
Issue: 3
Volume: 54
Year: 1998
Month: 5
X-DOI: 10.2469/faj.v54.n3.2179
File-URL: http://hdl.handle.net/10.2469/faj.v54.n3.2179
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:3:p:41-49




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Author-Name: Morris G. Danielson
Author-X-Name-First: Morris G.
Author-X-Name-Last: Danielson
Title: A Simple Valuation Model and Growth Expectations
Abstract: 
 A simple valuation model is presented in which a firm can invest in projects with
                    positive net present values for a limited number of years. Although prior models
                    have made this assumption, this model can be simplified to a concise,
                    easy-to-use form. The model can facilitate a broad understanding of the
                    expectations implied by a firm's stock price—for example, growth patterns
                    consistent with a firm's P/E—which can guide in-depth analysis of prices.
Journal: Financial Analysts Journal
Pages: 50-57
Issue: 3
Volume: 54
Year: 1998
Month: 5
X-DOI: 10.2469/faj.v54.n3.2180
File-URL: http://hdl.handle.net/10.2469/faj.v54.n3.2180
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:3:p:50-57




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Author-Name: Huong Ngo Higgins
Author-X-Name-First: Huong Ngo
Author-X-Name-Last: Higgins
Title: Analyst Forecasting Performance in Seven Countries
Abstract: 
 Through an examination of more than 11,000 firms in the United States, Japan, and
                    various European markets in the 1991–95 period, this article shows an
                    association between the level of firms' disclosures and analysts' ability to
                    forecast earnings per share. The findings are consistent with the notion that
                    analysts forecast earnings with more accuracy and less optimistic bias for firms
                    in countries that mandate relatively more disclosure than they do for firms in
                    countries with less stringent mandates. This article also reports the average
                    forecast errors for firms, by country, in the study. 
Journal: Financial Analysts Journal
Pages: 58-62
Issue: 3
Volume: 54
Year: 1998
Month: 5
X-DOI: 10.2469/faj.v54.n3.2181
File-URL: http://hdl.handle.net/10.2469/faj.v54.n3.2181
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:3:p:58-62




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Author-Name: Roger G. Clarke
Author-X-Name-First: Roger G.
Author-X-Name-Last: Clarke
Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: Bullish or Bearish?
Abstract: 
 The sentiment of newsletter writers, whether bullish or bearish, does not
                    forecast future returns, but past returns and the volatility of those returns do
                    affect sentiment. High returns over four-week periods are associated with a
                    migration of newsletter writers from the bearish camp into the bullish camp.
                    High returns over periods of 26 and 52 weeks are associated with “nervous
                    bullishness”—a migration of newsletter writers from the bearish
                    camp into both the bullish and the correction camps. High volatility, instead of
                    scaring newsletter writers into bearishness, reduces the effects of both
                    positive and negative returns on sentiment. Also, contrary to a popular
                    hypothesis, the crash of 1987 had no significant effect on the pattern of
                    forecasts. 
Journal: Financial Analysts Journal
Pages: 63-72
Issue: 3
Volume: 54
Year: 1998
Month: 5
X-DOI: 10.2469/faj.v54.n3.2182
File-URL: http://hdl.handle.net/10.2469/faj.v54.n3.2182
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:3:p:63-72




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Author-Name: Robert Fernholz
Author-X-Name-First: Robert
Author-X-Name-Last: Fernholz
Title: Crossovers, Dividends, and the Size Effect
Abstract: 
 The size effect may have been the result of high stock volatility and low
                    dividend payments. Suppose an equity market is partitioned into a large-stock
                    index and a small-stock index, and suppose that, over a given period of time,
                    each of the indexes retains its share of the total market capitalization. Price
                    volatility will cause some stocks to cross over from one index to the other,
                    which will result in higher returns for the small-stock index and lower returns
                    for the large-stock index. Dividend payments by large companies could offset the
                    effect of the crossovers, but they have historically been insufficient to do so.
                    Hence, the size effect. 
Journal: Financial Analysts Journal
Pages: 73-78
Issue: 3
Volume: 54
Year: 1998
Month: 5
X-DOI: 10.2469/faj.v54.n3.2183
File-URL: http://hdl.handle.net/10.2469/faj.v54.n3.2183
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:3:p:73-78




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Author-Name: Mark P. Kritzman
Author-X-Name-First: Mark P.
Author-X-Name-Last: Kritzman
Title: Real Misconceptions about Optimal Equity Allocation and Investment Horizon
Abstract: 
 This material comments on “Misconceptions about Optimal Equity Allocation and Investment Horizon”.
Journal: Financial Analysts Journal
Pages: 5-5
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2190
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2190
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:4:p:5-5




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Author-Name: Walter M. Cabot
Author-X-Name-First: Walter M.
Author-X-Name-Last: Cabot
Title: Restrictive Guidelines and Pressure to Outperform
Abstract: 
 Restrictive guidelines and an emphasis on outperforming benchmarks in the short term may cloud the relationship between clients and managers and impair long-term investment success. 
Journal: Financial Analysts Journal
Pages: 6-10
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2192
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2192
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:4:p:6-10




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Author-Name: Mark Hirschey
Author-X-Name-First: Mark
Author-X-Name-Last: Hirschey
Title: How Much Is a Tulip Worth?
Abstract: 
 The kind of passion to possess tulip bulbs that gripped Holland some 350 years ago may be alive and well today among certain U.S. equity investors. 
Journal: Financial Analysts Journal
Pages: 11-17
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2193
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2193
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Author-Name: William L. Fouse
Author-X-Name-First: William L.
Author-X-Name-Last: Fouse
Title: New Directions in Index-Based Management
Abstract: 
 An index pioneer sees the downfall of classic large-capitalization indexing and the rise of new opportunities from combining indexing with derivatives. 
Journal: Financial Analysts Journal
Pages: 18-20
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2194
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2194
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:4:p:18-20




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Author-Name: William F. Sharpe
Author-X-Name-First: William F.
Author-X-Name-Last: Sharpe
Title: Morningstar's Risk-Adjusted Ratings
Abstract: 
 The characteristics of the “risk-adjusted rating” (RAR) on which Morningstar bases its “star ratings” and “category ratings” are analyzed, and the RAR is compared with more traditional mean–variance measures. The RAR measure has characteristics similar to those of an expected utility function based on an underlying bilinear utility function. These characteristics are of some concern because strict adherence to maximizing expected utility with such a function could lead to extreme investment strategies. This study finds that Morningstar varies one of the parameters of this function in a manner that frequently produces results similar to the results of using the excess-return Sharpe ratio. Finally, the argument is presented that neither Morningstar's measure nor the excess-return Sharpe ratio is an efficient tool for choosing mutual funds within peer groups for a multifund portfolio. 
Journal: Financial Analysts Journal
Pages: 21-33
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2195
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2195
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:4:p:21-33




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Author-Name: Thomas H. Goodwin
Author-X-Name-First: Thomas H.
Author-X-Name-Last: Goodwin
Title: The Information Ratio
Abstract: 
 Despite the widespread use of information ratios to gauge the performance of active money managers, confusion persists over how to calculate an information ratio, how to interpret it, and what constitutes a “good” one. The argument here is that the simplest form and interpretation of the ratio is the most useful for investors. This article clarifies the relationship between an information ratio and a t-statistic, compares four methods of annualizing an information ratio, and presents the empirical evidence on the distribution of information ratios by style, which provides a context in which to examine manager performance. 
Journal: Financial Analysts Journal
Pages: 34-43
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2196
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2196
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Author-Name: Thomas Albrecht
Author-X-Name-First: Thomas
Author-X-Name-Last: Albrecht
Title: The Mean–Variance Framework and Long Horizons
Abstract: 
 Some have argued that low-risk investments grow more attractive at longer investment horizons as their Sharpe ratios improve relative to high-risk investments. This article rejects this view by showing that the long-term standard deviation of returns can be misleading as an indicator of risk: Because of compounding, investments with identical standard deviations can have entirely different long-term risk characteristics even if all instantaneous investment returns are normally distributed. Furthermore, even if an individual investor accepts standard deviation of long-term returns as a measure of long-term risk, the relative attractiveness of high-risk investments can be kept constant by proper portfolio adjustments. 
Journal: Financial Analysts Journal
Pages: 44-49
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2197
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2197
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:4:p:44-49




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Author-Name: Donald B. Keim
Author-X-Name-First: Donald B.
Author-X-Name-Last: Keim
Author-Name: Ananth Madhavan
Author-X-Name-First: Ananth
Author-X-Name-Last: Madhavan
Title: The Cost of Institutional Equity Trades
Abstract: 
 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. 
Journal: Financial Analysts Journal
Pages: 50-69
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2198
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2198
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:4:p:50-69




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Author-Name: Maggie Copeland
Author-X-Name-First: Maggie
Author-X-Name-Last: Copeland
Author-Name: Tom Copeland
Author-X-Name-First: Tom
Author-X-Name-Last: Copeland
Title: Leads, Lags, and Trading in Global Markets
Abstract: 
 The development of capital markets around the world has given rise to growing interest in how the markets are linked. This study, using the Dow Jones & Company country and industry indexes, found that the United States has statistically significant one-day leads over markets in Europe and Asia, that no significant leads extend beyond one day, that changes in foreign exchange rates contribute to the links among markets, and that the industries designated “global” are significantly more sensitive to leads than are “local” industries. Lead/lag relationships may allow yield enhancement, possibly even arbitrage, through trading futures in some markets. 
Journal: Financial Analysts Journal
Pages: 70-80
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2199
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2199
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:4:p:70-80




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Author-Name: John C. Alexander
Author-X-Name-First: John C.
Author-X-Name-Last: Alexander
Author-Name: James S. Ang
Author-X-Name-First: James S.
Author-X-Name-Last: Ang
Title: Do Equity Markets Respond to Earnings Paths?
Abstract: 
 We present our investigation of whether the U.S. equity market responds to the path of earnings information. An earnings path consisted of two consecutive quarters of earnings announcements, adjusted for expectations and seasonality by using analysts' consensus forecasts. After controlling for the information content over the period, we found that security returns for the two-quarter period are affected by the earnings path. The path-dependent security returns are more evident for smaller firms, and the path dependence persists after controlling for firm size and investor anticipation of future earnings surprises. 
Journal: Financial Analysts Journal
Pages: 81-94
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2200
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2200
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:4:p:81-94




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Author-Name: Dirk P.M. De Wit
Author-X-Name-First: Dirk P.M.
Author-X-Name-Last: De Wit
Title: Naive Diversification
Abstract: 
 Some diversifiable risk is always left in a portfolio. The argument here is that the excess risk in a randomly selected portfolio of a given size should be compensated for. The analysis shows that the required excess return of an imperfectly diversified portfolio depends on just two parameters: the equity risk premium and the average correlation between stock returns. 
Journal: Financial Analysts Journal
Pages: 95-100
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2201
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2201
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:4:p:95-100




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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Merton Miller on Derivatives (a review)
Abstract: 
 This collection of speeches and articles ranges much wider than constraints on derivatives as Miller demolishes the economic fallacies that pass for political discourse. 
Journal: Financial Analysts Journal
Pages: 101-102
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2202
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2202
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:4:p:101-102




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Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: It Was a Very Good Year: Extraordinary Moments in Stock Market History (a review)
Abstract: 
 This entertaining and enlightening history spotlights the 10 best years on Wall Street in the 20th century, describes the sequels to the great markets, and identifies harbingers of future Very Good Years. 
Journal: Financial Analysts Journal
Pages: 102-102
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2203
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2203
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: New Dimensions in Investor Relations: Competing for Capital in the 21st Century (a review)
Abstract: 
 This compendium is targeted to companies that wish to court investors and provides practical advice on investor relations that may be of use to those investors being courted. 
Journal: Financial Analysts Journal
Pages: 102-103
Issue: 4
Volume: 54
Year: 1998
Month: 7
X-DOI: 10.2469/faj.v54.n4.2204
File-URL: http://hdl.handle.net/10.2469/faj.v54.n4.2204
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Author-Name: Hoi Tay Wong
Author-X-Name-First: Hoi Tay
Author-X-Name-Last: Wong
Title: Maintaining Consistent Global Asset Views: A Comment
Abstract: 
 This material comments on “Maintaining Consistent Global Asset Views”.
Journal: Financial Analysts Journal
Pages: 7-8
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2205
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2205
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Author-Name: Mark Latham
Author-X-Name-First: Mark
Author-X-Name-Last: Latham
Title: Corporate Monitoring: New Shareholder Power Tool
Abstract: 
 Shareholders should vote to choose an outside agency for nominating directors. 
Journal: Financial Analysts Journal
Pages: 9-15
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2207
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2207
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:5:p:9-15




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Author-Name: Arun Khanna
Author-X-Name-First: Arun
Author-X-Name-Last: Khanna
Title: The Titanic: The Untold Economic Story
Abstract: 
 The sinking of the Titanic provides a natural setting for testing market efficiency. 
Journal: Financial Analysts Journal
Pages: 16-17
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2208
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2208
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Author-Name: Eric H. Sorensen
Author-X-Name-First: Eric H.
Author-X-Name-Last: Sorensen
Author-Name: Keith L. Miller
Author-X-Name-First: Keith L.
Author-X-Name-Last: Miller
Author-Name: Vele Samak
Author-X-Name-First: Vele
Author-X-Name-Last: Samak
Title: Allocating between Active and Passive Management
Abstract: 
 With the recent difficulty in beating the S&P 500 Index, the debate over active versus passive investing has risen to a new level of importance. We provide a framework for analyzing the trade-off the typical pension fund faces in deciding how much to index. Our analysis gets at the root of active performance—stock-picking skill. After analyzing the performance associated with various degrees of skill in various equity styles for the 1985–97 period, we found that a modest amount of stock-picking skill goes a long way and that the optimal amount of allocation to indexing declines as skill increases. For most risk categories, however, some allocation to indexing is appropriate. 
Journal: Financial Analysts Journal
Pages: 18-31
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2209
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2209
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:5:p:18-31




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# input file: UFAJ_A_12047106_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Eckhard Freimann
Author-X-Name-First: Eckhard
Author-X-Name-Last: Freimann
Title: Economic Integration and Country Allocation in Europe
Abstract: 
 The impact of European integration—at the company and macro levels—on correlations between stock market returns is analyzed. A new procedure based on randomization methodology is introduced to test for the absence of country-systematic differences in the return patterns of two stock markets. The results indicate that stock market integration in Europe is not yet complete, but the comovement of European markets has increased substantially and is likely to continue to grow. Therefore, top-down managers of European equity portfolios need to look for a new strategy other than country-based allocation. 
Journal: Financial Analysts Journal
Pages: 32-41
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2210
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2210
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:5:p:32-41




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# input file: UFAJ_A_12047107_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Kenneth R. Beller
Author-X-Name-First: Kenneth R.
Author-X-Name-Last: Beller
Author-Name: John L. Kling
Author-X-Name-First: John L.
Author-X-Name-Last: Kling
Author-Name: Michael J. Levinson
Author-X-Name-First: Michael J.
Author-X-Name-Last: Levinson
Title: Are Industry Stock Returns Predictable?
Abstract: 
 We investigated in-sample and out-of-sample predictability of equal-weighted and capitalization-weighted quarterly excess returns for 55 industries over the 1973–95 period. The in-sample analysis supported predictability for about 80 percent of the cap-weighted industries and about 90 percent of the equal-weighted industries. The out-of-sample analysis provided strong evidence that the forecasting models for industry returns combined with mean–variance optimization criteria are useful for portfolio selection. 
Journal: Financial Analysts Journal
Pages: 42-57
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2211
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2211
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:5:p:42-57




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# input file: UFAJ_A_12047108_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert A. Olsen
Author-X-Name-First: Robert A.
Author-X-Name-Last: Olsen
Author-Name: Muhammad Khaki
Author-X-Name-First: Muhammad
Author-X-Name-Last: Khaki
Title: Risk, Rationality, and Time Diversification
Abstract: 
 The validity of the concept of time diversification is the subject of long-running debate. Supporters of the concept argue that risk decreases as investment horizon increases; detractors suggest that the concept is false on the face of it. We argue that time diversification is consistent both theoretically and empirically with current conceptions of risk and rationality, and we also note the implications of changes in investment horizon for stock market behavior. 
Journal: Financial Analysts Journal
Pages: 58-63
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2212
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2212
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:5:p:58-63




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# input file: UFAJ_A_12047109_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hendrik Bessembinder
Author-X-Name-First: Hendrik
Author-X-Name-Last: Bessembinder
Author-Name: Herbert M. Kaufman
Author-X-Name-First: Herbert M.
Author-X-Name-Last: Kaufman
Title: Trading Costs and Volatility for Technology Stocks
Abstract: 
 Evidence on trade-execution costs and market quality for heavily traded technology stocks indicates that trading costs for these stocks are substantially lower on the NYSE than on Nasdaq. We report that for the full sample and two-year period of our test, quoted percentage bid–ask half-spreads were 11.8 basis points wider and effective bid–ask half-spreads were 11.3 basis points wider on Nasdaq. We also document that Nasdaq executes a substantially larger fraction of trades outside the quotations. Finally, we found returns on Nasdaq technology stocks to be more volatile than returns on NYSE technology stocks; the median standard deviation of daily returns was 51 percent larger for Nasdaq-traded companies. 
Journal: Financial Analysts Journal
Pages: 64-71
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2213
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2213
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:5:p:64-71




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# input file: UFAJ_A_12047110_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hans R. Stoll
Author-X-Name-First: Hans R.
Author-X-Name-Last: Stoll
Title: Reconsidering the Affirmative Obligation of Market Makers
Abstract: 
 Market makers on exchanges regulated by the U.S. SEC are subject to an affirmative obligation to make “fair and orderly markets,” and in return, they receive certain benefits. Financial economists have long been skeptical, however, of the efficacy of a legal requirement to “do good” and have found little evidence that the requirement contributes to the quality of markets. Moreover, competition across markets reduces the willingness of market makers to stabilize markets, and electronic trading reduces the importance of market makers. 
Journal: Financial Analysts Journal
Pages: 72-82
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2214
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2214
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:5:p:72-82




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# input file: UFAJ_A_12047111_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ranjan Sinha
Author-X-Name-First: Ranjan
Author-X-Name-Last: Sinha
Title: Company Cross-Holdings and Investment Analysis
Abstract: 
 Some analysts have suggested that the prevalence of cross-holdings leads to a significant distortion in aggregate market capitalizations. Moreover, equity investors and creditors are advised to undo the effects of these distortions when analyzing companies in markets where cross-holdings are common. The analysis here shows that for most equity investment decisions, undoing the effects of cross-holdings is inappropriate. Furthermore, cross-holdings do increase the debt-bearing capacity of firms and should not be entirely eliminated during credit analysis. Finally, empire building is unlikely to be the primary reason for cross-holdings. 
Journal: Financial Analysts Journal
Pages: 83-89
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2215
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2215
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:5:p:83-89




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# input file: UFAJ_A_12047112_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Prashant P. Kothari
Author-X-Name-First: Prashant P.
Author-X-Name-Last: Kothari
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Everything You've Heard about Investing is Wrong! How to Profit in the Coming Post-Bull Markets (a review)
Abstract: 
 The author of this readable book provides investors with solid insights and recommendations that are based on the assumption that the boom times are over. 
Journal: Financial Analysts Journal
Pages: 90-91
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2216
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2216
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:5:p:90-91




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# input file: UFAJ_A_12047113_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: A Scientist's Tools for Business: Metaphors and Modes of Thought (a review)
Abstract: 
 Intended for corporate executives, this book explores how the methods of science can help in dealing with a wide variety of business problems. 
Journal: Financial Analysts Journal
Pages: 91-92
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2217
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2217
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:5:p:91-92




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# input file: UFAJ_A_12047114_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Managing Credit Risk: The Next Great Challenge (a review)
Abstract: 
 This valuable resource for investors and risk managers provides a broad perspective on the evolving nature of credit risk and a detailed critique of techniques for quantifying and controlling it.
Journal: Financial Analysts Journal
Pages: 92-93
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2218
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2218
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:5:p:92-93




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# input file: UFAJ_A_12047115_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: H. Gifford Fong
Author-X-Name-First: H. Gifford
Author-X-Name-Last: Fong
Title: From the Editor
Abstract: 
 The Financial Analysts Journal has served the investment community for more than 50 years. With a growing readership of more than 35,000 professionals, it is one of the leading practitioner-oriented journals in the world. To be offered the position of editor is a great honor; to accept the position is a sacred responsibility. My goal is to maintain and improve a fully refereed journal that can serve its broad constituency with a high-quality platform for original research and knowledge. Our imprimatur will be the practical significance and readability of the material we print; we will honor the FAJ's standard of quality by pursuing academic rigor. The initiatives we will be pursuing include emphasis beyond the core of articles to include powerful introductions to topics and useful bibliographies on subjects. We will make use of technical appendixes to relieve mathematical congestion in the articles, and we will compile some issues according to themes in order to provide extensive coverage of specific topics of interest. The effort required to maintain the FAJ's standards and carry out the initiatives will draw heavily on an excellent staff, our active editorial board, and other selected referees. It is the individual and collective wisdom and input of this talented group that I will rely on as we go forward. Thankfully, we have the tenure of Van Harlow, our previous editor, to build on. I hope this brief reflection casts some light on the direction we are headed. You, the readers, are what we are all about. Your input is welcome and important as we proceed. 
Journal: Financial Analysts Journal
Pages: 6-6
Issue: 5
Volume: 54
Year: 1998
Month: 9
X-DOI: 10.2469/faj.v54.n5.2219
File-URL: http://hdl.handle.net/10.2469/faj.v54.n5.2219
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:5:p:6-6




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# input file: UFAJ_A_12047116_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Peter L. Bernstein
Author-X-Name-First: Peter L.
Author-X-Name-Last: Bernstein
Title: Where, Oh Where Are the .400 Hitters of Yesteryear?
Abstract: 
 The super investment manager seems to be disappearing, and the cause is probably ever-increasing efficiency in the equity markets. 
Journal: Financial Analysts Journal
Pages: 6-14
Issue: 6
Volume: 54
Year: 1998
Month: 11
X-DOI: 10.2469/faj.v54.n6.2220
File-URL: http://hdl.handle.net/10.2469/faj.v54.n6.2220
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:6:p:6-14




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# input file: UFAJ_A_12047117_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Keith Ambachtsheer
Author-X-Name-First: Keith
Author-X-Name-Last: Ambachtsheer
Author-Name: Ronald Capelle
Author-X-Name-First: Ronald
Author-X-Name-Last: Capelle
Author-Name: Tom Scheibelhut
Author-X-Name-First: Tom
Author-X-Name-Last: Scheibelhut
Title: Improving Pension Fund Performance
Abstract: 
 With global pension assets projected to reach US$12 trillion by 2000, understanding what drives pension fund performance has never been more important. The study of pension funds described in this article found that the funds, after adjustment for the incremental costs and risks they undertook, underperformed their passive policy benchmarks in the 1993–96 period by an average 60 basis points a year. We discuss three drivers of fund performance—fund size, proportion of assets passively managed, and quality of the fund's organization design—and offer suggestions for improving pension fund performance by improving elements of the fund's organization. 
Journal: Financial Analysts Journal
Pages: 15-21
Issue: 6
Volume: 54
Year: 1998
Month: 11
X-DOI: 10.2469/faj.v54.n6.2221
File-URL: http://hdl.handle.net/10.2469/faj.v54.n6.2221
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:6:p:15-21




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# input file: UFAJ_A_12047118_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Xavier Garza-Gómez
Author-X-Name-First: Xavier
Author-X-Name-Last: Garza-Gómez
Author-Name: Jiro Hodoshima
Author-X-Name-First: Jiro
Author-X-Name-Last: Hodoshima
Author-Name: Michio Kunimura
Author-X-Name-First: Michio
Author-X-Name-Last: Kunimura
Title: Does Size Really Matter in Japan?
Abstract: 
 Size-related regularities can be explained by riskiness and should not be regarded as anomalies. This article provides evidence that market value of equity reflects information about risk. Using data from the Japanese stock market, we found that among companies with similar cash flows, the companies with riskier cash flows had lower market values and higher expected returns. This role of market value of equity is strong over time and significant even when market beta estimates are considered. We also found, contrary to a “size effect,” a positive relationship between measures of physical size and returns. 
Journal: Financial Analysts Journal
Pages: 22-34
Issue: 6
Volume: 54
Year: 1998
Month: 11
X-DOI: 10.2469/faj.v54.n6.2222
File-URL: http://hdl.handle.net/10.2469/faj.v54.n6.2222
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:6:p:22-34




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# input file: UFAJ_A_12047119_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Vijay Kumar Chopra
Author-X-Name-First: Vijay Kumar
Author-X-Name-Last: Chopra
Title: Why So Much Error in Analysts' Earnings Forecasts?
Abstract: 
 Wall Street analysts tend to be too optimistic about the earnings prospects of companies they follow. The average consensus 12-month EPS growth forecast is 17.7 percent, which is more than twice the actual growth rate. In aggregate, forecasts are 11.2 percent above actual earnings at the start of a year and are revised downward continuously in the course of the year. For the full study period reported here, the percentage of 12-month earnings estimates revised downward exceeded the percentage revised upward, on average, by 4.4 percent every month. Since 1993, however, the quality of analyst forecasts seems to have improved. This article provides an intuitive explanation of the change and suggests ways in which analysts can use the explanation to improve portfolio performance. 
Journal: Financial Analysts Journal
Pages: 35-42
Issue: 6
Volume: 54
Year: 1998
Month: 11
X-DOI: 10.2469/faj.v54.n6.2223
File-URL: http://hdl.handle.net/10.2469/faj.v54.n6.2223
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:6:p:35-42




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# input file: UFAJ_A_12047120_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Kenneth R. Arteaga
Author-X-Name-First: Kenneth R.
Author-X-Name-Last: Arteaga
Author-Name: Conrad S. Ciccotello
Author-X-Name-First: Conrad S.
Author-X-Name-Last: Ciccotello
Author-Name: C. Terry Grant
Author-X-Name-First: C. Terry
Author-X-Name-Last: Grant
Title: New Equity Funds: Marketing and Performance
Abstract: 
 We discuss two strategies sponsors have used successfully to introduce new equity funds and promote the performance of the funds after their introduction. The strategy of “incubation” allows funds that compile a favorable track record in private to be marketed to the public at a later opportune time. The strategy of “selective attention” directs favorable allocations of “special situations” into new funds that are open to the public. Introduction strategies are most apparent among aggressive growth funds, where first-year performance has increasingly become superior. Incubator funds remain small while private, but once opened, they quickly increase in size and revert to median performance. The first-year success of selective attention funds also attracts large amounts of cash, which undermines their subsequent performance. 
Journal: Financial Analysts Journal
Pages: 43-49
Issue: 6
Volume: 54
Year: 1998
Month: 11
X-DOI: 10.2469/faj.v54.n6.2224
File-URL: http://hdl.handle.net/10.2469/faj.v54.n6.2224
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:6:p:43-49




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# input file: UFAJ_A_12047121_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Sandeep A. Patel
Author-X-Name-First: Sandeep A.
Author-X-Name-Last: Patel
Author-Name: Asani Sarkar
Author-X-Name-First: Asani
Author-X-Name-Last: Sarkar
Title: Crises in Developed and Emerging Stock Markets
Abstract: 
 Stock market crises in the developed markets differ in important ways from the crises in emerging stock markets. Our study of nine crises in the 1970–97 period indicates that developed market crises have become less severe over time, in terms of both the extent of price decline and duration, but those in emerging stock markets have not. In both markets, prices fall for at least three years subsequent to recovery from a crisis and the crisis in one market is likely to be followed by crises in most other markets in the region. Nevertheless, even in times of crises, international stocks continue to provide diversification benefits for U.S. investors with long investment horizons. 
Journal: Financial Analysts Journal
Pages: 50-61
Issue: 6
Volume: 54
Year: 1998
Month: 11
X-DOI: 10.2469/faj.v54.n6.2225
File-URL: http://hdl.handle.net/10.2469/faj.v54.n6.2225
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:6:p:50-61




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# input file: UFAJ_A_12047122_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Title: Franchise Valuation under Q-Type Competition
Abstract: 
 When considering a company's prospects, analysts often segment the earnings progression, either formally or intuitively, into a series of growth phases followed by a relatively stable terminal phase. This study focuses on the role of competition in the terminal phase. In the simplified two-phase model of a single-product company, the first-phase earnings growth drives the company's overall return on equity toward the (generally higher) incremental ROE on new investments. The company then enters the terminal phase with a high ROE that attracts the attention of a potential competitor that can replicate the company's production/distribution capacity at some multiple Q of the original capital cost. This “ Q-type competition” can lead to margin erosion and a reduction in earnings as the ROE slides to more competitive levels. The implication is that, unless a company has either the diversity of product/service cycles or other special ways to deflect competitive pressures, the analyst should address the potential impact of Q-type competition on the sustainability of the company's franchise and the company's valuation. 
Journal: Financial Analysts Journal
Pages: 62-74
Issue: 6
Volume: 54
Year: 1998
Month: 11
X-DOI: 10.2469/faj.v54.n6.2226
File-URL: http://hdl.handle.net/10.2469/faj.v54.n6.2226
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:6:p:62-74




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# input file: UFAJ_A_12047123_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Olivier de La Grandville
Author-X-Name-First: Olivier
Author-X-Name-Last: de La Grandville
Title: The Long-Term Expected Rate of Return: Setting It Right
Abstract: 
 A number of serious, widely held errors and misconceptions about the long-term expected rate of return need to be dispelled. First, this rate need not be approximated, because exact formulas for this estimate are easy to find and apply. Second, such an approximation could be quite misleading. This article offers simple methods and exact formulas to determine the expected value and variance of the n-year horizon rate of return directly in terms of the one-year parameters. The probability distribution of that return is also brought out. Concrete examples illustrate these results. 
Journal: Financial Analysts Journal
Pages: 75-80
Issue: 6
Volume: 54
Year: 1998
Month: 11
X-DOI: 10.2469/faj.v54.n6.2227
File-URL: http://hdl.handle.net/10.2469/faj.v54.n6.2227
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:6:p:75-80




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# input file: UFAJ_A_12047124_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Christopher M. Brockman
Author-X-Name-First: Christopher M.
Author-X-Name-Last: Brockman
Author-Name: Robert Brooks
Author-X-Name-First: Robert
Author-X-Name-Last: Brooks
Title: The CFA Charter: Adding Value to the Market
Abstract: 
 The Chartered Financial Analyst (CFA®) designation is recognized worldwide as one of the most prestigious and respected designations for investment professionals. We discuss the many benefits—to the profession, the professionals, and their clients—of professional designations in general and of the CFA designation in particular. We argue that as the number of CFA charterholders has increased, the overall integrity of the market has also increased, which has contributed to the overall increase in the value of the market since 1963. Thus, we contend, the CFA designation adds value to the market. 
Journal: Financial Analysts Journal
Pages: 81-85
Issue: 6
Volume: 54
Year: 1998
Month: 11
X-DOI: 10.2469/faj.v54.n6.2228
File-URL: http://hdl.handle.net/10.2469/faj.v54.n6.2228
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:6:p:81-85




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# input file: UFAJ_A_12047125_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Beyond Wall Street: The Art of Investing (a review)
Abstract: 
 Through description of outstanding money managers, the authors make a strong case that, despite widely varying methods, managers' relentless pursuit of not-yet-discounted information is the source of superior investment performance.
Journal: Financial Analysts Journal
Pages: 86-87
Issue: 6
Volume: 54
Year: 1998
Month: 11
X-DOI: 10.2469/faj.v54.n6.2229
File-URL: http://hdl.handle.net/10.2469/faj.v54.n6.2229
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:6:p:86-87




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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Contrarian Investment Strategies: The Next Generation (a review)
Abstract: 
 Forbes columnist Dreman provides investment professionals a treasure trove of research findings on value investing, explains the origins of analytical biases, and describes his own personal criteria for selecting specific contrarian stocks.
Journal: Financial Analysts Journal
Pages: 87-88
Issue: 6
Volume: 54
Year: 1998
Month: 11
X-DOI: 10.2469/faj.v54.n6.2230
File-URL: http://hdl.handle.net/10.2469/faj.v54.n6.2230
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Handle: RePEc:taf:ufajxx:v:54:y:1998:i:6:p:87-88




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# input file: UFAJ_A_12047127_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: H. Gifford Fong
Author-X-Name-First: H. Gifford
Author-X-Name-Last: Fong
Title: Letter from the Editor
Abstract: 
 This issue includes the first set of manuscripts that have qualified for publication under our new editorial procedures, which seek to promote the highest quality by a double-blind refereeing process and by providing constructive comments to authors. Our refereeing process draws on the knowledge and expertise of a talented editorial review board as well as a specially selected group of ad hoc referees. Each referee is distinguished by having expertise in specific areas and an ability to provide timely reviews and comments. I am very grateful for the support of this dedicated group. As we go forward, we will be pursuing some new editorial initiatives. For example, we are planning to devote an entire issue to the topic of behavioral finance. This issue will include an introductory overview and articles covering a number of areas of application. Please join me in the pursuit of making the Financial Analysts Journal an even better publication than it is already. Your suggestions and comments are welcome, and high-quality practitioner-oriented manuscripts are especially appreciated. 
Journal: Financial Analysts Journal
Pages: 6-6
Issue: 1
Volume: 55
Year: 1999
Month: 1
X-DOI: 10.2469/faj.v55.n1.2235
File-URL: http://hdl.handle.net/10.2469/faj.v55.n1.2235
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:1:p:6-6




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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to the article by Arun Khanna,“Titanic: The Untold Economic Story,” which appeared in the September/October 1998 issue. 
Journal: Financial Analysts Journal
Pages: 7-7
Issue: 1
Volume: 55
Year: 1999
Month: 1
X-DOI: 10.2469/faj.v55.n1.2236
File-URL: http://hdl.handle.net/10.2469/faj.v55.n1.2236
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:1:p:7-7




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Author-Name: Jack Treynor
Author-X-Name-First: Jack
Author-X-Name-Last: Treynor
Title: Zero Sum
Abstract: 
 The key to who wins and who loses on a securities trade is trading bias, the amount by which one trader underestimates the ultimate price impact of the counterparty's motive. 
Journal: Financial Analysts Journal
Pages: 8-12
Issue: 1
Volume: 55
Year: 1999
Month: 1
X-DOI: 10.2469/faj.v55.n1.2237
File-URL: http://hdl.handle.net/10.2469/faj.v55.n1.2237
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:1:p:8-12




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Author-Name: Andrew W. Lo
Author-X-Name-First: Andrew W.
Author-X-Name-Last: Lo
Title: The Three P's of Total Risk Management
Abstract: 
 Current risk-management practices are based on probabilities of extreme dollar losses (e.g., measures like Value at Risk), but these measures capture only part of the story. Any complete risk-management system must address two other important factors—prices and preferences. Together with probabilities, these compose the three P's of “Total Risk Management.” This article describes how the three P's interact to determine sensible risk profiles for corporations and for individuals—guidelines for how much risk to bear and how much to hedge. By synthesizing existing research in economics, psychology, and decision sciences and through an ambitious research agenda to extend this synthesis into other disciplines, a complete and systematic approach to rational decision making in an uncertain world is within reach. 
Journal: Financial Analysts Journal
Pages: 13-26
Issue: 1
Volume: 55
Year: 1999
Month: 1
X-DOI: 10.2469/faj.v55.n1.2238
File-URL: http://hdl.handle.net/10.2469/faj.v55.n1.2238
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:1:p:13-26




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Author-Name: Hayne E. Leland
Author-X-Name-First: Hayne E.
Author-X-Name-Last: Leland
Title: Beyond Mean–Variance: Performance Measurement in a Nonsymmetrical World (corrected)
Abstract: 
 Most practitioners use the capital asset pricing model to measure investment performance. The CAPM, however, assumes either that all asset returns are normally distributed (and thus symmetrical) or that investors have mean–variance preferences (and thus ignore skewness). Both assumptions are suspect. Assuming only that the rate of return on the market portfolio is independently and identically distributed and that markets are “perfect,” this article shows that the CAPM and its risk measures are invalid: The market portfolio is mean–variance inefficient, and the CAPM alpha mismeasures the value added by investment managers. Strategies with positively skewed returns, such as strategies limiting downside risk, will be incorrectly underrated. A simple modification of the CAPM beta, however, will produce correct risk measurement for portfolios with arbitrary return distributions, and the resulting alphas of all fairly priced options and/or dynamic strategies will be zero. The risk measure requires no more information to implement than the CAPM. 
Journal: Financial Analysts Journal
Pages: 27-36
Issue: 1
Volume: 55
Year: 1999
Month: 1
X-DOI: 10.2469/faj.v55.n1.2239
File-URL: http://hdl.handle.net/10.2469/faj.v55.n1.2239
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:1:p:27-36




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Author-Name: Duen-Li Kao
Author-X-Name-First: Duen-Li
Author-X-Name-Last: Kao
Author-Name: Robert D. Shumaker
Author-X-Name-First: Robert D.
Author-X-Name-Last: Shumaker
Title: Equity Style Timing (corrected)
Abstract: 
 The studies reported here had two purposes: (1) to review the opportunities in short-term timing strategies in the U.S. market and (2) to explore value versus growth investing in theory and in practice. We found that timing strategies in the U.S. market based on asset class and size have historically provided more opportunity for outperformance than a timing strategy based on value (versus growth), albeit with similar information ratios. A multivariate macroeconomic analysis shows that return differences between value and growth stocks can have a straightforward, intuitive basis. In practice, the approach of style timers may vary, but successful style timing depends on efficient implementation. 
Journal: Financial Analysts Journal
Pages: 37-48
Issue: 1
Volume: 55
Year: 1999
Month: 1
X-DOI: 10.2469/faj.v55.n1.2240
File-URL: http://hdl.handle.net/10.2469/faj.v55.n1.2240
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:1:p:37-48




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Author-Name: Philip H. Dybvig
Author-X-Name-First: Philip H.
Author-X-Name-Last: Dybvig
Title: Using Asset Allocation to Protect Spending
Abstract: 
 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. 
Journal: Financial Analysts Journal
Pages: 49-62
Issue: 1
Volume: 55
Year: 1999
Month: 1
X-DOI: 10.2469/faj.v55.n1.2241
File-URL: http://hdl.handle.net/10.2469/faj.v55.n1.2241
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:1:p:49-62




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Author-Name: Ming Yee Wang
Author-X-Name-First: Ming Yee
Author-X-Name-Last: Wang
Title: Multiple-Benchmark and Multiple-Portfolio Optimization
Abstract: 
 Numerous real-life portfolio optimization problems require consideration of more than one benchmark and/or more than one portfolio. These problems are formulated in a way that seems to be more complicated than the standard problem of mean–tracking-error-variance optimization. In fact, however, these diverse problems can be reduced to the standard case and solved with the same algorithm. This article provides solutions to the dual-benchmark problem, the portfolio partition problem, and the completion portfolio problem. Such solutions and applications are important to both portfolio managers and plan sponsors. 
Journal: Financial Analysts Journal
Pages: 63-72
Issue: 1
Volume: 55
Year: 1999
Month: 1
X-DOI: 10.2469/faj.v55.n1.2242
File-URL: http://hdl.handle.net/10.2469/faj.v55.n1.2242
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:1:p:63-72




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Author-Name: Darrell Duffie
Author-X-Name-First: Darrell
Author-X-Name-Last: Duffie
Title: Credit Swap Valuation
Abstract: 
 This review of the pricing of credit swaps, a form of derivative security that can be viewed as default insurance on loans or bonds, begins with a description of the credit swap contract, turns to pricing by reference to spreads over the risk-free rate of par floating-rate bonds of the same quality, and then considers model-based pricing. The role of asset swap spreads as a reference for pricing credit swaps is also considered. 
Journal: Financial Analysts Journal
Pages: 73-87
Issue: 1
Volume: 55
Year: 1999
Month: 1
X-DOI: 10.2469/faj.v55.n1.2243
File-URL: http://hdl.handle.net/10.2469/faj.v55.n1.2243
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:1:p:73-87




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Author-Name: Steven L. Heston
Author-X-Name-First: Steven L.
Author-X-Name-Last: Heston
Title: Valuation and Hedging of Risky Lease Payments
Abstract: 
 Presented here is a simple formula to value risky corporate lease payments. When the amount of debt displaced by a lease depends on the value of the lease, the displaced debt tax shields are risky. The value of these risky tax shields is less than the value of riskless tax shields. The valuation of the lease makes use of a dynamic investment strategy that replicates the lease payments and associated tax shields from displaced debt. A useful variation of the valuation formula requires only the contractual cash flows and the yield on lease-equivalent debt. Calculations show that the new formula can produce significantly different lease values from formulas that assume riskless cash flows. 
Journal: Financial Analysts Journal
Pages: 88-94
Issue: 1
Volume: 55
Year: 1999
Month: 1
X-DOI: 10.2469/faj.v55.n1.2244
File-URL: http://hdl.handle.net/10.2469/faj.v55.n1.2244
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:1:p:88-94




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# input file: UFAJ_A_12047137_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Boomernomics: The Future of Your Money in the Upcoming Generational Warfare (a review)
Abstract: 
 This stimulating book makes a succinct and highly readable case for a future shaped by demographics. 
Journal: Financial Analysts Journal
Pages: 95-95
Issue: 1
Volume: 55
Year: 1999
Month: 1
X-DOI: 10.2469/faj.v55.n1.2245
File-URL: http://hdl.handle.net/10.2469/faj.v55.n1.2245
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:1:p:95-95




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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “Equity Style Timing” by Duen-Li Kao and Robert D. Shumaker, which appeared in the January/February issue. 
Journal: Financial Analysts Journal
Pages: 6-6
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2231
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2231
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:2:p:6-6




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Author-Name: Jeremy J. Siegel
Author-X-Name-First: Jeremy J.
Author-X-Name-Last: Siegel
Title: Stocks, Bonds, the Sharpe Ratio, and the Investment Horizon: A Comment
Abstract: 
 This material comments on “Stocks, Bonds, the Sharpe Ratio, and the Investment Horizon.”
Journal: Financial Analysts Journal
Pages: 7-8
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2250
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2250
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Author-Name: Madeleine Mamaux
Author-X-Name-First: Madeleine
Author-X-Name-Last: Mamaux
Title: How Much Is a Tulip Worth? A Comment
Abstract: 
 This material comments on “How Much Is a Tulip Worth?”
Journal: Financial Analysts Journal
Pages: 8-9
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2251
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2251
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:2:p:8-9




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Author-Name: David T. Jack
Author-X-Name-First: David T.
Author-X-Name-Last: Jack
Title: Where, Oh Where Are the .400 Hitters of Yesteryear? A Commment
Abstract: 
 This material comments on “Where, Oh Where Are the .400 Hitters of Yesteryear?”
Journal: Financial Analysts Journal
Pages: 9-11
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2253
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2253
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Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: Foreign Stocks in Behavioral Portfolios
Abstract: 
 By the rules of mean–variance and the example of the global equity market, foreign stocks should be attractive to U.S. investors, so why are investors so apprehensive about foreign stocks? 
Journal: Financial Analysts Journal
Pages: 12-16
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2255
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2255
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Author-Name: Richard Bookstaber
Author-X-Name-First: Richard
Author-X-Name-Last: Bookstaber
Title: Risk Management in Complex Organizations
Abstract: 
 The true challenge in risk management is to establish a simple system that promotes the firm's ability to react to surprises, not every nuance of known risks. 
Journal: Financial Analysts Journal
Pages: 18-20
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2256
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2256
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Author-Name: Kenneth R. Miller
Author-X-Name-First: Kenneth R.
Author-X-Name-Last: Miller
Author-Name: Christopher B. Tobe
Author-X-Name-First: Christopher B.
Author-X-Name-Last: Tobe
Title: Value of the CFA® Designation to Public Pensions
Abstract: 
 Public-sector retirement systems may find some of the expertise they need and reduce management costs by employing CFA charterholders. 
Journal: Financial Analysts Journal
Pages: 21-25
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2257
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2257
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Author-Name: Jack Treynor
Author-X-Name-First: Jack
Author-X-Name-Last: Treynor
Title: The Investment Value of Brand Franchise
Abstract: 
 Brand loyalty manifests itself in consumers' willingness to pay a higher price for the brand they prefer. Some manufacturers choose to limit their output, sell only to customers loyal to their brand (their franchise), and charge the higher price. Others choose to charge a lower price rather than limit their output. Because franchises can contribute as much, or more, to future cash flows as their plants contribute, companies in the first group support their franchises by large investments in advertising, introducing new versions of their products, and so on. Accountants, however, are reluctant to capitalize the expenditures that support franchises, which causes gaps between market value and book value. If the fixed marketing costs can be identified, however, analysts can estimate the investment value of the franchise and the manufacturer's efficiency in defending it. 
Journal: Financial Analysts Journal
Pages: 27-34
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2258
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2258
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Author-Name: Thierry Lombard
Author-X-Name-First: Thierry
Author-X-Name-Last: Lombard
Author-Name: Jacques Roulet
Author-X-Name-First: Jacques
Author-X-Name-Last: Roulet
Author-Name: Bruno Solnik
Author-X-Name-First: Bruno
Author-X-Name-Last: Solnik
Title: Pricing of Domestic versus Multinational Companies
Abstract: 
 World financial markets are becoming integrated. Hence, global factors rather than domestic factors should dominate the pricing of stocks. All the empirical studies published until the mid-1990s, however, reported that stock prices respond primarily to domestic factors. In other words, the pricing of a company's stock is driven predominantly by the primary location of its stock listing rather than by the nature and geographical breakdown of its activities. We challenge this vision of international market pricing. We have found that stock pricing, at least for non-U.S. companies, is strongly influenced by the extent of the company's nondomestic activities. This finding has implications for the organization of global equity research departments and for the structure of the investment process. 
Journal: Financial Analysts Journal
Pages: 35-49
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2259
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2259
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Author-Name: Ralph P. Goldsticker
Author-X-Name-First: Ralph P.
Author-X-Name-Last: Goldsticker
Author-Name: Pankaj Agrrawal
Author-X-Name-First: Pankaj
Author-X-Name-Last: Agrrawal
Title: The Effects of Blending Primary and Diluted EPS Data
Abstract: 
 Companies are now reporting basic and diluted, rather than primary and fully diluted, earnings per share. And a number of vendors changed from providing only primary EPS to providing only diluted EPS. They are also providing growth rates calculated from a blend of primary and diluted EPS. The growth rates calculated from a blended earnings stream will be lower than growth rates calculated from only primary or only diluted earnings, and the more years that are blended, the greater the reduction in the growth rate. The average differences in growth rates calculated from the various combinations of primary and diluted earnings are not large enough to be a cause for concern, but at the company level, blending earnings can produce growth rates that are substantially different from those produced when only primary or only diluted EPS are used. 
Journal: Financial Analysts Journal
Pages: 51-60
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2260
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2260
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# input file: UFAJ_A_12047151_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Grant McQueen
Author-X-Name-First: Grant
Author-X-Name-Last: McQueen
Author-Name: Steven Thorley
Author-X-Name-First: Steven
Author-X-Name-Last: Thorley
Title: Mining Fool's Gold
Abstract: 
 We discuss the popular Motley Fool's Foolish Four portfolio as a case study in data mining. We document the performance of the Foolish Four portfolio and use it to illustrate the mistaken inferences that can plague any investment research project. We describe the warning signs of data mining and discuss the antidotes to it—out-of-sample tests and the adjustment of returns for risk, transaction costs, and taxes. Finally, we document that the Foolish Four and Dow 10 trading rules have become popular enough to influence selected stock prices at the turn of the year. 
Journal: Financial Analysts Journal
Pages: 61-72
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2261
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2261
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:2:p:61-72




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# input file: UFAJ_A_12047152_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Maggie M. Copeland
Author-X-Name-First: Maggie M.
Author-X-Name-Last: Copeland
Author-Name: Thomas E. Copeland
Author-X-Name-First: Thomas E.
Author-X-Name-Last: Copeland
Title: Market Timing: Style and Size Rotation Using the VIX
Abstract: 
 Changes in the Market Volatility Index (VIX) of the Chicago Board Options Exchange are statistically significant leading indicators of daily market returns. On days that follow increases in the VIX, portfolios of large-capitalization stocks outperform portfolios of small-capitalization stocks and value-based portfolios outperform growth-based portfolios. On days following a decrease in the VIX, the opposites occur. The implication is that market timing may be feasible—at least for portfolio yield enhancement. 
Journal: Financial Analysts Journal
Pages: 73-81
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2262
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2262
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:2:p:73-81




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# input file: UFAJ_A_12047153_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Gregory W. Brown
Author-X-Name-First: Gregory W.
Author-X-Name-Last: Brown
Title: Volatility, Sentiment, and Noise Traders
Abstract: 
 The most basic implication of noise-trader theory is that irrational investors acting coherently on a noisy signal can cause systematic risk. If noise traders affect prices, the noisy signal is sentiment, and the risk they cause is volatility, then sentiment should be correlated with volatility. This article shows that, in fact, unusual levels of individual investor sentiment are associated with greater volatility of closed-end investment funds. Furthermore, this volatility occurs only when the market is open and is associated with heightened trading activity. It persists after controlling for marketwide volatility and changes in fund discounts. 
Journal: Financial Analysts Journal
Pages: 82-90
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2263
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2263
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:2:p:82-90




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# input file: UFAJ_A_12047154_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: A History of Corporate Finance (a review)
Abstract: 
 This history weaves a lively story of the evolution of contractual arrangements that attempt to solve the problems of information and risk in the financing of business. 
Journal: Financial Analysts Journal
Pages: 91-92
Issue: 2
Volume: 55
Year: 1999
Month: 3
X-DOI: 10.2469/faj.v55.n2.2264
File-URL: http://hdl.handle.net/10.2469/faj.v55.n2.2264
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:2:p:91-92




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# input file: UFAJ_A_12047155_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert Ferguson
Author-X-Name-First: Robert
Author-X-Name-Last: Ferguson
Author-Name: Neal Hitzig
Author-X-Name-First: Neal
Author-X-Name-Last: Hitzig
Title: Company Cross-Holdings: The Finance Version
Abstract: 
 This material comments on “Company Cross-Holdings.”
Journal: Financial Analysts Journal
Pages: 7-9
Issue: 3
Volume: 55
Year: 1999
Month: 5
X-DOI: 10.2469/faj.v55.n3.2265
File-URL: http://hdl.handle.net/10.2469/faj.v55.n3.2265
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:3:p:7-9




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# input file: UFAJ_A_12047156_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ranjan Sinha
Author-X-Name-First: Ranjan
Author-X-Name-Last: Sinha
Title: Company Cross-Holdings: Comments
Abstract: 
 This material comments on “Company Cross-Holdings.”
Journal: Financial Analysts Journal
Pages: 9-13
Issue: 3
Volume: 55
Year: 1999
Month: 5
X-DOI: 10.2469/faj.v55.n3.2266
File-URL: http://hdl.handle.net/10.2469/faj.v55.n3.2266
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# input file: UFAJ_A_12047157_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jeffrey M. Bacidore
Author-X-Name-First: Jeffrey M.
Author-X-Name-Last: Bacidore
Author-Name: John A. Boquist
Author-X-Name-First: John A.
Author-X-Name-Last: Boquist
Author-Name: Todd T. Milbourn
Author-X-Name-First: Todd T.
Author-X-Name-Last: Milbourn
Author-Name: Anjan V. Thakor
Author-X-Name-First: Anjan V.
Author-X-Name-Last: Thakor
Title: Search for the Best Financial Performance Measure: Yes, Basics Are Better—If You Understand Them
Abstract: 
 This material comments on “Search for the Best Financial Performance Measure.”
Journal: Financial Analysts Journal
Pages: 14-16
Issue: 3
Volume: 55
Year: 1999
Month: 5
X-DOI: 10.2469/faj.v55.n3.2267
File-URL: http://hdl.handle.net/10.2469/faj.v55.n3.2267
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# input file: UFAJ_A_12047158_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert Ferguson
Author-X-Name-First: Robert
Author-X-Name-Last: Ferguson
Author-Name: Dean Leistikow
Author-X-Name-First: Dean
Author-X-Name-Last: Leistikow
Title: Search for the Best Financial Performance Measure: Basics Are Still Better
Abstract: 
 This material comments on “Search for the Best Financial Performance Measure.”
Journal: Financial Analysts Journal
Pages: 16-19
Issue: 3
Volume: 55
Year: 1999
Month: 5
X-DOI: 10.2469/faj.v55.n3.2268
File-URL: http://hdl.handle.net/10.2469/faj.v55.n3.2268
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# input file: UFAJ_A_12047159_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Zhen Deng
Author-X-Name-First: Zhen
Author-X-Name-Last: Deng
Author-Name: Baruch Lev
Author-X-Name-First: Baruch
Author-X-Name-Last: Lev
Author-Name: Francis Narin
Author-X-Name-First: Francis
Author-X-Name-Last: Narin
Title: Science and Technology as Predictors of Stock Performance
Abstract: 
 Innovation and technological change are the main drivers of companies' productivity and growth. But public information on companies' efforts to innovate (namely, their investment in science and technology and the consequences of that investment) is generally scant and not timely. To alleviate this impediment to the valuation of companies' performance and prospects, we examined the ability of a new set of publicly available patent-related measures to reflect science- and technology-based companies' potential and growth. We tested the ability of the patent-related measures to predict stock returns and market-to-book ratios. Our empirical results indicate that patent measures reflecting the volume of companies' research activity, the impact of companies' research on subsequent innovations, and the closeness of research and development to science are reliably associated with the future performance of R&D-intensive companies in capital markets. 
Journal: Financial Analysts Journal
Pages: 20-32
Issue: 3
Volume: 55
Year: 1999
Month: 5
X-DOI: 10.2469/faj.v55.n3.2269
File-URL: http://hdl.handle.net/10.2469/faj.v55.n3.2269
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:3:p:20-32




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# input file: UFAJ_A_12047160_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Title: P/E Forwards and Their Orbits
Abstract: 
 From a theoretical viewpoint, earnings growth that follows the consensus should—all else being equal—result in rising or falling P/Es that provide the equity investor with the price appreciation needed to just meet the market's total return expectation. For a given earnings growth rate, this expectational equilibrium should move a fairly priced P/E toward a sequence of “forward” values that ultimately trace out an implied “P/E orbit.” For two-phase models with the typically higher level of first-phase growth, the P/E orbit will trace a smooth year-by-year descent from the starting P/E to the terminal, second-phase P/E. These descending forward P/Es provide a baseline that represents the inertial pricing paths implied by an unaltered consensus. Analysts who assign P/E estimates that diverge from this baseline path presumably believe that they have special insights that justify such a departure from the consensus-implied level. Awareness of the P/E orbit concept should help analysts avoid falling for the classic trap of “P/E myopia”—misestimating the prospective return by automatically applying a current P/E to future earnings levels derived from consensus growth projections. 
Journal: Financial Analysts Journal
Pages: 33-47
Issue: 3
Volume: 55
Year: 1999
Month: 5
X-DOI: 10.2469/faj.v55.n3.2270
File-URL: http://hdl.handle.net/10.2469/faj.v55.n3.2270
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:3:p:33-47




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# input file: UFAJ_A_12047161_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Kirt C. Butler
Author-X-Name-First: Kirt C.
Author-X-Name-Last: Butler
Author-Name: Hakan Saraoglu
Author-X-Name-First: Hakan
Author-X-Name-Last: Saraoglu
Title: Improving Analysts' Negative Earnings Forecasts
Abstract: 
 In contrast to positive earnings forecasts, the negative earnings forecasts of security analysts are grossly optimistic. We adjusted negative earnings forecasts downward by varying amounts and evaluated forecast performance according to (1) forecast accuracy relative to the consensus, (2) the frequency of being closer to actual earnings than the consensus, and (3) the frequency with which adjusted forecasts underestimate actual earnings, thereby jeopardizing the analyst's relations with corporate managers. Relative forecast accuracy and the probability of beating the consensus are improved, without an inordinate increase in the probability of underestimating earnings, by adjusting negative forecasts downward by a small amount. 
Journal: Financial Analysts Journal
Pages: 48-56
Issue: 3
Volume: 55
Year: 1999
Month: 5
X-DOI: 10.2469/faj.v55.n3.2271
File-URL: http://hdl.handle.net/10.2469/faj.v55.n3.2271
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:3:p:48-56




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# input file: UFAJ_A_12047162_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: K. Geert Rouwenhorst
Author-X-Name-First: K. Geert
Author-X-Name-Last: Rouwenhorst
Title: European Equity Markets and the EMU
Abstract: 
 During the 1980s, country effects were larger than industry effects in the equity markets of Western Europe. This phenomenon continued for the countries of the European Monetary Union in the 1993–98 period despite the convergence of interest rates and the harmonization of fiscal and monetary policies following the Maastricht Treaty of 1992. Today, no evidence supports the disappearance of differences between EMU countries' equity returns. 
Journal: Financial Analysts Journal
Pages: 57-64
Issue: 3
Volume: 55
Year: 1999
Month: 5
X-DOI: 10.2469/faj.v55.n3.2272
File-URL: http://hdl.handle.net/10.2469/faj.v55.n3.2272
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:3:p:57-64




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# input file: UFAJ_A_12047163_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: George Chow
Author-X-Name-First: George
Author-X-Name-Last: Chow
Author-Name: Eric Jacquier
Author-X-Name-First: Eric
Author-X-Name-Last: Jacquier
Author-Name: Mark Kritzman
Author-X-Name-First: Mark
Author-X-Name-Last: Kritzman
Author-Name: Kenneth Lowry
Author-X-Name-First: Kenneth
Author-X-Name-Last: Lowry
Title: Optimal Portfolios in Good Times and Bad
Abstract: 
 Recent experience with emerging market investments and hedge funds has highlighted the fact that risk parameters are unstable. To address this problem, we introduce a procedure for identifying multivariate outliers and use the outliers to estimate a new covariance matrix. We suggest that a covariance matrix estimated from outliers characterizes a portfolio's riskiness during market turbulence better than a full-sample covariance matrix. We also introduce a procedure for blending an inside-sample covariance matrix with one from an outlier sample. This procedure enables one to express views about the likelihood of each risk regime and to differentiate one's aversion to them. Our framework collapses to the Markowitz mean–variance model if (1) we set the probabilities of the inside and outlying covariance matrixes equal to their empirical frequencies, (2) we are equally averse to both risk regimes, and (3) we estimate the inside and outlying covariances around the full sample's mean. 
Journal: Financial Analysts Journal
Pages: 65-73
Issue: 3
Volume: 55
Year: 1999
Month: 5
X-DOI: 10.2469/faj.v55.n3.2273
File-URL: http://hdl.handle.net/10.2469/faj.v55.n3.2273
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# input file: UFAJ_A_12047164_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Daniel C. Indro
Author-X-Name-First: Daniel C.
Author-X-Name-Last: Indro
Author-Name: Christine X. Jiang
Author-X-Name-First: Christine X.
Author-X-Name-Last: Jiang
Author-Name: Michael Y. Hu
Author-X-Name-First: Michael Y.
Author-X-Name-Last: Hu
Author-Name: Wayne Y. Lee
Author-X-Name-First: Wayne Y.
Author-X-Name-Last: Lee
Title: Mutual Fund Performance: Does Fund Size Matter?
Abstract: 
 Fund size (net assets under management) affects mutual fund performance. Mutual funds must attain a minimum fund size in order to achieve sufficient returns to justify their costs of acquiring and trading on information. Furthermore, there are diminishing marginal returns to information acquisition and trading, and the marginal returns become negative when the mutual fund exceeds its optimal fund size. In a sample of 683 nonindexed U.S. equity funds over the 1993–95 period, we found that 20 percent of the mutual funds were smaller than the breakeven-cost fund size and 10 percent of the largest funds overinvested in information acquisition and trading. In addition, we found that value funds and blend (value-and-growth) funds have more to gain than growth funds from these information activities. 
Journal: Financial Analysts Journal
Pages: 74-87
Issue: 3
Volume: 55
Year: 1999
Month: 5
X-DOI: 10.2469/faj.v55.n3.2274
File-URL: http://hdl.handle.net/10.2469/faj.v55.n3.2274
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:3:p:74-87




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# input file: UFAJ_A_12047165_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Kenneth L. Fisher
Author-X-Name-First: Kenneth L.
Author-X-Name-Last: Fisher
Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: A Behavioral Framework for Time Diversification
Abstract: 
 The box of factors that we call “risk” is both too large and too small. The box is large enough to include many, sometimes conflicting, measures of risk—variance and semivariance, probabilities of losses and their amounts. But the box is too small to include factors that affect choices but fall outside the boundaries of risk—frames and cognitive errors, self-control and regret. We explore the role of these factors in time diversification. The belief that time diversification reduces risk underlies the current drive to invest Social Security funds in stocks. But is such investment prudent? We discuss the role of advisors in providing prudent advice, changes in the standards of prudence over time, the use of time diversification in guiding investors to prudent portfolios, and its use in the current debate on Social Security. 
Journal: Financial Analysts Journal
Pages: 88-97
Issue: 3
Volume: 55
Year: 1999
Month: 5
X-DOI: 10.2469/faj.v55.n3.2275
File-URL: http://hdl.handle.net/10.2469/faj.v55.n3.2275
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:3:p:88-97




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# input file: UFAJ_A_12047166_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The New Financial Capitalists: Kohlberg Kravis Roberts & Co. and the Creation of Corporate Value (a review)
Abstract: 
 This book, an outgrowth of an internal study of KKR, is the first serious study of the leveraged-buyout phenomenon in its broad economic and historical context. 
Journal: Financial Analysts Journal
Pages: 98-100
Issue: 3
Volume: 55
Year: 1999
Month: 5
X-DOI: 10.2469/faj.v55.n3.2276
File-URL: http://hdl.handle.net/10.2469/faj.v55.n3.2276
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:3:p:98-100




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# input file: UFAJ_A_12047167_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Michael R. Granito
Author-X-Name-First: Michael R.
Author-X-Name-Last: Granito
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation (a review)
Abstract: 
 This useful contribution to the study of mean-variance portfolio efficiency is a readable account of the key methodologies for improving accuracy in using optimization tools, and it clarifies the optimization problem as an exercise in statistical estimation. 
Journal: Financial Analysts Journal
Pages: 101-102
Issue: 3
Volume: 55
Year: 1999
Month: 5
X-DOI: 10.2469/faj.v55.n3.2277
File-URL: http://hdl.handle.net/10.2469/faj.v55.n3.2277
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:3:p:101-102




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# input file: UFAJ_A_12047168_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard C. Schneider
Author-X-Name-First: Richard C.
Author-X-Name-Last: Schneider
Title: More on Reasons for Analysts' Forecast Errors
Abstract: 
 This material comments on “Why So Much Error in Analysts' Earnings Forecasts?”
Journal: Financial Analysts Journal
Pages: 4-4
Issue: 4
Volume: 55
Year: 1999
Month: 7
X-DOI: 10.2469/faj.v55.n4.2280
File-URL: http://hdl.handle.net/10.2469/faj.v55.n4.2280
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:4:p:4-4




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# input file: UFAJ_A_12047169_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Harry M. Markowitz
Author-X-Name-First: Harry M.
Author-X-Name-Last: Markowitz
Title: The Early History of Portfolio Theory: 1600–1960
Abstract: 
 Portfolio theory and practice are surveyed from Shakespeare to Sharpe—almost. 
Journal: Financial Analysts Journal
Pages: 5-16
Issue: 4
Volume: 55
Year: 1999
Month: 7
X-DOI: 10.2469/faj.v55.n4.2281
File-URL: http://hdl.handle.net/10.2469/faj.v55.n4.2281
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:4:p:5-16




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# input file: UFAJ_A_12047170_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Carlo Capaul
Author-X-Name-First: Carlo
Author-X-Name-Last: Capaul
Title: Asset-Pricing Anomalies in Global Industry Indexes
Abstract: 
 Most studies of asset-pricing anomalies have concentrated on country-specific or regional aggregates of country-specific equity universes. The study reported here concentrated on the performance of anomaly-based investment styles in industry-specific global portfolios. The perspective is that of a U.S. dollar-based investor, and the period is January 1991 through August 1998. The article compares the success during the period of a global industry-neutral strategy, a global industry-rotation strategy, and a global unrestricted investment strategy. 
Journal: Financial Analysts Journal
Pages: 17-37
Issue: 4
Volume: 55
Year: 1999
Month: 7
X-DOI: 10.2469/faj.v55.n4.2282
File-URL: http://hdl.handle.net/10.2469/faj.v55.n4.2282
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# input file: UFAJ_A_12047171_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: C. Mitchell Conover
Author-X-Name-First: C. Mitchell
Author-X-Name-Last: Conover
Author-Name: Gerald R. Jensen
Author-X-Name-First: Gerald R.
Author-X-Name-Last: Jensen
Author-Name: Robert R. Johnson
Author-X-Name-First: Robert R.
Author-X-Name-Last: Johnson
Title: Monetary Conditions and International Investing
Abstract: 
 We examine the relationship between monetary conditions and global stock returns. Previous studies established that U.S. stock returns during expansive U.S. monetary periods are significantly higher than returns during restrictive periods. We found that this pattern prevails in non-U.S. markets; furthermore, the pattern exists relative to both local and U.S. monetary conditions. By examining several investment strategies, we show that investors could have improved portfolio performance in the period studied by using both U.S. and local monetary conditions to guide their portfolio allocations. Using monetary conditions to determine portfolio composition would have been consistently beneficial throughout the past 30 years. 
Journal: Financial Analysts Journal
Pages: 38-48
Issue: 4
Volume: 55
Year: 1999
Month: 7
X-DOI: 10.2469/faj.v55.n4.2283
File-URL: http://hdl.handle.net/10.2469/faj.v55.n4.2283
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Author-Name: James Scott
Author-X-Name-First: James
Author-X-Name-Last: Scott
Author-Name: Mark Stumpp
Author-X-Name-First: Mark
Author-X-Name-Last: Stumpp
Author-Name: Peter Xu
Author-X-Name-First: Peter
Author-X-Name-Last: Xu
Title: Behavioral Bias, Valuation, and Active Management
Abstract: 
 We examine the consequences of behavioral biases in the context of valuation theory. Although the biases we consider have been well documented elsewhere, the framework we provide is new. It not only allows a rationalization of previous findings, but it also makes possible identification of the types of stocks for which specific biases will be strongest. We provide empirical evidence concerning the ability of an array of commonly used active investment strategies, such as value and growth tilts, to exploit biases. We also use the framework to test the relative importance of prospect theory and the overconfidence hypothesis as justification for momentum investing. 
Journal: Financial Analysts Journal
Pages: 49-57
Issue: 4
Volume: 55
Year: 1999
Month: 7
X-DOI: 10.2469/faj.v55.n4.2284
File-URL: http://hdl.handle.net/10.2469/faj.v55.n4.2284
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:4:p:49-57




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# input file: UFAJ_A_12047173_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: John D. Neill
Author-X-Name-First: John D.
Author-X-Name-Last: Neill
Author-Name: Glenn M. Pfeiffer
Author-X-Name-First: Glenn M.
Author-X-Name-Last: Pfeiffer
Title: The Effect of Potentially Dilutive Securities on P/Es
Abstract: 
 We demonstrate empirically that P/Es calculated from accounting measures of EPS are understated because of the presence of potentially dilutive securities. This result persisted after we controlled for the effects of risk and growth, and we found it to hold for both generally accepted accounting measures of EPS (i.e., basic and diluted EPS). It is not surprising that P/Es calculated from basic EPS are understated. Basic EPS tends to be overstated because it is calculated without consideration of the effect of potentially dilutive securities. It is surprising that P/Es computed from diluted EPS, which is generally believed to be an extremely conservative measure that reflects maximum dilution, are also understated. Because of the importance of P/Es as inputs in models of stock valuation and portfolio formulation, our findings should be of interest generally to investors and financial analysts. 
Journal: Financial Analysts Journal
Pages: 58-64
Issue: 4
Volume: 55
Year: 1999
Month: 7
X-DOI: 10.2469/faj.v55.n4.2285
File-URL: http://hdl.handle.net/10.2469/faj.v55.n4.2285
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:4:p:58-64




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Author-Name: Kevin Dowd
Author-X-Name-First: Kevin
Author-X-Name-Last: Dowd
Title: Financial Risk Management (corrected)
Abstract: 
 This article presents an integrated theoretical framework to guide financial risk management decisions. The framework is based on two key principles: the use of a “Sharpe rule” to assess prospective changes in a firm's or portfolio's risk–expected return profile and the maintenance of a constant probability of default, which determines the firm's or portfolio's leverage. The rules are not restricted to normal return distributions; they can also accommodate a variety of nonnormal distributions. The approach can be applied with either portfolio standard deviation or value at risk as the measure of risk. 
Journal: Financial Analysts Journal
Pages: 65-71
Issue: 4
Volume: 55
Year: 1999
Month: 7
X-DOI: 10.2469/faj.v55.n4.2286
File-URL: http://hdl.handle.net/10.2469/faj.v55.n4.2286
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:4:p:65-71




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# input file: UFAJ_A_12047175_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bing Liang
Author-X-Name-First: Bing
Author-X-Name-Last: Liang
Title: On the Performance of Hedge Funds
Abstract: 
 Empirical evidence indicates that hedge funds differ substantially from traditional investment vehicles, such as mutual funds. Unlike mutual funds, hedge funds follow dynamic trading strategies and have low systematic risk. Hedge funds' special fee structures apparently align managers' incentives with fund performance. Funds with “high watermarks” (under which managers are required to make up previous losses before receiving any incentive fees) significantly outperform those without. Hedge funds provide higher Sharpe ratios than mutual funds, and their performance in the period of January 1992 through December 1996 reflects better manager skills, although hedge fund returns are more volatile. Average hedge fund returns are related positively to incentive fees, fund assets, and the lockup period. 
Journal: Financial Analysts Journal
Pages: 72-85
Issue: 4
Volume: 55
Year: 1999
Month: 7
X-DOI: 10.2469/faj.v55.n4.2287
File-URL: http://hdl.handle.net/10.2469/faj.v55.n4.2287
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Author-Name: Stanley B. Block
Author-X-Name-First: Stanley B.
Author-X-Name-Last: Block
Title: A Study of Financial Analysts: Practice and Theory
Abstract: 
 The study reported here focused on determining what analytical techniques financial analysts who are members of AIMR actually use. The study achieved a response rate of 33.75 percent. Questions covered 16 areas, including the use of present value analysis, the importance of quarterly earnings' announcements in decision making, belief in efficient markets, acceptance or rejection of market anomalies, and belief in the importance of international diversification for risk reduction. 
Journal: Financial Analysts Journal
Pages: 86-95
Issue: 4
Volume: 55
Year: 1999
Month: 7
X-DOI: 10.2469/faj.v55.n4.2288
File-URL: http://hdl.handle.net/10.2469/faj.v55.n4.2288
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:4:p:86-95




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# input file: UFAJ_A_12047177_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: H. Gifford Fong
Author-X-Name-First: H. Gifford
Author-X-Name-Last: Fong
Title: From the Editor
Abstract: 
 A number of Financial Analysts Journal authors and potential contributors have asked me to clarify the philosophy behind article selection for the FAJ—in particular, what we mean by “original” research. The description of the FAJ's philosophy in the Submission Guidelines states that we are looking for original research in investment analysis, investment management, and related subjects.… We seek articles that are practitioner oriented, forward looking, and rigorous. Articles should enhance an analyst's human capital by providing insights and wisdom unavailable from other sources.  In short, the editorial policy of the FAJ is to showcase manuscripts that describe research of practical relevance to the investment management professional. Articles at the intersection of theoretical soundness and practical application are the hallmarks of the FAJ. Our objective is to produce a collection of theoretically sound original research that can further the knowledge and practice of the investment management practitioner. In this context, “original” includes fresh, first-time adaptations of academic papers from leading finance journals suited to our practitioner purposes. We welcome such adaptations of original research. Our guidelines for submission go on to describe the form and presentation of ideas that we have found most useful for our practitioner readers: Articles must be fresh, original, well documented, and carefully reasoned; they should clearly state the implications of the research for practicing analysts.  In all FAJ articles, we strive to ensure the highest quality of theory and methodology by requiring effective introductions and relevant bibliographies. A strong introduction that provides the background to the article and a comprehensive reference list are essential for providing practitioners with directions toward the basic research underlying the article. I hope this discussion has been helpful to contributors. I and the rest of the FAJ staff are always willing and happy to answer your questions about suitability of articles or any other aspect of the FAJ philosophy or operations. For the full Submission Guidelines, please see our Submission Guidelines, or call us at 434-951-5442. 
Journal: Financial Analysts Journal
Pages: 3-3
Issue: 4
Volume: 55
Year: 1999
Month: 7
X-DOI: 10.2469/faj.v55.n4.2289
File-URL: http://hdl.handle.net/10.2469/faj.v55.n4.2289
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:4:p:3-3




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Author-Name: Charles M.C. Lee
Author-X-Name-First: Charles M.C.
Author-X-Name-Last: Lee
Author-Name: Bhaskaran Swaminathan
Author-X-Name-First: Bhaskaran
Author-X-Name-Last: Swaminathan
Title: Valuing the Dow: A Bottom-Up Approach
Abstract: 
 We use a bottom-up approach to estimate the intrinsic value of the 30 stocks in the Dow Jones Industrial Average. In recent years, traditional aggregate market multiples (e.g., book to price, earnings to price) have had little predictive power for overall market returns. We show that an aggregate value-to-price ratio, in which “value” is based on a discounted residual income model, has statistically reliable predictive power, not only for returns on the Dow but also for returns on the S&P 500 Index and for a small-stock portfolio. We discuss the implications of these findings for tactical asset allocation strategies, the current level of the U.S. equity market, and the issue of equity valuation in general. 
Journal: Financial Analysts Journal
Pages: 4-23
Issue: 5
Volume: 55
Year: 1999
Month: 9
X-DOI: 10.2469/faj.v55.n5.2295
File-URL: http://hdl.handle.net/10.2469/faj.v55.n5.2295
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:5:p:4-23




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Author-Name: Messod D. Beneish
Author-X-Name-First: Messod D.
Author-X-Name-Last: Beneish
Title: The Detection of Earnings Manipulation
Abstract: 
 Presented are a profile of a sample of earnings manipulators, their distinguishing characteristics, and a suggested model for detecting manipulation. The model's variables are designed to capture either the financial statement distortions that can result from manipulation or preconditions that might prompt companies to engage in such activity. The results suggest a systematic relationship between the probability of manipulation and some financial statement variables. This evidence is consistent with the usefulness of accounting data in detecting manipulation and assessing the reliability of reported earnings. The model identifies approximately half of the companies involved in earnings manipulation prior to public discovery. Because companies that are discovered manipulating earnings see their stocks plummet in value, the model can be a useful screening device for investment professionals. The screening results, however, require determination of whether the distortions in the financial statement numbers result from earnings manipulation or have another structural root. 
Journal: Financial Analysts Journal
Pages: 24-36
Issue: 5
Volume: 55
Year: 1999
Month: 9
X-DOI: 10.2469/faj.v55.n5.2296
File-URL: http://hdl.handle.net/10.2469/faj.v55.n5.2296
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:5:p:24-36




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# input file: UFAJ_A_12047180_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Diane K. Schooley
Author-X-Name-First: Diane K.
Author-X-Name-Last: Schooley
Author-Name: Debra Drecnik Worden
Author-X-Name-First: Debra Drecnik
Author-X-Name-Last: Worden
Title: Investors' Asset Allocations versus Life-Cycle Funds
Abstract: 
 Life-cycle funds, among the newest asset allocation fund offerings, are managed according to investors' time horizons and risk tolerances. Partly in response to the appearance of these funds, we examined the relationships among the risk in individual investors' portfolios, their financial-planning time horizons, and their risk tolerances. Generally, we found that portfolio risk increases as time horizon and willingness to take risk increase. This relationship held when we used multivariate analysis. Additional factors related to portfolio risk were found to be the investor's expectations of a future economic downturn, age, education, and marital status. 
Journal: Financial Analysts Journal
Pages: 37-43
Issue: 5
Volume: 55
Year: 1999
Month: 9
X-DOI: 10.2469/faj.v55.n5.2297
File-URL: http://hdl.handle.net/10.2469/faj.v55.n5.2297
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:5:p:37-43




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Author-Name: John G. Gallo
Author-X-Name-First: John G.
Author-X-Name-Last: Gallo
Author-Name: Larry J. Lockwood
Author-X-Name-First: Larry J.
Author-X-Name-Last: Lockwood
Title: Fund Management Changes and Equity Style Shifts
Abstract: 
 We examined changes in performance, risk, and investment style for mutual funds that changed managers during the 1983–91 period. Results show that funds experiencing a managerial change performed poorly before the change, primarily as a result of inferior security selection. Risk-adjusted performance, on average, improved 200 basis points annually and systematic risk increased significantly after the management change. We also classified funds according to their equity “effective mix” of company sizes and value versus growth. More than 65 percent of the funds experienced a shift in investment style after the management change. 
Journal: Financial Analysts Journal
Pages: 44-52
Issue: 5
Volume: 55
Year: 1999
Month: 9
X-DOI: 10.2469/faj.v55.n5.2298
File-URL: http://hdl.handle.net/10.2469/faj.v55.n5.2298
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:5:p:44-52




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Author-Name: Ivan Rudolph-Shabinsky
Author-X-Name-First: Ivan
Author-X-Name-Last: Rudolph-Shabinsky
Author-Name: Francis H. Trainer
Author-X-Name-First: Francis H.
Author-X-Name-Last: Trainer
Title: Assigning a Duration to Inflation-Protected Bonds
Abstract: 
 In evaluating U.S. Treasury inflation-protected securities (TIPS) for fixed-income portfolios, managers frequently use the TIPS' effective durations, which are much shorter than modified durations. Unfortunately, when the manager's intention is to profit from a decrease in real rates or an increase in the market's implied inflation forecast, the use of effective durations will thwart obtaining the objective. We discuss this unfortunate effect and recommend alternative duration strategies when TIPS are to be used in an actively managed portfolio with a nominal benchmark. 
Journal: Financial Analysts Journal
Pages: 53-59
Issue: 5
Volume: 55
Year: 1999
Month: 9
X-DOI: 10.2469/faj.v55.n5.2299
File-URL: http://hdl.handle.net/10.2469/faj.v55.n5.2299
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:5:p:53-59




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# input file: UFAJ_A_12047183_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Manjeet S. Dhatt
Author-X-Name-First: Manjeet S.
Author-X-Name-Last: Dhatt
Author-Name: Yong H. Kim
Author-X-Name-First: Yong H.
Author-X-Name-Last: Kim
Author-Name: Sandip Mukherji
Author-X-Name-First: Sandip
Author-X-Name-Last: Mukherji
Title: The Value Premium for Small-Capitalization Stocks
Abstract: 
 We investigated whether an exploitable value premium existed for stocks in the Russell 2000 Index, the commonly used U.S. small-cap benchmark, in the 1979–97 period. For portfolios formed on the basis of price-to-earnings, price-to-sales, and market-to-book ratios, value stocks in the study outperformed growth stocks by 5.28–8.40 percentage points a year and had lower standard deviations and lower coefficients of variation than growth stocks did. Combining the valuation measures to identify value boosted returns and improved the risk–return characteristics of value portfolios. Most of the value premium for small-cap stocks occurred outside the month of January and was available for reasonably liquid stocks. These findings suggest that small-cap stocks offer a substantial value premium that is of practical significance to investors. 
Journal: Financial Analysts Journal
Pages: 60-68
Issue: 5
Volume: 55
Year: 1999
Month: 9
X-DOI: 10.2469/faj.v55.n5.2300
File-URL: http://hdl.handle.net/10.2469/faj.v55.n5.2300
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:5:p:60-68




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Author-Name: John Dobson
Author-X-Name-First: John
Author-X-Name-Last: Dobson
Title: Is Shareholder Wealth Maximization Immoral?
Abstract: 
 For those educated in modern business schools, the justification for decisions made by financial professionals in business organizations has been supplied by financial economic theory. Broadly, this theory posits that the ultimate objective of a business organization is to maximize its market value (often referred to as maximizing shareholder wealth). This objective is, in turn, justified (in a theory often termed “the invisible hand”) by the premise that such activity undertaken competitively, within the law, by individual firms will lead to maximal social welfare. This view of the ultimate aims of corporate activity has come under increased scrutiny—and, indeed, challenge—by a growing body of thought that can be loosely labeled “business ethics theory.” As business ethics theory filters into the financial professional's milieu—through, for example, corporate creeds—some confusion is inevitable. This article clears the confusion by evaluating the objective of shareholder wealth maximization as a moral justification for behavior in business. 
Journal: Financial Analysts Journal
Pages: 69-75
Issue: 5
Volume: 55
Year: 1999
Month: 9
X-DOI: 10.2469/faj.v55.n5.2301
File-URL: http://hdl.handle.net/10.2469/faj.v55.n5.2301
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:5:p:69-75




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Author-Name: Edward S. O'Neal
Author-X-Name-First: Edward S.
Author-X-Name-Last: O'Neal
Title: Mutual Fund Share Classes and Broker Incentives
Abstract: 
 U.S. SEC Rule 18f-3 allows mutual funds to offer multiple share classes that represent claims on the same underlying assets. Share classes differ with respect to distribution arrangements, which are modified by varying the timing and magnitude of load charges and annual distribution fees. For investors, the choice of share classes depends primarily on the expected holding period. Rule 18f-3 has also given rise to broker compensation arrangements that differ among share classes and, consequently, create for brokers a stake in the class of shares clients purchase. In most circumstances and for most share class structures, brokers have monetary incentives to sell the class of shares that is least advantageous to investors. This conflict of interest is especially troubling because of the probable lack of financial sophistication of investors who pay for investment advice about mutual funds. The adverse incentives are potentially damaging to the mutual fund industry and should provoke a reconsideration of multiple share classes and the accompanying broker compensation arrangements. 
Journal: Financial Analysts Journal
Pages: 76-87
Issue: 5
Volume: 55
Year: 1999
Month: 9
X-DOI: 10.2469/faj.v55.n5.2302
File-URL: http://hdl.handle.net/10.2469/faj.v55.n5.2302
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:5:p:76-87




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Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Seeing Tomorrow: Rewriting the Rules of Risk (a review)
Abstract: 
 This book discusses the application of decision theory to risk problems in everyday life and finance. 
Journal: Financial Analysts Journal
Pages: 88-89
Issue: 5
Volume: 55
Year: 1999
Month: 9
X-DOI: 10.2469/faj.v55.n5.2303
File-URL: http://hdl.handle.net/10.2469/faj.v55.n5.2303
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:5:p:88-89




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Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: A Traitor to His Class: Robert A.G. Monks and the Battle to Change Corporate America (a review)
Abstract: 
 This book provides a journalist's view of the shareholder rights movement and its adversaries. 
Journal: Financial Analysts Journal
Pages: 90-91
Issue: 5
Volume: 55
Year: 1999
Month: 9
X-DOI: 10.2469/faj.v55.n5.2304
File-URL: http://hdl.handle.net/10.2469/faj.v55.n5.2304
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:5:p:90-91




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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Value Investing: A Balanced Approach (a review)
Abstract: 
 This critique of contemporary practice in security analysis argues that corporate control is the key to the accumulation of exceptional personal wealth. 
Journal: Financial Analysts Journal
Pages: 92-93
Issue: 5
Volume: 55
Year: 1999
Month: 9
X-DOI: 10.2469/faj.v55.n5.2305
File-URL: http://hdl.handle.net/10.2469/faj.v55.n5.2305
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:5:p:92-93




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Author-Name: H. Gifford Fong
Author-X-Name-First: H. Gifford
Author-X-Name-Last: Fong
Title: From the Editor
Abstract: 
 I am pleased to announce some additions to the Editorial Board of the Financial Analysts Journal for September 1999–August 2000. We welcome the new members of the team: Werner F.M. De Bondt; Khalid Ghayur, CFA; Charles M.C. Lee; Jay Shanken; Paul Suckow, CFA; and Brett Trueman. To promote renewal, some turnover in the editorial board will occur every year. The objective is to foster insights and refereeing support from a periodically changing group of talented and dedicated individuals. The quality of the FAJ highly depends on the work of these people. Our retiring board members are Charles Ellis, CFA; Joanne Hill; David Lukach; Arnold Wood; and Arthur Zeikel. Each has dedicated many hours to the FAJ, and on behalf of the editorial staff and AIMR, I extend my thanks and appreciation to all of them for their devotion. Supplementing the editorial board's efforts for the past year has been a group of ad hoc referees who have graciously participated in the review and evaluation of the many manuscripts that have been submitted to the FAJ: Lee Carty; Greg Duffee; Darrell Duffie; Richard Grinold; Steven Heston; Narasimhan Jegadeesh; Raymond Kan; Josef Lakonishok; Charles M.C. Lee; Hayne Leland; Jim Meehan; Terrance Odean; Hersh Shefrin; Meir Statman; Paul Suckow, CFA; Sheridan Titman; Brett Trueman; John Van Reenen; and Ming Wang. I would like to extend our thanks and appreciation to these dedicated referees. 
Journal: Financial Analysts Journal
Pages: 3-3
Issue: 5
Volume: 55
Year: 1999
Month: 9
X-DOI: 10.2469/faj.v55.n5.2306
File-URL: http://hdl.handle.net/10.2469/faj.v55.n5.2306
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# input file: UFAJ_A_12047190_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard H. Thaler
Author-X-Name-First: Richard H.
Author-X-Name-Last: Thaler
Title: The End of Behavioral Finance
Abstract: 
 The controversy surrounding behavioral finance is dying out as scholars accept it as simply a new way of doing financial economic research. Behavioral finance has, during its short history, been considered a controversial field. Some consider it heresy. Why? Few have ever believed that all investors really make decisions according to the rational axioms of choice under uncertainty. Rather, defenders of the rational efficient market hypothesis have argued that markets can be efficient even when many investors make systematic errors; as long as there are a few smart arbitrageurs, according to this logic, market prices will still be rational. We now know that this argument is flawed. Limits to arbitrage allow for the possibility that prices can diverge from intrinsic value, even in the presence of rational arbitrageurs.A useful example of this principle is the case of Royal Dutch/Shell Group. The two components of this company (Royal Dutch and Shell Transport) should trade at a price ratio of 1.5 because, by charter, Royal Dutch is entitled to 60 percent of the revenues, with the rest going to Shell. Although prices in this case would seem simple enough to get right, the actual price ratio has deviated from the expected one by as much as 35 percent. Hedge funds have tried to profit from this discrepancy, but such trades run the risk that the prices will diverge even more (as happened in August and September 1998).If markets can get prices wrong in this relatively simple case—and wrong by so much—then in other, more complex situations, prices can be much farther out of line. For example, consider the current prices of Internet stocks. If they exceed intrinsic values (as many believe), arbitrageurs can do little to correct the situation. “Smart” investors who have been short the Internet sector over the past two years have had a painful ride.Plenty of other evidence indicates markets do not seem to be behaving in a textbook fashion. Compared with a rational model, markets seem to have too much volume and too much volatility. Companies pay dividends, although share repurchases seem to be a dominant strategy. Stock prices move in predictable patterns. And the return difference between stocks and bonds, the equity premium, has historically been much higher than any rational model can explain.Some of these puzzles are beginning to be understood by incorporating psychological phenomena into our models of financial markets. For example, too much trading is explained by overconfidence. Stock price predictability can be explained by the biases generated from the use of simple rules of thumb, or heuristics. The enormous equity premium can be explained by a combination of mental accounting and loss aversion.Surely, the idea that we might be able to understand some aspects of financial market behavior by incorporating ideas from psychology and other social sciences should not be considered controversial. I am thus predicting an end to the controversy and, indeed, an end to behavioral finance. In the future, financial economists will routinely incorporate as much “behavior” into their models as they observe in the real world. After all, to do otherwise would be irrational.
Journal: Financial Analysts Journal
Pages: 12-17
Issue: 6
Volume: 55
Year: 1999
Month: 11
X-DOI: 10.2469/faj.v55.n6.2310
File-URL: http://hdl.handle.net/10.2469/faj.v55.n6.2310
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# input file: UFAJ_A_12047191_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: Behaviorial Finance: Past Battles and Future Engagements
Abstract: 
 Market efficiency is at the center of the battle of standard finance versus behavioral finance versus investment professionals. But the battle is not joined because the term “market efficiency” has two meanings. One meaning is that investors cannot systematically beat the market. The other is that security prices are rational. Rational prices reflect only utilitarian characteristics, such as risk, not value-expressive characteristics, such as sentiment. Behavioral finance has shown, however, that value-expressive characteristics matter in both investor choices and asset prices. Therefore, the discipline of finance would do well to accept the first meaning of market efficiency and reject the notion that security prices are rational. We could then stop fighting the market efficiency battle and focus on exploring (1) asset-pricing models that reflect both value-expressive and utilitarian characteristics and (2) the benefits, both utilitarian and value expressive, that investment professionals provide to investors. Investment professionals can benefit from understanding how behavioral finance augments standard finance. And they can benefit from understanding that the “normal investor” of behavioral finance has needs and preferences that go beyond the utilitarian needs of the “rational investor” of standard finance.Marketing scholars divide the characteristics of products into two groups, utilitarian and value expressive. This breakdown applies to the investment business just as it does to, for example, the watch business. Consider a Microsoft Corporation share and a Kmart Corporation share. The two may be different in terms of utilitarian characteristics; they are surely different in terms of value-expressive ones. Microsoft, like a Rolex, is a high-status (growth) stock; Kmart, like a Timex, is a low-status (value) stock. Timex buyers, like Kmart buyers, do not beat the watch market when they buy a $50 Timex in place of a $10,000 Rolex. Rolex buyers, like Microsoft buyers, get $50 worth of utilitarian time-telling and $9,950 worth of value-expressive status.The fact that arbitrage between Rolex and Timex or Microsoft and Kmart is limited does not imply the market is inefficient in the beat-the-market sense. It only means that equilibrium prices reflect value-expressive characteristics.Investment academics and professionals usually consider investments to be utilitarian products: A dividend dollar is identical to a capital dollar and a tobacco dollar is as green as a socially responsible dollar. Many investors, however, care about the value-expressive characteristics of investment products; they know that their investments, like their watches, say a lot about them. Some investors want the righteousness of socially responsible funds; other investors want the high status of hedge funds.Utilitarian and value-expressive characteristics play roles in the battle among standard finance, investment professionals, and behavioral finance over market efficiency. Investment professionals embrace the finding of return anomalies by behavioral finance as an ally in the battle. But the market efficiency battle is futile because the term has two meanings. One meaning is that investors cannot systematically beat the market. The second is that security prices are rational. That is, prices reflect only utilitarian characteristics, such as risk, but not value-expressive characteristics, such as sentiment. I argue that we would do well to accept market efficiency in the beat-the-market sense but reject it in the rational sense. This approach would allow us to explore capital asset pricing models that include both utilitarian and value-expressive characteristics.Questions about the utilitarian and value-expressive preferences of investors hold the key to understanding how the products and services of the investment profession affect the bottom line of the investment business. Acceptance of market efficiency in the beat-the-market sense and its rejection in the rational sense allow us to explore the many roles of investment professionals, roles that go much beyond market beating. For example, investment advisors help investors stay the investment course when markets are volatile, and Internet brokerage firms provide 24-hour trading to those who seek excitement.
Journal: Financial Analysts Journal
Pages: 18-27
Issue: 6
Volume: 55
Year: 1999
Month: 11
X-DOI: 10.2469/faj.v55.n6.2311
File-URL: http://hdl.handle.net/10.2469/faj.v55.n6.2311
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Handle: RePEc:taf:ufajxx:v:55:y:1999:i:6:p:18-27




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# input file: UFAJ_A_12047192_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Kent Daniel
Author-X-Name-First: Kent
Author-X-Name-Last: Daniel
Author-Name: Sheridan Titman
Author-X-Name-First: Sheridan
Author-X-Name-Last: Titman
Title: Market Efficiency in an Irrational World
Abstract: 
 We discuss why investors are likely to be overconfident and how this behavioral bias affects investment decisions. Our analysis suggests that investor overconfidence can generate momentum in stock returns and that this momentum effect is likely to be strongest in those stocks whose valuations require the interpretation of ambiguous information. Consistent with this analysis, we found that momentum effects are stronger for growth stocks than for stable stocks. A portfolio strategy based on this hypothesis generated strong abnormal returns from U.S. equity portfolios that did not appear to be attributable to risk. Although these results violate the traditional efficient market hypothesis, they do not necessarily imply that rational but uninformed investors could have actually achieved the returns without the benefit of hindsight. To examine whether unexploited profit opportunities exist, we tested for a somewhat weak form of market efficiency, adaptive 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 rejected the notion that the U.S. equity market is adaptive efficient. The psychology literature describes numerous behavioral biases. Potentially, these biases can explain almost any pricing anomaly imaginable. We believe the most important is overconfidence, and we concentrate on how it affects decisions and stock prices and how it results in markets that are not efficient.Numerous experimental studies have demonstrated the pervasiveness of overconfidence and its deleterious effects on decision making. That individuals tend to be overconfident should not be surprising; overconfidence endows people with clear advantages. Individuals who exude confidence are likely, for example, to more successfully woo mates—and clients. Thus, they should prosper and compose a large portion of the investor population. But overconfidence may hinder a person's ability to make good investment decisions. Because psychology studies suggest that individuals are likely to be the most overconfident in their abilities when they are evaluating information that is the most vague, we hypothesized that investors will be especially overconfident about their abilities to evaluate the stocks whose values depend more heavily on future (therefore, vague) growth options than about their ability to evaluate the stocks of stable companies. This behavior would open the door to pricing anomalies.To test this hypothesis, we examined the performance of a portfolio strategy for the July 1963 to December 1997 period that dictated buying the stocks of (U.S.-listed) companies with high book-to-market values that also had positive momentum and shorting the stocks of companies with low book-to-market values and negative momentum. The strategy produced strong abnormal returns that do not appear to be related to risk. We show that uncovering excess returns of this magnitude would be unlikely, even with considerable data mining, if markets were efficient.To test whether the returns would have been available to an investor at the time, one who did not enjoy the benefits of perfect hindsight, we tested for what we call “adaptive efficiency” in the market. Adaptive efficiency is a somewhat weak form of market efficiency that allows for the appearance of profit opportunities in historical data but posits that these opportunities will dissipate when they become apparent.To test this notion, we carried out a purely mechanical trading strategy in the sample period that each year followed investment styles that had performed well in the previous 10 years. This adaptive strategy did exceptionally well, and contrary to the predictions of adaptive efficiency, the excess returns it generated showed no sign of diminishing over time. Indeed, the strategy generated positive profits each year from 1982 through 1997.
Journal: Financial Analysts Journal
Pages: 28-40
Issue: 6
Volume: 55
Year: 1999
Month: 11
X-DOI: 10.2469/faj.v55.n6.2312
File-URL: http://hdl.handle.net/10.2469/faj.v55.n6.2312
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# input file: UFAJ_A_12047193_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Brad M. Barber
Author-X-Name-First: Brad M.
Author-X-Name-Last: Barber
Author-Name: Terrance Odean
Author-X-Name-First: Terrance
Author-X-Name-Last: Odean
Title: The Courage of Misguided Convictions
Abstract: 
 The field of modern financial economics assumes that people behave with extreme rationality, but they do not. Furthermore, people's deviations from rationality are often systematic. Behavioral finance relaxes the traditional assumptions of financial economics by incorporating these observable, systematic, and very human departures from rationality into standard models of financial markets. We highlight two common mistakes investors make: excessive trading and the tendency to disproportionately hold on to losing investments while selling winners. We argue that these systematic biases have their origins in human psychology. The tendency for human beings to be overconfident causes the first bias in investors, and the human desire to avoid regret prompts the second. Modern financial economics assumes that people behave with extreme rationality, but they do not. Furthermore, our deviations from rationality are often systematic. Behavioral finance relaxes the traditional assumptions of financial economics by incorporating these observable, systematic, and very human departures from rationality into standard models of financial markets.We describe empirical tests of two predictions of behavioral finance that have implications for investors and investment professionals: (1) that investors tend to sell their winning stocks and hold on to their losing stocks and (2) that, as a result of overconfidence, investors trade too much.The tendency to sell winners too soon and hold losers too long is called “the disposition effect.” To test for this effect, we used account data from a large discount broker. We found that the individual investors in the data set were 50 percent more likely to sell a winning investment than a losing investment (relative to their opportunities to do so). We also found that many investors engage in tax-motivated selling, especially in December.We discuss various alternative explanations for why investors might realize their profitable investments while retaining their losing investments: the belief that current losers will outperform current winners in the future, the desire to rebalance their portfolios, and the higher transaction costs of trading at lower prices. When we controlled the data for rebalancing and for share price, however, we continued to observe the disposition effect. And the winning investments that the investors chose to sell continued in subsequent months to outperform the losers they kept. This investment behavior is difficult to justify rationally; it is pure folly in an investor's taxable account.We next discuss a simple and powerful explanation for the high levels of trading in financial markets-overconfidence. Human beings are overconfident about their abilities, their knowledge, and their future prospects. Overconfident investors trade more than rational investors and doing so lowers their expected utilities.We present evidence that the average individual investor pays an extremely large performance penalty for trading and that those investors who trade most actively earn, on average, the lowest returns. The stocks individual investors purchase do not outperform those they sell by enough to cover the costs of trading. In fact, the purchased stocks, on average, subsequently underperform those sold-even when trading is not apparently motivated by liquidity demands, tax-loss selling, portfolio rebalancing, or a move to lower-risk securities.Our common psychological heritage ensures that we systematically share biases. Overconfidence provides the will to act. It gives us the courage of our misguided convictions.
Journal: Financial Analysts Journal
Pages: 41-55
Issue: 6
Volume: 55
Year: 1999
Month: 11
X-DOI: 10.2469/faj.v55.n6.2313
File-URL: http://hdl.handle.net/10.2469/faj.v55.n6.2313
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# input file: UFAJ_A_12047194_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Priya Raghubir
Author-X-Name-First: Priya
Author-X-Name-Last: Raghubir
Author-Name: Sanjiv Ranjan Das
Author-X-Name-First: Sanjiv Ranjan
Author-X-Name-Last: Das
Title: A Case for Theory-Driven Experimental Enquiry
Abstract: 
 We argue that finance theorists and practitioners need to examine the reasons behind a seeming anomaly. The behavioral anomalies in the finance literature can be classified as price and return effects, volume and volatility effects, time-series patterns, and miscellaneous effects. For each category, the empirical literature offers a multitude of explanations. Our main thesis is that theory-driven experimental analysis will allow clarification among competing explanations and should complement existing empirical paradigms. We present a theoretical information-processing framework for examining the psychology of financial decision making. The framework comprises both cognitive and motivational antecedents of bias in financial decision making and provides a grounding for many behavioral anomalies noted in the literature. To illustrate use of the model, we examine financial decision-making biases in the choice between underpriced (value) and overpriced (glamour) stocks. The main thesis of this article is that theory-driven experimental enquiry is an appropriate methodological tool at this stage of the life cycle of behavioral finance. Many empirical irregularities have been found and shown to be robust, and numerous compelling explanations have been proffered for their existence. But either multiple explanations are argued for the same effect, or alternative explanations are posited to be driving the effect. Theory-based empirical enquiry can eliminate alternative explanations and isolate key causes. It can also highlight potentially important gaps in the literature and direct future empirical investigation. The biases have been demonstrated and replicated; what remains is to isolate why they occur.We develop a theoretical information-processing framework to examine the psychology of financial decision making. Many behavioral anomalies noted in the finance literature can be derived from this framework. A brief survey of the literature results in a classification of common behavioral anomalies into three primary categories—price and return effects, volume and volatility effects, and time-series patterns—and a fourth miscellaneous category for other effects. For each category, we found that the empirical literature offers a multitude of explanations.The theoretical framework we suggest comprises both cognitive and motivational antecedents of bias in financial decision making. The model posits five stages at which cognitive biases may arise: perception, memory retrieval, information integration, judgment making, and behavior. Motivational effects are theorized either to directly affect the manner in which information is processed or to indirectly moderate the likelihood that cognitive biases will affect decisions.We used the proposed model to examine biases in the choice between underpriced (value) stocks and overpriced (glamour) stocks. A systematic series of five mini-experiments demonstrates the following results: First, there is experimental support for the hypothesis that when prior information about a stock is negative, people overreact to good news about the stock. Second, those results do not depend on whether the participant is trading for his or her own account or for a client. Third, the systematic preference for one stock versus another vanishes when the trade decision is a buy instead of a sell. Fourth, in a buy situation, when one stock's prior condition is positive, one stock's prior condition is negative, but all the news is positive, the stocks with previous negative results are significantly preferred to those with previous positive results. In summary, the primary antecedent driving choices between value and glamour stocks appears to be cognitive; thus, results differ according to information conditions and decision tasks. But our experimental exercise implies that psychological antecedents moderate the cognitive effects in the glamour versus value decision.Practitioners as well as finance theorists and researchers need to examine the why of a seeming anomaly. Practitioners need to understand underlying causes if they are to design appropriate, successful training, risk-management, and product communications. Theorists and researchers need to incorporate a psychological theory-driven experimental paradigm at the micro level to complement their existing work in behavioral finance. The model presented here should be a good first step toward a comprehensive theory of how financial decisions are made.
Journal: Financial Analysts Journal
Pages: 56-79
Issue: 6
Volume: 55
Year: 1999
Month: 11
X-DOI: 10.2469/faj.v55.n6.2314
File-URL: http://hdl.handle.net/10.2469/faj.v55.n6.2314
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# input file: UFAJ_A_12047195_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Louis K.C. Chan
Author-X-Name-First: Louis K.C.
Author-X-Name-Last: Chan
Author-Name: Narasimhan Jegadeesh
Author-X-Name-First: Narasimhan
Author-X-Name-Last: Jegadeesh
Author-Name: Josef Lakonishok
Author-X-Name-First: Josef
Author-X-Name-Last: Lakonishok
Title: The Profitability of Momentum Strategies
Abstract: 
 Momentum strategies based on continuations in stock prices have attracted a wide following among money managers and investors. We evaluated the profitability of price momentum strategies based on past return and earnings momentum strategies based on standardized unexpected earnings and revisions of consensus forecasts. The strategies proved to be profitable for intermediate horizons. Chasing momentum can generate high turnover, however; hence, implementation of momentum strategies requires a focus on managing trading costs. Comparing the strategies yielded evidence that they reflect distinct phenomena and provided information about the sources of profits. The results indicate that the market is slow to incorporate the full impact of information in its valuations. Momentum strategies that are based on continuations in stock prices over intermediate horizons have attracted a wide following among money managers and investors. In evaluating the usefulness of momentum strategies, measuring their profitability and also understanding why they work are important. In the absence of a reasonable explanation for the profitability of momentum strategies, the pattern of profits observed in the past may be a statistical fluke, in which case, it may not recur.Using a sample that included all U.S. stocks from the NYSE, Amex, and Nasdaq for 1973–1993, we evaluated the profitability of strategies based on price momentum (past return) and on earnings momentum (standardized unexpected earnings and revisions in consensus forecasts).We found that strategies based on price momentum and earnings momentum yielded significant profits over a 6–12-month horizon. For example, sorting stocks by prior six-month return yielded spreads in returns of 15.4 percentage points (pps) over the subsequent year. Similarly, ranking stocks by past earnings momentum produced large differences in future returns. The spreads in the subsequent year were 7.5 pps for portfolios based on standardized unexpected earnings and 9.7 pps based on a moving average of past revisions in consensus estimates of earnings.A critical comparison of these strategies yielded evidence that they reflect distinct phenomena. None of the momentum variables subsumed any of the others; they each exploited different pieces of information. In fact, combinations of these momentum strategies yielded higher profits than any of the strategies individually.The results presented are fairly robust. The strategies continued to generate profits when applied to a sample of large stocks only, although the spreads were lower than for the full sample. Furthermore, when we extended our results to the 1994–98 period, our main results held.These results indicate that the market is slow to incorporate the full impact of information in its valuations. For instance, the market seems to be pleasantly surprised around future earnings announcements for past winners and vice versa for past losers. In fact, a substantial portion of the momentum effect is concentrated around subsequent earnings announcements. Generally, if the market is surprised by good or bad earnings news, then on average, the market continues to be surprised in the same direction, at least over the next two subsequent announcements. Another piece of evidence compatible with a sluggish response is that analysts continue to revise their earnings forecasts downward for past losers for up to 12 months after the ranking period.We considered holding periods of six months and one year for the momentum strategies. Because of the resulting high turnover and because of potentially high transaction costs for some of the small, less liquid stocks in the winner and loser portfolios, practical implementation of momentum strategies will require skillful management of trade execution.
Journal: Financial Analysts Journal
Pages: 80-90
Issue: 6
Volume: 55
Year: 1999
Month: 11
X-DOI: 10.2469/faj.v55.n6.2315
File-URL: http://hdl.handle.net/10.2469/faj.v55.n6.2315
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# input file: UFAJ_A_12047196_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hersh Shefrin
Author-X-Name-First: Hersh
Author-X-Name-Last: Shefrin
Title: Irrational Exuberance and Option Smiles
Abstract: 
 Disagreement among investors is pervasive. Some investors see a trend and predict continuation; others see the same trend and predict reversal. Some investors overreact; others underreact. I explain how disagreement can and does cause markets to be inefficient. And I argue that option markets are particularly vulnerable in this respect; the “volatility smile” associated with index options is one manifestation of inefficiency stemming from heterogeneous beliefs. As part of the argument, I discuss an event study about “irrational exuberance,” the term Alan Greenspan, chair of the U.S. Federal Reserve Board, used in late 1996 to describe stock market sentiment. To study this event, I combined the information gleaned from option-pricing data with other information about market sentiment to assess the impact of heterogeneous beliefs on market efficiency. Do investors overreact, as the evidence on long-term reversals suggests? Or do they underreact, as the evidence on short-term momentum suggests? The truth is that some investors overreact and others underreact. Some observe a recent trend in security prices and predict continuation; others observe the same trend and predict reversal. Because markets serve to aggregate disparate beliefs, this issue is important for market efficiency. For example, some scholars argue that because investors overreact about as often as they underreact, markets are efficient.I explain how investor disagreement can and does cause markets to be inefficient. I argue that option markets are particularly vulnerable in this respect. Even when the strength of bullish opinion is matched by that of bearish opinion, bulls overbid the prices of index call options and bears overbid the prices of index put options. The result is mispricing at both ends of the exercise-price spectrum. The effect is a pronounced “volatility smile”—that is, the volatilities associated with intermediate exercise prices are lower than at the extremes, both low and high, which is a common characteristic in index option pricing.When a market trend has been conspicuous, individual investors tend to predict continuation of the trend but professional investors tend to predict reversal. For this reason, the study described here focused on the latter part of 1996, when the uptrend in market prices was particularly notable. In fact, the trend was so salient that on December 5, 1996, in a remark that gained worldwide attention, Alan Greenspan, the chair of the U.S. Federal Reserve Board, used the term “irrational exuberance” to describe U.S. stock market sentiment. I show that during November 1996, not all investors were irrationally exuberant; in fact, disagreement among investors was strong—and prices were inefficient.To study efficiency of the market and investor sentiment in November and December of 1996, I used indicators to track the sentiment of advisory newsletter writers, individual investors, and option traders. For tracking option trader sentiment, I obtained daily data of implied volatilities and estimated the time series of risk-neutral probabilities for all S&P 500 Index options traded from June through December of 1996. For each listed S&P 500 option, I obtained the price, date, and time of the last trade, the bid price, the ask price, and trading volume. I also obtained the closing price of the S&P 500 and the prevailing three-month U.S. T-bill rate. I focused on the December 1996 options because they expired about two weeks after Greenspan's irrational exuberance remark.By and large, I found that bullish sentiment among newsletter writers and individual investors was above average and rising during November. During the course of the month, the option volatility smile intensified, which suggests that differences of opinion were growing.I also found that traders in index options were becoming increasingly pessimistic as the S&P 500 rose during the course of the month. In theory, the risk-neutral probabilities associated with call options are the same as those associated with puts. But during the latter part of November, the risk-neutral probabilities derived from calls were markedly different from the probabilities derived from puts and indicated growing trader pessimism. The character of the risk-neutral probabilities also suggests that arbitrage was not fully carried out at the time, so arbitrage profits were possible.
Journal: Financial Analysts Journal
Pages: 91-103
Issue: 6
Volume: 55
Year: 1999
Month: 11
X-DOI: 10.2469/faj.v55.n6.2316
File-URL: http://hdl.handle.net/10.2469/faj.v55.n6.2316
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# input file: UFAJ_A_12047197_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Dirk Schiereck
Author-X-Name-First: Dirk
Author-X-Name-Last: Schiereck
Author-Name: Werner De Bondt
Author-X-Name-First: Werner
Author-X-Name-Last: De Bondt
Author-Name: Martin Weber
Author-X-Name-First: Martin
Author-X-Name-Last: Weber
Title: Contrarian and Momentum Strategies in Germany
Abstract: 
 Two traditional methods of managing equity portfolios are investing based on price momentum and value-based contrarian investing. These strategies may be motivated by a behavioral theory of under- and overreaction to news or by empirical research, mostly for the NYSE, that has found persistence in price movements over short horizons and reversion to the mean over longer horizons. However, the apparent success of these strategies may be due to institutional factors and the mismeasurement of risk, or it may result from data mining. For these reasons, we studied all major German companies listed on the Frankfurt Stock Exchange for the three decades between 1961 and 1991. The dynamics of stock prices in Frankfurt are remarkably similar to New York. The data suggest that equity prices reflect investor forecasts of company profits that are predictably wrong. Two traditional methods of managing equity portfolios are investing based on price momentum and value-based contrarian investing. We can justify these strategies with a behavioral theory of under- and overreaction to news or with empirical research for the United States that finds persistence in price movements over short horizons and reversion to the mean over longer horizons. Still, the seeming success of these strategies may be an illusion (the product of data mining), the result of the mismeasurement of risk, or the result of institutional factors that are unique to the United States.We studied all major companies listed on the Frankfurt Stock Exchange for the three decades between 1961 and 1991. We used return and accounting data for 357 firms. Nearly every German company whose name is internationally recognized (e.g., Deutsche Bank, Daimler-Benz, Bayer) was included in the sample. To judge the profitability of momentum strategies, we “bought” portfolios of extreme past winners. We also “sold” short portfolios of extreme past losers. Companies were sorted into winners and losers on the basis of their returns over the past 1, 3, 6, or 12 months (the rank period). We studied the performance of past winners, past losers, and arbitrage portfolios for the next year (the test period). To judge the profitability of contrarian strategies, we bought extreme past losers and we sold extreme past winners. Both the rank and test periods were five years long for this part of the study.The momentum and contrarian investment strategies all apparently beat a passive indexing strategy. The magnitude of the results was similar to what has been observed in the United States. For instance, zero-investment arbitrage contrarian portfolios (with the top 20 prior winners bought and the top 20 prior losers sold short) earned, on average, cumulative five-year test period returns of 21.7 percent. The results, which were driven by the exceptional performance of the prior losers, may be economically meaningful—especially because contrarian strategies require only limited trading. The momentum strategies also produced profits that may be substantial enough to be of interest to portfolio managers.We tried to reconcile the results with standard theories, but factors such as beta, risk, and firm size do not easily account for the findings. The evidence suggests, instead, that equity prices reflect forecasts of company profits that are predictably wrong.From the viewpoint of behavioral finance, what is most surprising is how closely the results for Germany match the findings for the United States—despite profound differences in the social, economic, and financial environment. Perhaps general traits in human behavior and psychology overcome these differences and ultimately drive the speculative dynamics of asset prices in world financial markets.
Journal: Financial Analysts Journal
Pages: 104-116
Issue: 6
Volume: 55
Year: 1999
Month: 11
X-DOI: 10.2469/faj.v55.n6.2317
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# input file: UFAJ_A_12047198_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark T. Finn
Author-X-Name-First: Mark T.
Author-X-Name-Last: Finn
Author-Name: Russell J. Fuller
Author-X-Name-First: Russell J.
Author-X-Name-Last: Fuller
Author-Name: John L. Kling
Author-X-Name-First: John L.
Author-X-Name-Last: Kling
Title: Equity Mispricing: It's Mostly on the Short Side
Abstract: 
 In the large-cap sector of the U.S. equity market, the degree of mispricing is much greater for stocks one would like to sell short than for stocks one would like to buy long. For example, if no attempt is made to control tracking error, large-cap short/sell candidates tend to be overpriced by as much as four times the amount the large-cap long/purchase candidates are underpriced. With respect to tracking error, we found that controlling for firm size, even in the large-cap sample of stocks we examined, significantly reduces tracking error. Controlling for value versus growth also reduces tracking error. Once one controls for value versus growth and firm size, controlling for economic sector has relatively little effect on tracking error. We investigated mispricing in the large-cap sector of the U.S. equity market. To explore stocks that appear to be overpriced (short/sell candidates) and stocks that appear to be underpriced (long/purchase candidates), we examined one anomaly from among many in the literature classified as value strategies and one anomaly from among many in the literature that might be classified as growth strategies. The value criterion was a combination of low p/E and share repurchase; the growth criterion was earnings surprise.Our principal finding is that among the S&p 500 Index stocks, the short/sell candidates identified by either strategy (value or growth) tend to be much more overpriced than the long/purchase candidates are underpriced. For example, in the case where we did not control for risk, the alpha for the short/sell candidates using the value criterion was −7.9 percent compared with +1.3 percent for the long/purchase candidates. When we used the growth criterion (and no risk control), the alpha for short/sale candidates was −9.7 percent compared with +3.8 percent for the long/purchase candidates.In our tests, we also controlled for three dimensions of risk relative to the S&p 500: style (in this case, value versus growth),size (market capitalization), andindustry exposure.We looked at these measures with respect to controlling tracking error. Combining both the value strategy (long and short) with the growth strategy (long and short) reduced tracking error substantially. In addition, controlling for firm size (even within the S&P 500 stocks) considerably reduced tracking error. After controlling for value versus growth and for firm size, controlling for economic sector weights did not reduce tracking error significantly.Given the significantly larger mispricing for short/sell candidates, the following strategy might be desirable for U.S. plan sponsors who want an enhanced index portfolio: Using both value and growth strategies, construct a dollar-neutral long–short portfolio, with most of the emphasis placed on identifying mispriced short candidates, and equitize the portfolio by buying S&P 500 futures contracts.
Journal: Financial Analysts Journal
Pages: 117-126
Issue: 6
Volume: 55
Year: 1999
Month: 11
X-DOI: 10.2469/faj.v55.n6.2318
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# input file: UFAJ_A_12047199_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Rediscovered Benjamin Graham: Selected Writings of the Wall Street Legend (a review)
Abstract: 
 This useful compilation of short works by a founder of modern security analysis contains advice as pertinent today as when first written. 
Journal: Financial Analysts Journal
Pages: 127-129
Issue: 6
Volume: 55
Year: 1999
Month: 11
X-DOI: 10.2469/faj.v55.n6.2319
File-URL: http://hdl.handle.net/10.2469/faj.v55.n6.2319
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# input file: UFAJ_A_12047200_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: H. Gifford Fong
Author-X-Name-First: H. Gifford
Author-X-Name-Last: Fong
Title: From the Editor
Abstract: 
 This issue of the Financial Analysts Journal is devoted to the topic of behavioral finance. Rather than trying to define the term, we leave it to the reader to determine. And defining behavioral finance is in itself a large part of the controversy associated with this area: What it is and how it can be validated are central issues. For the practitioner, the stakes are profound. If the efficient market hypothesis (including its popular variants) is not to be fully accepted, what is (are) the alternative(s), and how does one reconcile the differences? Behavioral finance may help in the solution. We do not profess to provide the definitive answer, but we have set an objective of providing a sound introductory framework and also a range of articles to provide the basis for the reader to gain insights, practical conclusions, and the motivation to learn more about the topic. We are fortunate to have a group of authors who have brought to bear on the topic distinguished careers and backgrounds in research on behavioral finance. Dick Thaler provides a macro view of behavioral finance in his Perspectives article. He highlights the nature of behavioral finance and its potential role. Meir Statman follows with a basic introduction to the topic that also provides a broad bibliography for further follow-up. An article by Priya Raghubir and Sanjiv Das, which also contains an extensive reference list, and one from Brad Barber and Terry Odean focus on the behavioral dimensions of the individual in investment decision making. Five pieces that follow discuss behavioral finance with respect to specific investment strategies. Hersh Shefrin investigates the implications in option-pricing data; Kent Daniel and Sheridan Titman discuss a number of market anomalies; and Louis Chan, Narasimhan Jegadeesh, and Josef Lakonishok take a look at momentum strategies. A global perspective is provided by Dirk Schiereck, Werner De Bondt, and Martin Weber, who report a study of momentum and contrarian strategies in Germany. Last but not least, Mark Finn, Russ Fuller, and John Kling complete the issue with an article on large-cap investing. Our gratitude belongs to all of these authors. Their contributions provide a framework for understanding behavioral finance and for further investigation of this important field of study. We are also pleased to announce the introduction in this issue of a feature called Author Digests. The role of the Author Digests is to provide a summary of each article while highlighting its practical significance. The digests are grouped together near the front of the issue to provide a quick read for practitioners who want to keep up to date on current research in their world. 
Journal: Financial Analysts Journal
Pages: 3-3
Issue: 6
Volume: 55
Year: 1999
Month: 11
X-DOI: 10.2469/faj.v55.n6.2320
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Author-Name: Robert Ferguson
Author-X-Name-First: Robert
Author-X-Name-Last: Ferguson
Title: Saving Social Security
Abstract: 
 To save Social Security, it would have to be transformed from a transfer payment system to a real-saving system. The outlook for the U.S. Social Security system is poor. Benefit schedules that would make the system solvent would probably require politicians to give up power they are unwilling to give up and require workers to contribute more of their future production than they are willing to contribute. This article shows why the Social Security system probably cannot be saved, explains why most of the discussion about saving it misses the mark, and provides workers and retirees the insight needed to evaluate legislative proposals and prepare for the consequences.The goods Social Security recipients consume could come from real savings or from transfer payments. Real savings are like something stashed away, as opposed to government debt. Transfer payments take from one person to give to another, which is the system operated by Social Security. The trust fund, a portfolio of government debt, is irrelevant to solvency. The issue of Social Security solvency is whether an expropriation schedule to pay retirees what they have been promised will be honored by future workers.The various schemes put forth by politicians to “solve” the Social Security problem will not work; they simply provide cover for increased government spending and higher taxes.For the country as a whole, investing in government debt is not useful because the proceeds tend not to be used to create physical capital (or store consumption goods). Investing in privately issued securities does lead to the creation of productive capacity, so investing the Social Security trust fund in privately issued securities is a step in the right direction. Unfortunately, it cannot help much if benefits are still funded with transfer payments. The fundamental problem remains whether future workers will honor the expropriation schedule.The issue of what kind of private securities should be held is often misunderstood. A common argument is that stocks would be preferable to bonds because they have higher long-term returns, but long-term returns are not the issue. Solvency depends only on whether the current value of assets exceeds the present value of liabilities. And a dollar's worth of stocks has the same value as a dollar's worth of assets in any other form.Help for the Social Security system could come in the form of transformation into a system based on real savings set up like a private defined-contribution plan with individual, actuarially sound accounts. Such a system would remove any incentive for workers to complain about excessive retiree benefits and would have no possibility of insolvency. Transfer payments would be used only to guarantee that all retirees would receive adequate retirement income. The required level of transfer payments would be far smaller than in the current Social Security system.Implementation of this kind of Social Security system would require current workers to save for themselves in addition to enduring continued expropriation of their production to support existing retirees. Probably the only way workers would accept such a situation is if reduced government spending in other areas were used to assure that the workers' own consumption did not suffer. Unfortunately, such reduced spending is unlikely, because in our political climate, spending confers political power.
Journal: Financial Analysts Journal
Pages: 13-16
Issue: 1
Volume: 56
Year: 2000
Month: 1
X-DOI: 10.2469/faj.v56.n1.2325
File-URL: http://hdl.handle.net/10.2469/faj.v56.n1.2325
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# input file: UFAJ_A_12047202_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Brad M. Barber
Author-X-Name-First: Brad M.
Author-X-Name-Last: Barber
Author-Name: Terrance Odean
Author-X-Name-First: Terrance
Author-X-Name-Last: Odean
Title: Too Many Cooks Spoil the Profits: Investment Club Performance
Abstract: 
 We report our analysis, using account data from a large discount brokerage firm, of the common stock investment performance of 166 investment clubs from February 1991 through January 1997. The average club tilted its common stock investment toward high-beta, small-cap growth stocks and turned over 65 percent of its portfolio annually. The average club lagged the performance of a broad-based market index and the performance of individual investors. Moreover, 60 percent of the clubs underperformed the index. The financial press has made frequent and bold claims about the performance of investment clubs. One often-quoted figure from a National Association of Investors Corporation survey states that 60 percent of investment clubs beat the market. Are these claims myth or reality?We used account data from a large discount broker to analyze the common stock investment performance of 166 investment clubs from February 1991 to January 1997. We report that the average club earned an annualized geometric mean return of 14.1 percent whereas a market index returned 17.9 percent. In addition, 60 percent of the clubs we analyzed underperformed the index. Not only did the average club fail to beat the market, it failed to match the performance of the average individual investor, who earned 16.4 percent during our sample period.Two reasons account for the poor performance of investment clubs relative to individual investors—trading costs and investment style. Despite having roughly similar account sizes, the clubs executed smaller trades and held more stocks than did individuals. Thus, their proportionate cost of trading was higher. Trading costs accounted for approximately one-third of the clubs' performance shortfall relative to individuals. The remaining two-thirds of the shortfall was accounted for by investment style. Relative to individuals, the clubs tilted more toward large-cap stocks and growth stocks. During our sample period, large-cap stocks underperformed small-cap stocks by 15 basis points a month and growth stocks underperformed value stocks by 20 basis points a month.Investment clubs serve many useful functions: They encourage savings; they educate their members about financial matters; they foster friendships and social ties; and they entertain. Unfortunately, their investments do not beat the market.
Journal: Financial Analysts Journal
Pages: 17-25
Issue: 1
Volume: 56
Year: 2000
Month: 1
X-DOI: 10.2469/faj.v56.n1.2326
File-URL: http://hdl.handle.net/10.2469/faj.v56.n1.2326
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# input file: UFAJ_A_12047203_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Roger G. Ibbotson
Author-X-Name-First: Roger G.
Author-X-Name-Last: Ibbotson
Author-Name: Paul D. Kaplan
Author-X-Name-First: Paul D.
Author-X-Name-Last: Kaplan
Title: Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?
Abstract: 
 Disagreement over the importance of asset allocation policy stems from asking different questions. We used balanced mutual fund and pension fund data to answer the three relevant questions. We found that about 90 percent of the variability in returns of a typical fund across time is explained by policy, about 40 percent of the variation of returns among funds is explained by policy, and on average about 100 percent of the return level is explained by the policy return level. Does asset allocation policy explain 40 percent, 90 percent, or 100 percent of performance? The answer depends on what the analyst is trying to explain. 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. So, if an analyst is trying to explain the variability of returns over time, asset allocation is very important.The results of previous studies are often applied, however, to questions the studies never intended to address. Rather than the importance of asset allocation over time, 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: How much of the variability of returns across time is explained by asset allocation policy?How much of the variation of returns among funds is explained by differences in asset allocation policy?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:Question #1: We regressed each fund's total returns against its policy returns and recorded the R2 value for each fund in the study. We found that, on average, about 90 percent of the variability of returns of a typical fund across time is explained by asset allocation policy. Most of a fund's ups and downs are explained by the ups and downs of the overall market.Question #2: We ran a cross-sectional regression of compound annual fund returns for the entire period on compound annual policy returns for the entire period. The R2 statistics from this regression showed that for the mutual funds, 40 percent of the return difference from one fund to another (and for the pension fund sample, 35 percent) is explained by policy differences. For example, among mutual funds, if one fund's return is 13 percent and another fund's return is 8 percent, then on average, about 2 percent of the difference is explained by the difference in asset mix policy; the remaining 3 percent difference is explained by other factors, such as timing, security selection, and fee differences between the funds.Question #3: For each fund, we divided the compound annual policy return for the entire period by the compound annual fund return. We found that, on average, about 100 percent of the return level is explained by the return to asset allocation policy. Thus, the average fund's return to asset-mix policy is about the same as the return to the benchmarks for the asset classes.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 level of returns. Thus, the answer to the question of whether asset allocation policy explains 40 percent, 90 percent, or 100 percent of performance depends on how the question is interpreted.
Journal: Financial Analysts Journal
Pages: 26-33
Issue: 1
Volume: 56
Year: 2000
Month: 1
X-DOI: 10.2469/faj.v56.n1.2327
File-URL: http://hdl.handle.net/10.2469/faj.v56.n1.2327
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# input file: UFAJ_A_12047204_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Timothy Falcon Crack
Author-X-Name-First: Timothy Falcon
Author-X-Name-Last: Crack
Author-Name: Sanjay K. Nawalkha
Author-X-Name-First: Sanjay K.
Author-X-Name-Last: Nawalkha
Title: Interest Rate Sensitivities of Bond Risk Measures
Abstract: 
 We present a simple expression for the sensitivity of duration, convexity, and higher-order bond risk measures to changes in term-structure shape parameters. Our analysis enables fixed-income portfolio managers to capture the combined effects of shifts in term-structure level, slope, and curvature on any specific bond risk measure. These results are particularly important in environments characterized by volatile interest rates. We provide simple numerical examples. Building on previous research into the sensitivities of bond risk measures, we present a simple expression for the sensitivity of duration, convexity, and higher-order bond risk measures to nonparallel changes in the shape of the yield curve. Although researchers have analyzed the sensitivity of a bond's duration to changes in the bond's yield, little is known about the interest rate sensitivity of duration, convexity, and so on, to changes in level, slope, and curvature of the term structure. The subject is important because up to 95 percent of returns to portfolios of U.S. Treasury securities are explained by term-structure level, slope, and curvature shifts—and these shifts can be quite extreme in volatile interest rate environments.We captured these parameters of term-structure shape by using a simple polynomial representation of the continuously compounded spot yield curve. Given a noninfinitesimal, nonparallel shift in the yield curve, we were able to derive closed-form expressions for the resulting changes in bond risk measures as a function of changes in the level, slope, and curvature of term structure and as a function of the bond risk measures themselves.Our framework enabled us to answer questions that are relevant to the work of managers who are required to maintain target durations for their bond portfolios and who wish to know how sensitive their bond risk positions are to general interest rate changes: How does the duration of a bond change with respect to a change in the slope of the term structure? How does the convexity of a bond change with respect to a change in the level of the term structure? Do the duration and convexity of a barbell portfolio change more rapidly than those of a bullet portfolio? These questions are relevant to managers of fixed-income portfolios and managers of financial institutions.Shifts in term-structure level, slope, and curvature are not independent. For example, increases in level tend to be associated with decreases in slope. We used such interrelationships to derive a simple but realistic numerical example of the effect of a noninfinitesimal, nonparallel term structure shift on a bullet bond and two barbell bonds. We found that if we ignored the slope and curvature shifts and accounted only for the level shift, we seriously misestimated the effect of the full term-structure shift on bond duration measures for the barbell bonds. The percentage error we made became larger as the cash flow spacing of the barbell became wider. When we added a term (i.e., slope to level) and then two terms (i.e., curvature and slope to level), the magnitude of our estimation errors decreased substantially. Therefore, accounting for the impact of level shifts alone (i.e., parallel shifts) is not sufficient when estimating the effect of changes in term-structure shape on bond risk measures.We also note one simple result: Although the bonds in our numerical example all had the same initial price and duration, the effect of the nonparallel shift in term structure on their prices was quite different. This outcome is a simple reminder that practitioners must look beyond parallel term-structure shifts when analyzing bonds.
Journal: Financial Analysts Journal
Pages: 34-43
Issue: 1
Volume: 56
Year: 2000
Month: 1
X-DOI: 10.2469/faj.v56.n1.2328
File-URL: http://hdl.handle.net/10.2469/faj.v56.n1.2328
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Author-Name: Wenling Lin
Author-X-Name-First: Wenling
Author-X-Name-Last: Lin
Title: Controlling Risk in Global Multimanager Portfolios
Abstract: 
 The issue of country and sector effects is important for portfolio construction and risk management. Unlike the many studies that have addressed the issue by analyzing individual stocks, this article focuses on analyzing managed portfolios. Using global data on manager excess returns and portfolio characteristics, I examined the relative effects of country versus sector bets on excess-return variations. I then evaluated alternative portfolio construction strategies by using optimization and simulation methods. I found that active country exposure is a larger driver of variations in individual managers' excess returns than is active sector exposure. Using this information, money managers can learn current investment industry trends in country and sector selection and fund managers can construct their multimanager portfolios to reduce tracking error by weighting individual managers to limit country exposure in an overall portfolio. Portfolio construction and risk management in international equity investing is especially difficult because of the number of risk factors involved—such as country allocation, sector allocation, currency management, and stock selection. Past studies of country and sector effects have found that when country and sector tilts are relatively the same size in relation to the benchmark, country factors make the strongest impact on benchmark-relative volatility. These studies examined individual stock returns, however; similar studies involving global portfolios are lacking.The drivers of individual stock returns and risk may differ from those of portfolio returns and risk because active managers' bets vary in size and volatility. Using the return data and information on characteristics of managed portfolios from the World and World ex United States universes of Frank Russell Company from roughly 1993 to 1998, I examined the relative importance of country and sector effects on the managers' excess-return variations, their types of country and sector bets, and the performance of hypothetical alternative strategies for multimanager portfolio construction and risk control.A simple factor model was used to examine the cross-sectional regression of the managers' excess returns on the benchmark-relative country and sector weights and establish these factors' explanatory power. In these tests, country deviations explained 50 percent of managers' excess-return variations whereas sector deviations explained only 31 percent. In combination, the two factors explained 65 percent of excess-return variations.The analysis of managers' country and sector bets suggests that the following key tilts were significant in contributing to tracking error in the sample studied: For the portfolios benchmarked to both non-U.S. equities (MSCI Europe/Australasia/Far East Index as benchmark) and global equities (MSCI World Index as benchmark), active tilts away from Japanese equities contributed the most to benchmark-relative tracking error, followed by tilts toward nonbenchmark countries.The largest sector impact for non-U.S. global portfolios came from persistent underweighting of financial services, which caused a 43 basis point (bp) increase in tracking error.In global portfolios, managers' sector weightings tended to stay closer to the benchmark, on average, than they did in the non-U.S. global portfolios. Nevertheless, a persistent underweighting of utilities added 21 bps to tracking error.In the portfolio strategy simulations, 500 random draws of the managers in the database were made to evaluate three strategies—equal weighting, optimal weighting to minimize country exposure, and optimal weighting to minimize sector exposure. Compared with the equal-weighting strategy, minimizing country exposure reduced tracking error 108 bps whereas minimizing sector strategy reduced tracking error only 40 bps.This study provides a number of insights into portfolio construction and risk management for pension and endowment fund mangers. First, it provides a clear picture of the overall trends in managed global equity portfolios as to country and sector selections. It also clarifies the close link between the magnitude of individual country and sector tilts and their impact on tracking error. This study suggests that for a given size of the tilt, country tilts generate more benchmark-relative risk than sector tilts. Thus, in selecting investment managers and building international portfolios, fund managers need to assess the correlated risks of country tilts among portfolios. Finally, the study suggests that considering country and sector deviations when establishing or rebalancing manager weightings can be an effective tool for controlling benchmark-relative risk.
Journal: Financial Analysts Journal
Pages: 44-53
Issue: 1
Volume: 56
Year: 2000
Month: 1
X-DOI: 10.2469/faj.v56.n1.2329
File-URL: http://hdl.handle.net/10.2469/faj.v56.n1.2329
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# input file: UFAJ_A_12047206_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bruno Solnik
Author-X-Name-First: Bruno
Author-X-Name-Last: Solnik
Author-Name: Jacques Roulet
Author-X-Name-First: Jacques
Author-X-Name-Last: Roulet
Title: Dispersion as Cross-Sectional Correlation
Abstract: 
 We introduce the concept of cross-sectional dispersion of stock market returns as an alternative to the time-series approach to estimating the global correlation level of equity markets. Our objective is to derive a simple, instantaneous measure of the general level of global market correlation. Our cross-sectional method of estimating global correlation is dynamic and, using cross-sectional data, gives instantaneous information on the trend of global correlation. The traditional time-series method requires a long period of observations, and overlapping data have to be used to study the change in correlation. Both methods yield similar estimates for a “long” period, however, so a combination of the cross-sectional and time-series approaches should be of practical use to global asset managers. We introduce a new approach to estimating the global correlation of stock markets that has as the key ingredient the cross-sectional dispersion of stock market returns. The simple model of global market correlation is based on the postulate that each country has a beta of 1 relative to the world market. This model allows one, in a simple manner, to derive global correlation from the dispersion, and it also implies that global correlation is inversely proportional to dispersion. On the basis of the model, we show how to estimate the global market correlation by using cross-sectional (contemporaneous) short-term data. An important aspect is that the model allows derivation of an instantaneous measure of the general level and trend of global market correlation.The issue of changes in global correlations has strong practical relevance. Investment managers optimize their asset allocations partly on the basis of the international covariance of market returns. The level of global correlation affects the degree of diversification needed in investment portfolios. It also has a bearing on the extent of profit opportunities available to active asset allocators. What managers need is an indicator that will instantaneously track the time variation in global correlation—especially when market volatility is high, because the globalization of investments and the instantaneous flow of information have made crises contagious. By providing instantaneous detection of changes in correlation, our dispersion indicator and the global correlation measure derived from it are practical, even if partial, tools to meet this need.The traditional time-series method requires a long observation period and overlapping data (moving windows) in order for the change in correlation to be studied. Thus, it yields a slow-moving estimate of the level of global correlation that is poorly suited to rapid detection of changes in global correlations. Because our dispersion-based correlation uses only contemporaneous data, estimates at two successive points in time use independent data sets; therefore, changes in the global correlation level can be detected immediately. The two methods yield similar estimates when data over a long (five-year or more) period are used.We illustrate the concept of dispersion by reporting a study of its estimated values from January 1971 to September 1998 for a set of developed market indexes. We found that the dispersion was quite stable over the period, at an average of 4.5 percent a month or 15.6 percent annually but that the dispersion has had a tendency to decrease with time, which suggests more integrated equity markets.We then report results for using the model to derive the global correlation level from the dispersion for the same equity markets and period. We found that correlation has had a positive trend, increasing from 66 percent at the beginning of 1971 to 74 percent in September 1998, but that the slope of the regression is quite weak. These findings suggest that the developed equity markets have been becoming more integrated but at a slower pace than some analysts believe.We make no conclusions about whether global investment should be conducted along country lines or industry lines. But our approach could be extended to detect valid asset classes: groupings of stocks that have large covariance between them and small covariance within them.
Journal: Financial Analysts Journal
Pages: 54-61
Issue: 1
Volume: 56
Year: 2000
Month: 1
X-DOI: 10.2469/faj.v56.n1.2330
File-URL: http://hdl.handle.net/10.2469/faj.v56.n1.2330
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:1:p:54-61




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# input file: UFAJ_A_12047207_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark Hirschey
Author-X-Name-First: Mark
Author-X-Name-Last: Hirschey
Author-Name: Vernon J. Richardson
Author-X-Name-First: Vernon J.
Author-X-Name-Last: Richardson
Author-Name: Susan Scholz
Author-X-Name-First: Susan
Author-X-Name-Last: Scholz
Title: How “Foolish” Are Internet Investors?
Abstract: 
 We offer the first systematic evidence that stock recommendations published on the Internet move prices and trading volumes. We found that buy announcements for small-cap growth stocks published in the nightly performance recap of The Motley Fool's Rule Breaker Portfolio engender statistically significant abnormal returns. The effects were generally larger than those following secondhand buy recommendations published in the print media or after a stock purchase recommendation on the television program “Wall $treet Week.” Our finding of unusual trading volume also provides evidence consistent with the hypothesis that The Motley Fool buy announcements are closely followed and acted on by Internet investors. An interesting body of financial research documents the effects of buy/sell advice published in the print and electronic media on the prices and trading volume of U.S. stocks. Abnormal stock returns of 1.1 percentage points, 2.35 pps, and 4.06 pps have been tied to stock recommendations given, respectively, on the television program “Wall Street Week,” in Business Week's “Inside Wall Street” column, and in the Wall Street Journal's “Dartboard” column.We offer the first systematic evidence that stock recommendations made on the Internet move prices and trading volumes. To test the power of Internet stock advice, we considered ramifications of online buy announcements for The Motley Fool's Rule Breaker Portfolio. The Motley Fool (TMF) states that it has 1.5 million daily readers, and the daily performance recaps for the Rule Breaker Portfolio are its most popular feature. On average, TMF small-capitalization buy announcements for the Rule Breaker Portfolio had statistically significant positive wealth effects on the announcement day (Day 0) of, depending on the estimation method, 3.36–3.72 pps. Cumulative abnormal returns over the entire event period (Day −1, Day +1) averaged a surprisingly high 6.08–6.87 pps and suggest that such announcements are more newsworthy than secondhand buy/sell recommendations, such as those published in Business Week and the Wall Street Journal.Corroborating evidence came from nonparametric estimates, but they tended to be somewhat smaller and of less statistical significance than the parametric results. Corroborating evidence of the effect of buy announcements also came from our finding of abnormal trading volume. Following the buy announcements of small-cap growth stocks, we found average abnormal trading volume on Day 0 to be 126.53 percent above the trading volume norms for these stocks predicted by the market model and for the entire event period, volume of 568.12 percent above norms.The small-cap growth stocks that benefited from TMF buy announcements also tended to rise significantly on the trading day before the announcement, as would be true if preannouncement leaks or front running were occurring.Taken as a whole, our evidence documents that TMF's widely followed buy announcements for the Rule Breaker Portfolio are acted upon by Internet investors. Buy announcements and stock advice in TMF move stock prices. These results are especially interesting in light of the TMF mission statement in the Web site's “Introduction,” which advises that “the whole point of Foolishness is to make your own decisions, sink or swim based on your own beliefs.” In fact, however, TMF's online readers closely follow and act upon the stock trading advice they find there.
Journal: Financial Analysts Journal
Pages: 62-69
Issue: 1
Volume: 56
Year: 2000
Month: 1
X-DOI: 10.2469/faj.v56.n1.2331
File-URL: http://hdl.handle.net/10.2469/faj.v56.n1.2331
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:1:p:62-69




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# input file: UFAJ_A_12047208_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: John B. Corgel
Author-X-Name-First: John B.
Author-X-Name-Last: Corgel
Author-Name: Chris Djoganopoulos
Author-X-Name-First: Chris
Author-X-Name-Last: Djoganopoulos
Title: Equity REIT Beta Estimation
Abstract: 
 Recent research has provided a summary of procedures for selecting and estimating beta that are assumed to be invariant to the type of company being analyzed. For companies such as real estate investment trusts, however, institutional details may dictate the use of different procedures. Specifically, U.S. REITs qualify for corporate tax exemption only by following rules that require high dividend payouts. Also, they are generally considered to be small-capitalization stocks. We present here a review of how financial services firms calculate REIT betas. The findings indicate that these firms make no special provisions for REITs and that their different procedures for estimating beta generally yield statistically different results among the REIT sample. Then, we present a study of elements that may be important in estimating REIT cost of capital. Through a series of beta estimations, using the same companies over the same period, we tested how treatments of dividends, use of small-cap versus broad market indexes, and use of other specialized procedures influence cost-of-capital results for REITs. The public real estate market has reached a scale and duration of trading that warrant the application of standard valuation models, particularly the capital asset pricing model (CAPM) and multifactor asset-pricing models, to the analysis of real estate investment trusts. Financial analysts have the option of using their own model designs to perform the calculations or obtaining betas from the many commercial financial service providers that now offer betas for REITs. The temptation for analysts and service providers has been to proceed in these modeling efforts as if REITs operate and trade in the same ways industrial and service companies do. Unlike other companies, however, REITs do not pay income taxes but, in return, they do face extremely high dividend payout requirements. Analysts must take special care to accommodate these unique features when applying asset-pricing models to REITs.Our review of how commercial firms calculate REIT betas indicates that they make no attempt to customize their models for REITs. Indeed, in at least one case, we found that the firm uses the standard corporate tax rate to unlever REIT betas. Our statistical analysis of commercial service estimates for the period January 1993 through November 1997 revealed no difference among the providers in the betas they assign to REITs collectively but significant differences among the betas they assign to individual REITs.Our examination of various specifications in asset-pricing models for REITs considers the effects of dividends, the use of a small-capitalization market index instead of a broad index, and the introduction of additional variables frequently recommended to improve the results of single-factor models. Our findings are as follows: First, because of the unusual dividend pattern in REIT returns, we found statistically different estimates of the cost of equity capital from various service providers depending on whether the provider firm included or excluded dividends in the return calculation. Thus, differences among the REIT betas produced by commercial services may be rooted in how the services treat dividends in the model.Second, neither the substitution of a small-cap stock index for a broad market index nor taking cross auto-correlation into account had a statistically significant influence on REIT cost-of-capital estimates.Third, the only asset-pricing model innovation that generated statistically significant improvement in cost-of-capital estimates was the addition to the CAPM of a factor representing the premium return on small-cap versus large-cap stocks and a factor representing the difference in return on stocks of high market-to-book companies and stocks of low market-to-book companies. The introduction of these additional factors increased the average R2 from about 3 percent to 11 percent and doubled the number of significant betas in the sample studied.No real surprises emerged from straightforward estimations of REIT betas. The betas were low (i.e., less than 0.4 in most cases), which is consistent with the long-term nature of the contractual obligations supporting the income streams from the REITs' underlying assets. The low average R2 for the sample regression (0.03) when the S&P 500 Index was used as the market is not new evidence, but it does confirm that stock market return indexes do a poor job of explaining variations in REIT returns—which may be related to the traditional wisdom that real estate is a good diversifier for common stock portfolios in the United States. The REIT company is a unique entity, not only because of its statutory tradition but also because REITs are the only companies for which the underlying assets trade in their own active secondary markets.
Journal: Financial Analysts Journal
Pages: 70-79
Issue: 1
Volume: 56
Year: 2000
Month: 1
X-DOI: 10.2469/faj.v56.n1.2332
File-URL: http://hdl.handle.net/10.2469/faj.v56.n1.2332
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:1:p:70-79




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# input file: UFAJ_A_12047209_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Kenneth L. Fisher
Author-X-Name-First: Kenneth L.
Author-X-Name-Last: Fisher
Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: Investor Sentiment and Stock Returns
Abstract: 
 Investors are not all alike, and neither are their sentiments. We show that the sentiment of Wall Street strategists is unrelated to the sentiment of individual investors or that of newsletter writers, although the sentiment of the last two groups is closely related. Sentiment can be useful for tactical asset allocation. We found a negative relationship between the sentiment of each of these three groups and future stock returns, and the relationship is statistically significant for Wall Street strategists and individual investors. Is the sentiment of small, individual investors different from the sentiment of large investors? Does the sentiment of investors—large, medium, or small—predict stock returns? Do high returns turn investors into exuberant bulls? Do individual investors follow their sentiment in investment actions? These are the questions we answer in this article.We studied three groups of investors—small (individual investors), medium (writers of investment newsletters), and large (Wall Street strategists). Newsletter writers are often described as semiprofessionals, midway between amateur individual investors and professional Wall Street strategists.We found that the sentiments of the three groups of investors do not move in lockstep. A significant positive relationship exists between changes in the sentiment of individual investors and that of newsletter writers, but virtually no relationship exists between changes in the sentiment of Wall Street strategists and those of either individual investors or newsletter writers.We also found that the sentiments of both small and large investors are reliable contrary indicators for future S&P 500 Index returns. The relationship between the sentiment of individual investors and future S&P 500 returns is negative and statistically significant, as is the relationship between the sentiment of Wall Street strategists and future S&P 500 returns. Although the relationship between the sentiment of newsletter writers and future S&P 500 returns is also negative, that relationship is not statistically significant. A combination of the sentiment of the three groups provides forecasts of future S&P 500 returns that can be used in a tactical asset allocation program.Individual investors and newsletter writers form their sentiments as if they expect continuations of short-term returns. High S&P 500 returns during a month make them bullish. The sentiment of Wall Street strategists, however, is little affected by stock returns. We found no statistically significant relationship between S&P 500 returns and changes in the sentiment of Wall Street strategists.We found no support for the claim that the sentiment of small investors is influenced mostly by the returns of small-cap stocks and the sentiment of large investors is influenced mostly by the returns of large-cap stocks. Indeed, the correlation of changes in the sentiment of Wall Street strategists with the returns of small-cap stocks is higher than the correlation of changes in the strategists' sentiment with the returns of large-cap stocks. Similarly, the correlation of changes in the sentiment of individual investors with the returns of large-cap stocks is higher than the correlation of their sentiment with the returns of small-cap stocks.Individual investors are wiser in their investment actions than in their sentiment. Although we found a negative and statistically significant relationship between the sentiment of individual investors and future S&P 500 returns, we found a positive, although not statistically significant, relationship between the actual stock allocations in the portfolios of individual investors and future S&P 500 returns.
Journal: Financial Analysts Journal
Pages: 16-23
Issue: 2
Volume: 56
Year: 2000
Month: 3
X-DOI: 10.2469/faj.v56.n2.2340
File-URL: http://hdl.handle.net/10.2469/faj.v56.n2.2340
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:2:p:16-23




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# input file: UFAJ_A_12047210_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert A. Olsen
Author-X-Name-First: Robert A.
Author-X-Name-Last: Olsen
Author-Name: George H. Troughton
Author-X-Name-First: George H.
Author-X-Name-Last: Troughton
Title: Are Risk Premium Anomalies Caused by Ambiguity?
Abstract: 
 Numerous studies have provided evidence of two equity return anomalies in recent years. The “risk-premium puzzle” is the anomaly that equity returns have been excessive relative to risk. The “small-firm effect” is the anomaly that risk premiums on small-cap stocks have been excessive relative to premiums on large-cap stocks. We present unique evidence that both of these anomalies may be caused by the presence of ambiguity. More generally, we propose that the current conceptions of risk are too limited to explain equity returns and, therefore, that the distinction between risk and uncertainty developed by Frank Knight approximately 80 years ago be revisited. As numerous other studies have found, risk in the traditional sense is primarily a function of the possibility of incurring a loss. Uncertainty (ambiguity) is directly related to lack of information and lack of confidence in estimating future distributions of possible returns and the possibility of incurring a loss. In recent years, numerous studies have noted that actual risk premiums on common stocks are larger than would be expected if investors were perceiving risk as only a function of variability of return. Studies have also indicated that the risk premium for small-cap stocks is greater than it theoretically should be. Previous theoretical and empirical research on risk perception conducted in noninvestment domains suggests that risk premiums are not only a function of beliefs about future outcomes but also a function of the degree of confidence decision makers have about their beliefs. More specifically, in situations where decision makers' beliefs are subject to greater ambiguity (lack of knowing), risk premiums appear to be greater. One purpose of this study was to see whether risk premiums on common stocks are also a direct function of ambiguity of belief about possible future distributions of returns.The data in the study came from the responses of 314 professional money managers (68 percent of whom were holders of the Chartered Financial Analyst™ designation) surveyed at a conference or by mail. All materials were pretested and structured to avoid response bias. Also, we presented survey respondents with diverse exercises in order to confirm the generality of response patterns. In the first exercise, respondents were asked to rate a number of potential risk attributes by the degree of their importance to risk assessment. Consistent with results of such exercises conducted in other decision domains, we found that measures of downside risk, such as the size of possible loss, received the highest ratings, but measures of ambiguity about such downside outcomes were rated a close second. Measures of variability of return were rated less highly.A second exercise had respondents rate actual common stocks as to perceived risk level (measured by conventional risk measures), a downside risk measure, and a measure of ambiguity based on disagreement among experts about future prospects. We found that downside risk and ambiguity were considered to be the most significant explanatory factors. Statistical testing ruled out multicollinearity between explanatory variables.A third exercise asked respondents to rate asset classes instead of individual stocks. The results were similar to those for individual stocks, with downside risk and ambiguity having significant explanatory power.Finally, respondents were asked about their risk perceptions in various investment decision environments. Their responses indicated that they felt less confident when making forecasts for small companies. They also believed that quantitative models are of little use in making decisions for new companies. When ambiguity was great, they tended to rely less on analytical techniques and quantitative information than on narrative information about the companies.This study implies that risk premiums are influenced by ambiguity about future outcomes. Current valuation models underestimate required risk premiums that vary directly with uncertainty of belief or ambiguity. We thus propose that the distinction between risk and uncertainty developed by Frank Knight some 80 years ago be revisited. As this study and numerous others have found, risk in the traditional sense is more a function of the possibility of incurring a loss than of variability of return. Uncertainty (ambiguity) is directly related to lack of information and lack of confidence in estimating that possibility for the future.
Journal: Financial Analysts Journal
Pages: 24-31
Issue: 2
Volume: 56
Year: 2000
Month: 3
X-DOI: 10.2469/faj.v56.n2.2341
File-URL: http://hdl.handle.net/10.2469/faj.v56.n2.2341
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:2:p:24-31




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# input file: UFAJ_A_12047211_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Gwangheon Hong
Author-X-Name-First: Gwangheon
Author-X-Name-Last: Hong
Author-Name: Arthur Warga
Author-X-Name-First: Arthur
Author-X-Name-Last: Warga
Title: An Empirical Study of Bond Market Transactions
Abstract: 
 Short histories of dealer-market and exchange-based bond transactions in machine-readable form have recently become available. They permitted us to provide for the first time direct estimation of the effective bid-ask spread for corporate bonds in the institutional and retail markets. Overall, we found effective spreads for NYSE-traded corporate bonds to be similar to effective spreads for dealer-market transactions. Evidence is that corporate bond spreads have declined over time and that dealers carry out U.S. government bond trades with major institutional clients as a nonprofit service, perhaps to support other (ostensibly) profitable activities. We demonstrate that bid-ask spreads and the magnitude of price discrepancies between data sources are reliably associated with proxies for risk and liquidity. In spite of decades of research involving corporate bond prices, little is known of the actual behavior of transactions from either the exchange or the dealer market. Our purpose was to estimate and compare effective bid–ask spreads (expected round-trip trading costs) between the dealer and exchange markets and assess whether any systematic differences exist in exchange transaction prices and dealer-market quotes relative to transactions in the dominant dealer market. We were able to perform such research for the first time because data were recently made available on transactions from both markets.The dealer and exchange markets represented here provide very different environments in which similar (in many cases, identical) securities trade. The exchange is a transparent electronic limit-order market, and the dealer market is characterized by a lack of transparency. Investors have an obvious interest in knowing about bid–ask spreads in different markets, but also important is the degree to which bid–ask spreads and their determinants differ between these markets.To carry out the study, we used transactions reported to the National Association of Insurance Commissioners by all insurance companies (which are the largest group of counterparties to dealer-market bond trades) and transactions and bid–ask quotes from the NYSE's Automated Bond System (ABS). Surprisingly, despite the large size differences in transactions between the dealer and exchange markets, we found estimates of effective bid–ask spreads in the markets to be quite similar. Per $100 par value, investment-grade corporate bonds have average spreads of about 13 cents in the dealer market and 20 cents on the ABS for trades of 10 bonds or more. High-yield bonds (below a Baa rating) have spreads of about 19 cents (per $100 par value) in both the dealer and ABS markets. These spreads are smaller than estimates found in a study based on data from an earlier period.We also found that transaction-based prices from the dealer market and from the NYSE's bond exchange are broadly in agreement with each other and with bid quotations from a major dealer (Lehman Brothers). Given the large difference in implicit transaction size, the closeness of the dealer and ABS markets is remarkable. We also found, however, that bid quotes from the exchange, which do not correspond to transactions (but are reported as indicative prices by various data vendors), did deviate significantly from quotes and transactions in the dealer market. This finding was not unexpected. It stems from the fact that the NYSE's bond exchange is an order-driven system that reflects the level of interest in instruments (such as bonds) that do not trade as frequently as, say, equities.In addition, we found no evidence that participants in the ABS market are influenced by these inactive quotes. We also found evidence that dealers realize little explicit profit in their U.S. government bond trading with insurance companies. Finally, we show that bid–ask spreads and the magnitude of price discrepancies for all classes of bonds are reliably associated with proxies for risk and liquidity.
Journal: Financial Analysts Journal
Pages: 32-46
Issue: 2
Volume: 56
Year: 2000
Month: 3
X-DOI: 10.2469/faj.v56.n2.2342
File-URL: http://hdl.handle.net/10.2469/faj.v56.n2.2342
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:2:p:32-46




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# input file: UFAJ_A_12047212_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Thomas J. Linsmeier
Author-X-Name-First: Thomas J.
Author-X-Name-Last: Linsmeier
Author-Name: Neil D. Pearson
Author-X-Name-First: Neil D.
Author-X-Name-Last: Pearson
Title: Value at Risk
Abstract: 
 This article is a self-contained introduction to the concept and methodology of value at risk (VAR), a recently developed tool for measuring an entity's exposure to market risk. We explain the concept of VAR and then describe in detail the three methods for computing it—historical simulation, the delta-normal method, and Monte Carlo simulation. We also discuss the advantages and disadvantages of the three methods for computing VAR. Finally, we briefly describe stress testing and two alternative measures of market risk. We provide an introduction to the concept and methodology of value at risk (VAR), a recently developed tool for measuring an entity's exposure to market risk. We explain the concept of VAR, describe and compare the three methods for computing it, and describe two alternative concepts.The need for VAR stems from the past few decades' tremendous volatility in exchange rates, interest rates, and commodity prices and its proliferation of derivative instruments for managing the risks of changes in market rates and prices. Increased trading of cash instruments and securities and the growth of financing opportunities accompanied the proliferation of derivatives. As a result, many companies have portfolios that include large numbers of (sometimes complex) cash and derivative instruments. Moreover, the magnitudes of the risks in companies' portfolios often are not obvious. The result is increasing demand for a portfolio-level quantitative measure of market risk.VAR is a single, summary statistical measure of possible portfolio losses. Using a probability of x percent and a holding period of t days, an entity's VAR is the loss that is expected to be exceeded with a probability of only x percent during the next t-day holding period. Loosely, it is the loss that is expected to be exceeded during x percent of t-day holding periods. For example, if the VAR computed for a one-day holding period at a probability of 5 percent is $90,000, then the loss in the mark-to-market value of the portfolio will exceed $90,000 with a probability of 5 percent. Thus, the VAR is $90,000. Subject to the simplifying assumptions used in its calculation, VAR aggregates all of the risks in a portfolio into a single number that is suitable for use in the boardroom, reporting to regulators, or disclosure in an annual report.Of the three main methods for computing VAR, historical simulation is the simplest. The approach begins by constructing the distribution of possible profits and losses. The distribution is constructed by taking the current portfolio and subjecting it to the actual changes in the market factors to which the portfolio is exposed that were experienced during each of the last N periods, usually days. That is, N sets of hypothetical market factors are constructed by using their current values and the changes experienced during the last N periods. Using these hypothetical values of the market factors, N hypothetical mark-to-market portfolio values are computed. This step allows one to compute N hypothetical mark-to-market profits and losses on the portfolio as compared with the current mark-to-market portfolio value. VAR is the magnitude of loss that is exceeded by only x percent of the market losses.The delta-normal approach is based on two key ideas. First, the assumption is made that changes in the underlying market factors that drive the changes in the value of the portfolio have a multivariate normal distribution. Second, the approach is to replace the actual portfolio held by the company or institution with a simpler portfolio that has approximately the same risk and then compute the VAR of the simpler portfolio. In particular, the approach involves identifying a set of k market factors (which might be yields on zero-coupon bonds) that account for most of the changes in value of the portfolio and, therefore, capture its risks. Then, for each market factor, one identifies a standardized position (e.g., a zero-coupon bond) that is exposed only to the risk of one market factor. The simpler approximating portfolio consists of a portfolio of the standardized positions, which has the same deltas or exposures to the basic market factors (and thus the same risks) as the original portfolio. Using these ideas, one can determine the distribution of mark-to-market portfolio profits and losses, which is also normal. Once this distribution has been obtained, one uses the standard mathematical properties of the normal distribution to determine the loss that will be equaled or exceeded x percent of the time (i.e., the VAR).The Monte Carlo simulation methodology is similar to historical simulation. The main difference is that one chooses a statistical distribution that is believed to adequately capture or approximate the possible changes in the market factors. Then, a pseudo-random number generator is used to generate thousands of hypothetical changes in the market factors. These results are then used to construct thousands of hypothetical portfolio profits and losses on the current portfolio and the distribution of possible portfolio profit or loss. Finally, the VAR is determined from this distribution; that is, the VAR is the portfolio loss that is exceeded only x percent of the time.We briefly describe some alternatives to VAR but focus on the advantages and disadvantages of the three methods for computing VAR. The methods differ in ability to capture the risks of options and option-like instruments, ease of implementation, ease of explanation to senior managers, flexibility in analyzing the effect of changes in the assumptions, and reliability of the results. The best choice will be determined by which dimensions the risk manager finds most important.
Journal: Financial Analysts Journal
Pages: 47-67
Issue: 2
Volume: 56
Year: 2000
Month: 3
X-DOI: 10.2469/faj.v56.n2.2343
File-URL: http://hdl.handle.net/10.2469/faj.v56.n2.2343
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:2:p:47-67




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# input file: UFAJ_A_12047213_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Title: Franchise Labor
Abstract: 
 In today's global environment, with the increasing emphasis on knowledge-based resources and information dissemination through high-tech channels, key employees play a crucial role in a company's profitability. Such key employees can represent an important component of a company's overall business franchise. At the same time, competitive compensation policies have begun to treat (explicitly and/or implicitly) these “franchise labor” employees as a special class of super-shareholders. The claims on profits put forward by this cadre of franchise labor can have a major impact on firm valuation. In today's global environment, with the increasing emphasis on knowledge-based resources and information dissemination through high-tech channels, a cadre of key technical and managerial employees can play a crucial role in determining a company's profitability. This highly skilled human capital thus represents an important component of the company's business franchise, and the term “franchise labor” is an apt description of this group.A large body of literature exists on the apportionment of current earnings between labor and capital, but relatively little attention has been given at the micro level to the effect of franchise labor claims on incremental future profits from new initiatives.As might be expected, the nature of the rewards for franchise labor have undergone a material evolution in recent years. Competitive compensation policies—bonuses, stock, stock options, and so on—have bestowed a kind of super-shareholder status on franchise laborers. This status often allows them, individually and as a class, to participate in the current and future earnings of the company on a priority basis ahead of traditional investors.These franchise labor claims can have a critical impact on a company's valuation. For high-growth companies with high P/Es—the companies most likely to depend on high-performance employees—claims on gross profits from future growth can have a significant valuation effect, especially when the claims have de facto preferential status relative to other stakeholders. For example, for a company with a P/E of 25, a 10 percent claim on future earnings can erode the company's present value by more than 20 percent.Ordinary shareholders should not resent the reasonable claims of franchise labor. The critical employees who are essential to a company's success deserve to be rewarded accordingly. The challenge for the company is to strike the right balance between compensating these individuals in a manner that is consistent with their true contributions and maintaining shareholder value.For the analyst, no matter how the claims arise (and whether they are considered “fair” or not), franchise labor claims must be taken seriously and properly incorporated in the valuation process.
Journal: Financial Analysts Journal
Pages: 68-76
Issue: 2
Volume: 56
Year: 2000
Month: 3
X-DOI: 10.2469/faj.v56.n2.2344
File-URL: http://hdl.handle.net/10.2469/faj.v56.n2.2344
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# input file: UFAJ_A_12047214_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Tom Arnold
Author-X-Name-First: Tom
Author-X-Name-Last: Arnold
Author-Name: Jerry James
Author-X-Name-First: Jerry
Author-X-Name-Last: James
Title: Finding Firm Value without a Pro Forma Analysis (corrected)
Abstract: 
 We present a firm value calculator (FVC) that uses applications of growth-annuity and growth-perpetuity equations. The FVC provides the same detailed analysis of firm value as the more complicated pro forma analysis and can thus replace a pro forma analysis or be used to check or correct it. The FVC can be easily implemented—through either a computer spreadsheet or a handheld calculator. The algorithmic nature of the FVC may also be implemented through computer programming to quickly produce a large number of analyses, which can save a practitioner a great deal of time when many companies are to be analyzed or compared. Pro forma analysis is frequently used to assess the value of a company or a proposed project, but it is a tedious endeavor involving spreadsheets. In pro forma analysis, the analyst often needs to worry about the issue of the spreadsheet cell calculations as much as the assumptions that drive the analysis. The mechanics of the spreadsheet may be mundane, but the pro forma results are useless unless the mechanics are carried out correctly. The analyst ordinarily has no other way to assure accuracy but to continuously check and recheck the individual cell calculations.We present a firm value calculator (FVC) based on free cash flow that uses applications of growth-annuity and growth-perpetuity equations. The FVC provides the same detailed firm value analysis as the more complicated pro forma analysis, but it is so simple that it can be performed on a handheld calculator or readily programmed into a spreadsheet software package. The algorithmic format of the FVC makes it amenable to many programming platforms. It can be used as the sole measure of company value or to check the figures of an existing pro forma analysis.The FVC can save practitioners—whether financial analysts or corporate financial managers—a great deal of time when they must analyze many companies. When practitioners do not need to focus on mechanical accuracy, they can spend more time on assessing the more important fundamental logic of the analysis.To provide a basis for comparing the two methods, we first set up the typical assumptions for a pro forma analysis and carry out the analysis. We then develop the necessary equations for the FVC. The equations are derived in a clear, logical fashion that anyone with a basic knowledge of the time value of money can readily understand. Next, we compare the FVC final and intermediate calculations with those calculations performed under the initial pro forma analysis and show that the FVC produces the same results with much less effort.Although we focus solely on free cash flow, other cash flow analyses can be readily developed. Sensitivity analysis can also be easily implemented, particularly with current versions of spreadsheet software.
Journal: Financial Analysts Journal
Pages: 77-84
Issue: 2
Volume: 56
Year: 2000
Month: 3
X-DOI: 10.2469/faj.v56.n2.2345
File-URL: http://hdl.handle.net/10.2469/faj.v56.n2.2345
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:2:p:77-84




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# input file: UFAJ_A_12047215_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hung-Jen Wang
Author-X-Name-First: Hung-Jen
Author-X-Name-Last: Wang
Title: Symmetrical Information and Credit Rationing: Graphical Demonstrations
Abstract: 
 As this article shows, the pro-debtor U.S. Bankruptcy Code alone can cause credit rationing, even without asymmetrical information in the market, because the code entails substantial costs to lenders if borrowers file for bankruptcy. In the absence of bankruptcy cost, lenders are always justified in raising interest rates and clearing markets. If the bankruptcy cost is nontrivial, however, lenders' profits are concave in the relevant range of interest rates. Thus, lenders cannot always clear the market by using higher rates. The study reported here also found that the use of collateral in debt contracts can reduce rationing but that even 100 percent collateral does not eliminate all rationing possibilities. A positive relationship was found between credit risk and the amount of pledged collateral, which is not necessarily true with models based on asymmetrical information. Credit rationing describes a situation in which lenders do not raise interest rates to clear excess demand. Since the pioneering work on credit rationing in the early 1980s, most theoretical studies of credit rationing have assumed ex ante asymmetrical information between borrowers and lenders to be the underlying cause of credit rationing. The purpose of this article is to demonstrate that credit rationing can take place even if information is symmetrical. This approach is important because the current literature's partial treatment of this subject may lead practitioners and government agencies to overlook non-information-related factors that cause credit rationing when they are seeking to correct the problem.I use a simple model to demonstrate that credit rationing can take place even if information regarding investment projects and managerial behavior is symmetrical, both ex ante and ex post, between borrowers and lenders. A helpful feature of the article is that a graphical approach is used to demonstrate credit rationing. The model can be seen as a generalized version of earlier models that assumed no ex ante asymmetrical information and attributed credit rationing to bankruptcy costs. Unlike most other studies, in which credit rationing exists under sets of propositions and lemmas, the graphical representation used here has the advantage of simplicity and clarity, which should be particularly appealing to practitioners.In addition, in this article, bankruptcy costs are motivated by the design of the U.S. Bankruptcy Code, which should be of particular interest to practitioners. I specifically highlight problems in the Bankruptcy Code and practices in the bankruptcy courts in explaining the credit-rationing phenomenon. The substantial costs imposed on creditors through this channel are well established in the literature. The discussion in this article shows that pro-debtor bankruptcy proceedings often entail substantial costs to lenders when borrowers file for bankruptcy and that such costs give rise to a nonlinear function of lenders' profits with respect to interest rates. I show that credit rationing is more likely to happen when, in the presence of bankruptcy costs, a proposed investment project has a low expected return or high variance of expected return and when the opportunity cost of funds is high. The results indicate the existence of a role for government intervention in redesigning the Bankruptcy Code.The model presented in the article was also used to investigate the role of collateral in credit rationing. The results indicate that collateral in debt contracts can usually mitigate rationing problems because it compensates lenders in the event of bankruptcy and also reduces the probability of default. The model also demonstrates, however, that given nontrivial bankruptcy costs, even 100 percent collateral does not necessarily eliminate all the rationing possibilities.Another finding of using this model is that riskier borrowers pledge more collateral, which is opposite to the predictions of many asymmetrical-information-based theories. The existence of this positive relationship between collateral and credit risk draws empirical support from the literature.
Journal: Financial Analysts Journal
Pages: 85-95
Issue: 2
Volume: 56
Year: 2000
Month: 3
X-DOI: 10.2469/faj.v56.n2.2346
File-URL: http://hdl.handle.net/10.2469/faj.v56.n2.2346
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# input file: UFAJ_A_12047216_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Clifford S. Asness
Author-X-Name-First: Clifford S.
Author-X-Name-Last: Asness
Title: Stocks versus Bonds: Explaining the Equity Risk Premium
Abstract: 
 From the 19th century through the mid-20th century, the dividend yield (dividends/price) and earnings yield (earnings/price) on stocks generally exceeded the yield on long-term U.S. government bonds, usually by a substantial margin. Since the mid-20th century, however, the situation has radically changed. In addressing this situation, I argue that the difference between stock yields and bond yields is driven by the long-run difference in volatility between stocks and bonds. This model fits 1871–1998 data extremely well. Moreover, it explains the currently low stock market dividend and earnings yields. Many authors have found that although both stock yields forecast stock returns, they generally have more forecasting power for long horizons. I found, using data up to May 1998, that the portion of dividend and earnings yields explained by the model presented here has predictive power only over the long term whereas the portion not explained by the model has power largely over the short term. This article examines the relationship between stock and bond yields and, by extension, the relationship between stock and bond market returns (or the equity risk premium).The dividend yield on the S&P 500 Index has long been examined as a measure of stock market value. For instance, the well-known Gordon model expresses a stock price (or a stock market's price) as the discounted value of a perpetually growing dividend stream. Based on the Gordon model, the expected return on stocks equals the dividend yield (that is, dividends to price, D/P) in Year 0 plus the annual growth rate of dividends in perpetuity. Thus, if growth is constant, changes in D/P are exactly the changes in expected (or required) return. Numerous empirical studies have found that the dividend yield on the market portfolio of stocks has forecasting power for aggregate stock market returns and that this power increases as forecasting horizon lengthens.The market earnings yield (earnings to price or E/P) represents how much investors are willing to pay for a given dollar of earnings. E/P and D/P are linked by the payout ratio, dividends to earnings, which represents how much of current earnings is being passed directly to shareholders through dividends. Numerous studies have found that the market E/P has power to forecast the aggregate market return.Under certain assumptions, a bond's yield to maturity will equal the nominal holding-period return on the bond. As with equity yields, the inverse of the bond yield can be thought of as a price paid for the bond's cash flows (coupon payments and repayment of principal). When the yield is low (high), the price paid for the bond's cash flow is high (low). Research has shown that bond yield levels have power to predict future bond returns.The hypothesis of the study reported is that the yield stocks must provide in relation to bonds is driven by the experience of each generation of investors with each asset class. Defining a generation as 20 years, I found that stocks must provide relatively more yield (and expected return) versus bonds when for the preceding 20 years they were relatively more volatile.The article goes on to address the observation of many authors, economists, and market strategists that dividend and earnings yields on stocks as of May 1998 were, by historical standards, shockingly low. I found that today's low stock yields are predicted by the model presented in the article and, therefore, are not shocking.Finally, I decomposed stock yields into a fitted portion (stock yields explained by the model) and a residual portion (stock yields not explained by the model). I found that the residual portion forecasts primarily short-term returns and the fitted portion forecasts long-term returns only. These results point to approximately average short-term stock returns in the future but below-average long-term stock returns. These results run counter to certain popular arguments that the world is undergoing a one-time change that is driving equity risk premiums to zero and that, as this change continues, stock prices are set to soar.
Journal: Financial Analysts Journal
Pages: 96-113
Issue: 2
Volume: 56
Year: 2000
Month: 3
X-DOI: 10.2469/faj.v56.n2.2347
File-URL: http://hdl.handle.net/10.2469/faj.v56.n2.2347
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# input file: UFAJ_A_12047217_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Ultimate Investor: The People and Ideas that Make Modern Investment (a review)
Abstract: 
 This collection of insights, problems, and witticisms covers 30 major topics ranging from active managemant to performance measurement. 
Journal: Financial Analysts Journal
Pages: 114-114
Issue: 2
Volume: 56
Year: 2000
Month: 3
X-DOI: 10.2469/faj.v56.n2.2348
File-URL: http://hdl.handle.net/10.2469/faj.v56.n2.2348
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# input file: UFAJ_A_12047218_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Mutual Fund Business (a review)
Abstract: 
 This primer on the mutual fund industry consists of readings and commentary divided into sections—an overview, portfolio management and trading, marketing and the fund client, and specialized subjects. 
Journal: Financial Analysts Journal
Pages: 115-116
Issue: 2
Volume: 56
Year: 2000
Month: 3
X-DOI: 10.2469/faj.v56.n2.2349
File-URL: http://hdl.handle.net/10.2469/faj.v56.n2.2349
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# input file: UFAJ_A_12047219_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Investing by the Numbers (a review)
Abstract: 
 In this compendium of practical wisdom and analytical insight, Wilcox melds the use of quantitative tools and market experience. 
Journal: Financial Analysts Journal
Pages: 116-117
Issue: 2
Volume: 56
Year: 2000
Month: 3
X-DOI: 10.2469/faj.v56.n2.2350
File-URL: http://hdl.handle.net/10.2469/faj.v56.n2.2350
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# input file: UFAJ_A_12047220_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: John Nuttall
Author-X-Name-First: John
Author-X-Name-Last: Nuttall
Author-Name: William Jahnke
Author-X-Name-First: William
Author-X-Name-Last: Jahnke
Title: Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? Comments
Abstract: 
 This material comments on “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?”.
Journal: Financial Analysts Journal
Pages: 16-19
Issue: 3
Volume: 56
Year: 2000
Month: 5
X-DOI: 10.2469/faj.v56.n3.2355
File-URL: http://hdl.handle.net/10.2469/faj.v56.n3.2355
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# input file: UFAJ_A_12047222_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hemang Desai
Author-X-Name-First: Hemang
Author-X-Name-Last: Desai
Author-Name: Bing Liang
Author-X-Name-First: Bing
Author-X-Name-Last: Liang
Author-Name: Ajai K. Singh
Author-X-Name-First: Ajai K.
Author-X-Name-Last: Singh
Title: Do All-Stars Shine? Evaluation of Analyst Recommendations
Abstract: 
 Using a unique data set, we studied the performance of stock recommendations made by Wall Street Journal all-star analysts. We document that stocks recommended by the all-star analysts outperform benchmarks controlled for size and industry. Stocks recommended by analysts who focus on a single industry outperform those recommended by analysts covering multiple industries. We also document a herding behavior among analysts in an industry. Unlike previous studies that found superior analyst performance only for small-cap stocks, our results indicate that superior performance also exists for large-cap stocks. Whether recommendations of brokerage analysts have investment value has been a contentious issue for more than six decades. Some researchers have found that a portfolio of the most highly recommended stocks can provide an annual abnormal return of about 4 percent. The implementation of the strategy to achieve such results requires daily rebalancing, however, so annual turnover rates are enormous. In addition, such superior performance may be driven mainly by small-cap stocks, for which transaction costs are likely to be higher than for large-cap stocks.We examined a set of analysts likely to possess superior stock-picking skills. The Wall Street Journal (WSJ) and Zacks Investment Research of Chicago, Illinois, have been conducting an annual All-Star Analysts Survey since 1993. The survey is published in a special pull-out section of the WSJ each summer. This survey evaluates the performance of the stocks recommended by the senior industry analysts of a large number of brokerage houses during the previous calendar year. Each analyst is then ranked on the basis of performance within each industry. The top five performers in each industry are termed “all-stars,” and the WSJ publishes the profiles and stock picks of the top three all-stars. We report the results of our tests of the performance of these recommendations relative to size- and industry-matched control companies.We followed a naive buy-and-hold strategy of investing in all the stocks recommended by the all-stars identified and published in the WSJ. We found that the market responds positively and significantly to these recommendations on the day of their publication. We also found that stocks recommended by all-stars continued to outperform the control companies for holding periods of one year (250 trading days) and two years (500 trading days). The results indicate that the all-star industry analysts, on average, do indeed have a good understanding of the industries they follow and have superior stock-picking ability within their industries.To test whether the analysts who follow only one industry do better than those who cover multiple industries, we analyzed the performance of these two groups. We found that analysts who focus on one specific industry do better than analysts who cover multiple industries.We document a herding behavior among analysts in a specific industry. About 27 percent of all stocks in our sample were recommended by more than one analyst. We found that of the 1,158 recommended stocks in our sample, 843 were recommended by one all-star analyst, 245 were recommended by two analysts, and 70 were recommended by three or more analysts. We did not find significant differences in returns among the three groups. Most of the stocks in our sample were large-cap stocks; of the 1,158 stocks, 924 were in the top size deciles (Deciles 9 or 10) of the NYSE/Amex universe of stocks. Prior studies have indicated that superior performance of analyst-recommended stocks is confined to small companies. We found that the superior performance also exists for large companies. In particular, we report holding-period returns for the large-cap stocks of 4.78 percent for a holding period of one year and 5.58 percent for a holding period of two years. For the smaller companies, although the publication-day returns were 1.23 percent and significant, we did not find significant holding-period returns for one or two years.
Journal: Financial Analysts Journal
Pages: 20-29
Issue: 3
Volume: 56
Year: 2000
Month: 5
X-DOI: 10.2469/faj.v56.n3.2357
File-URL: http://hdl.handle.net/10.2469/faj.v56.n3.2357
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# input file: UFAJ_A_12047223_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: Socially Responsible Mutual Funds (corrected)
Abstract: 
 Conversations about socially responsible investing are difficult because they combine facts with beliefs. Proponents of socially responsible investing believe that combining social goals with investments does good; opponents believe that such combinations are unwise or even illegitimate. In this article, I try to separate facts from beliefs. I report that the Domini Social Index, an index of socially responsible stocks, did better than the S&P 500 Index and that socially responsible mutual funds did better than conventional mutual funds over the 1990–98 period but the differences between their risk-adjusted returns are not statistically significant. Both groups of mutual funds trailed the S&P 500 Index.  Errata Socially responsible mutual funds performed as well as conventional mutual funds in the period May 1990 through September 1998, and the Domini Social Index (DSI), an index of stocks of socially responsible companies, performed as well as the S&P 500 Index.The DSI is a capitalization-weighted index modeled on the S&P 500 but with a combination of exclusionary and qualitative screens used in its construction. The screens eliminate from the DSI companies that derive 2 percent or more of sales from military weapons systems, derive any revenues from the manufacture of alcohol or tobacco products, or derive any revenues from the provision of gaming products or services. The qualitative screens reflect the entire company record on diversity, employee relations, the environment, and similar issues.For the May 1990 to September 1998 period, the DSI beat the S&P 500 by a small margin when performance was measured by raw returns. The mean arithmetic annualized return of the DSI in the study period was 17.31 percent, which exceeded the 16.95 percent mean return of the S&P 500. Beta and standard deviation both indicated that the DSI is somewhat riskier than the S&P 500. When risk-adjusted returns were measured, the S&P 500 beat the DSI by a small, statistically insignificant, margin.The Domini Social Equity Fund, a mutual fund indexed to the DSI, uses the DSI social screens. Some other socially responsible mutual funds, however, do not use the DSI screens. For example, the Amana Fund screens reflect Islamic principles, and the Meyers Pride Fund screens in companies that support gay rights. The screens do share some common themes: 84 percent of socially screened portfolios exclude tobacco, 72 percent exclude gambling, 69 percent exclude weapons, and 68 percent exclude alcohol.The risk-adjusted performance of the study's 31 socially responsible mutual funds lagged the S&P 500 by an average of 5.02 percentage points a year when risk was measured by beta. The average performance of a matching sample of 62 conventional mutual funds was worse, lagging the S&P 500 by an average of 7.45 percentage points. The difference between the performance of the socially responsible and the conventional funds was not, however, statistically significant. The poor performance of both socially responsible and conventional mutual funds reflects, in part, the general tilt of mutual funds toward small-cap stocks and the poor performance of such stocks in the period studied.Socially responsible investors may use their investment activities as banners or as swords in the battle to affect the behavior of companies. Socially responsible funds act as swords when their withdrawal of money from the stocks of companies raises those companies' costs of capital and reduces the availability of the product. Socially responsible investing acts as a banner when it rallies the public to use political action as swords. For example, the social responsibility movement played a role in the battle that led to the imposition of high taxes and settlement costs on tobacco companies.Socially responsible investments provide insights into the general demand for securities that meet investors' search for value-expressive as well as utilitarian features in their investing. In the future, a comprehensive model of asset pricing will need to describe how both utilitarian and value-expressive features determine the demand for investments and their expected returns.
Journal: Financial Analysts Journal
Pages: 30-39
Issue: 3
Volume: 56
Year: 2000
Month: 5
X-DOI: 10.2469/faj.v56.n3.2358
File-URL: http://hdl.handle.net/10.2469/faj.v56.n3.2358
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# input file: UFAJ_A_12047224_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ninon Kohers
Author-X-Name-First: Ninon
Author-X-Name-Last: Kohers
Author-Name: Theodor Kohers
Author-X-Name-First: Theodor
Author-X-Name-Last: Kohers
Title: The Value Creation Potential of High-Tech Mergers
Abstract: 
 The distinctive high-growth, high-risk nature of technology-based industries raises important questions about the creation of wealth in high-tech takeovers. Do investors perceive acquisitions of high-tech targets to have strong potential for value creation? Or, given the large degree of uncertainty associated with many high-tech companies, is the market skeptical of the potential benefits of high-tech acquisitions? Our results show that acquirers of high-tech targets experience significantly positive abnormal returns, regardless of whether the merger is financed with cash or stock. Factors influencing bidder returns are the time period in which the merger occurs, the ownership structure of the acquirer, the high-tech affiliation of acquirers, and the ownership status of the target. High-tech companies have emerged as leaders in the economy through their technological advancements, job growth creation, and efficiency gains. This article provides important information to the investment analyst who is charged with valuing mergers and acquisitions in these distinctively high-growth/high-risk industries.The rapid growth of technology-based industries suggests that targets from these sectors may be able to provide greater shareholder wealth benefits for acquiring companies than slower-growth target companies. In addition to their high-growth potential, however, another feature of high-tech industries is the uncertainty associated with any company whose value relies on future outcomes or developments in unproven, uncharted fields. For example, the value of a biotechnology company may depend on the success or failure of a single new drug or medical device. Furthermore, some high-tech companies are not expected to generate any cash flow in the near future, which makes the valuation process notably riskier for the bidder in a high-tech valuation. Thus, from the perspective of a bidder's shareholders, the attractive growth prospects offered by a high-tech target may come with a high price tag.Given such risk factors, we expected that the bidders that engage in these transactions would have confidence in their ability to successfully manage the acquisition. Furthermore, these acquirers would need to instill such confidence in their investors. To find out, we studied 1,634 mergers in the various high-tech areas that occurred from January 1987 through April 1996. We found that the average performance of the acquirers prior to the merger was significantly higher than that of their industry-matched competitors, which would help to convince investors that these acquirers are capable of creating value through the acquisition.Moreover, considering the high premiums acquirers have been willing to pay for these high-risk investments, we also investigated whether shareholders in bidder companies perceive the deals favorably. Are investors generally optimistic about the potential synergies of acquiring high-tech targets? Our results show that acquirers of high-tech targets experience significantly positive abnormal returns at the time of the merger announcement—regardless of whether the merger was financed with cash or stock. This finding, together with the relatively high premiums that high-tech targets receive, suggests that the market is optimistic about the future benefits of high-tech mergers. The wealth gains to acquirers indicate that high-tech acquisitions are value enhancing in the short run. The finding that the use of stock to finance the merger or acquisition did not result, on average, in significantly negative excess returns for the acquiring company suggests that investors consider the nature of the investment for which the financing is being used rather than simply react to the financing decision by assuming that stock offerings imply overvaluation.We found that the factors that influenced bidder returns in the study are as follows: the time period in which the merger was announced (with higher abnormal returns in more recent acquisitions); the high-tech affiliation of the acquirer; the growth stage of the target (with takeovers of private targets generating higher bidder abnormal returns than takeovers of public targets); the bidder ownership structure (with moderate levels of insider ownership having a positive relationship and institutional ownership having a negative relationship with bidder returns); and the size of the transaction relative to the bidder (with larger transactions associated with larger bidder returns).
Journal: Financial Analysts Journal
Pages: 40-51
Issue: 3
Volume: 56
Year: 2000
Month: 5
X-DOI: 10.2469/faj.v56.n3.2359
File-URL: http://hdl.handle.net/10.2469/faj.v56.n3.2359
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# input file: UFAJ_A_12047225_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Michael Stutzer
Author-X-Name-First: Michael
Author-X-Name-Last: Stutzer
Title: A Portfolio Performance Index
Abstract: 
 Fund managers may sensibly be averse to earning a time-averaged portfolio return that is less than the average return of some designated benchmark. When a portfolio is expected to earn a higher average return than the benchmark return, the probability that it will not approaches zero asymptotically at a computable exponential decay rate. The probability decay rate is thus proposed here as a new portfolio “performance index.” In the widely analyzed special case in which returns are normally distributed, the new performance-index-maximizing portfolio is the same as the popular Sharpe-ratio-maximizing portfolio. The results of the two approaches generally differ, however, because of nonnormal levels of skewness and/or kurtosis in the portfolio attributable to large asymmetrical economic shocks or investments in options and other derivative securities. An illustrative example will show that the new index is easy to implement and, consistent with empirical evidence on portfolio choice, favors investments with positively skewed returns. Analysts and portfolio managers find important uses for conventional portfolio optimization tools. The estimated mean-variance-efficient frontier and the Sharpe-ratio-maximizing portfolio on it provide some information about the risk-return trade-offs inherent in asset allocation and in decisions concerning specific asset classes—for example, whether currency exposures should be hedged. However, many problems limit the practical applicability of these tools. Two of those problems may be remedied by use of the “performance index” method suggested in this article.One problem is that the mean-variance tools are designed to aid decisions about assets whose returns are normally distributed, but relevant nonnormalities arise in asset returns from at least two sources. First, a well-documented finding is that equity portfolio returns are often negatively skewed because of sporadic market crashes. Second, the application of option-like strategies introduces nonnormalities.Another problem is that mean-variance analytical tools must be modified to explicitly incorporate the influence of quantitative benchmarks that pension or endowment funds give to their portfolio managers. Such benchmarks are pervasive in the investment management industry today.The approaches that have been devised to cope with nonnormality in the past are either inherently ad hoc or require additional information that is not readily available. An example of an ad hoc approach is the use of the semivariance in place of the variance. An example of an additional requirement is the values of utility function coefficients needed to calculate a portfolio's expected utility. In addition to requiring utility function coefficients, the expected utility approach has never been given a concrete statistical interpretation.I develop an extension of modern portfolio theory that addresses these problems. It allows managers to specify a benchmark and then estimate the effect of various asset allocations on the probability that they will underperform the designated benchmark's average performance over the long span of time relevant to pension and endowment funds. The manager can then identify the allocation that minimizes the probability of underperformance and, therefore, maximizes the probability of outperforming the benchmark's average return.When portfolio returns are normally distributed and the designated benchmark is the riskless rate of interest, this new performance index ranks portfolios in the same order as the Sharpe ratio. When returns are not normally distributed, the performance index provides a different ranking that favorably weights positively skewed returns. The new ranking is equivalent to that given by a benchmark-modified expected utility index, with a specific and easily estimated risk-aversion coefficient. Thus, the performance index provides a concrete statistical interpretation for what is usually considered to be a subjective expected utility index.The article contains an example consisting of 23 randomly chosen stocks that demonstrates that the performance index, in contrast to the Sharpe ratio, favors positively skewed returns. The example illustrates how the performance index can be implemented by using garden-variety spreadsheet calculations.
Journal: Financial Analysts Journal
Pages: 52-61
Issue: 3
Volume: 56
Year: 2000
Month: 5
X-DOI: 10.2469/faj.v56.n3.2360
File-URL: http://hdl.handle.net/10.2469/faj.v56.n3.2360
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:3:p:52-61




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# input file: UFAJ_A_12047226_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Eduardo S. Schwartz
Author-X-Name-First: Eduardo S.
Author-X-Name-Last: Schwartz
Author-Name: Mark Moon
Author-X-Name-First: Mark
Author-X-Name-Last: Moon
Title: Rational Pricing of Internet Companies
Abstract: 
 We apply real-options theory and capital-budgeting techniques 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. We report that, depending on the parameters chosen, the value of an Internet stock may be rational if growth rates in revenues are high enough. Even with a real chance that a company may go bankrupt, if the initial growth rates are sufficiently high and if this growth rate contains enough volatility over time, then valuations can reach a level that would otherwise appear dramatically high. In addition, the valuation is highly sensitive to initial conditions and exact specification of the parameters, which is consistent with observations that the returns of Internet stocks have been strikingly volatile. Probably no recent investment topic elicits stronger feelings than Internet stocks. The skyrocketing valuations of these companies have made millionaires and billionaires out of many Internet entrepreneurs while the actual companies were generating significant and often growing losses.We developed a simple model to value an Internet company that is fundamentally based on assumptions about the expected growth rate of revenues and on expectations about the cost structure of the company. Because these expectations are likely to change continuously as new information becomes available, the model generates company values and stock prices that are highly volatile, but it provides a systematic way to think about the drivers of value of Internet companies and directs analyst attention to the critical parameters in the valuation.The model basically applies real-options theory and modern capital budgeting to the problem of valuing an Internet stock. 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 analyses. We found that, depending on the parameters chosen, the value of an Internet stock may be rational if growth rates in revenues are high enough. Even with a real chance that a company will go bankrupt, if the initial growth rates are sufficiently high and if there is enough volatility in this growth over time, valuations can be what would otherwise appear to be unbelievably high. In addition, we found a large sensitivity of the valuation to initial conditions and exact specification of the parameters, which is consistent with the observation that the returns of Internet stocks have been strikingly volatile.To implement the model, we make many assumptions about possible future financing, about future cash distributions to shareholders and bondholders, about the horizon of the estimation, and so on. Alternative assumptions are possible and easily incorporated in the analysis. We expect that potential users of a model such as the one presented will have a deep-enough knowledge of the company and its industry to make more reasonable (perhaps!) assumptions.We illustrate the methodology by applying it to Amazon.com. The basic data used for the valuation included quarterly sales, cost of goods sold, and other expenses for the last 15 quarters. We also used balance sheet data to estimate the loss carry-forward and the amount of cash available at the valuation date. Given the profitability assumed in the valuation (through the cost function), we found that Amazon equity is overpriced. Substantially higher profitability would be needed to obtain model prices that are consistent with those observed in the market.We intend to extend the analysis along a number of important dimensions. One is to make the cost function stochastic to reflect, for example, the uncertainty about future potential competitors, market share, or technological developments. Another is to take into account seasonality. If seasonality is not taken into account when estimating parameters for those industries in which it is characteristic, the volatility of the growth rate in revenues will be overestimated, which can significantly affect company valuation.
Journal: Financial Analysts Journal
Pages: 62-75
Issue: 3
Volume: 56
Year: 2000
Month: 5
X-DOI: 10.2469/faj.v56.n3.2361
File-URL: http://hdl.handle.net/10.2469/faj.v56.n3.2361
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# input file: UFAJ_A_12047227_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David Kellogg
Author-X-Name-First: David
Author-X-Name-Last: Kellogg
Author-Name: John M. Charnes
Author-X-Name-First: John M.
Author-X-Name-Last: Charnes
Title: Real-Options Valuation for a Biotechnology Company
Abstract: 
 Many companies in the biotechnology industry have significant valuations despite having no product revenue because their products are in early stages of development. In the past 10–15 years, investors have bid up the stock prices of companies showing promise of developing a blockbuster drug. We explain the decision-tree method and binomial-lattice method (which adds a growth option) and use them to value a biotechnology company, Agouron Pharmaceuticals, as the sum of the values of its drug-development projects. The growth option was added because the development of an initial new molecular entity (NME) is similar to purchasing a call option on the value of a subsequent NME. We compare our computed values of Agouron with actual market values at selected points in time during the development of Agouron's Viracept, a drug used to treat HIV-positive patients. Many companies in the biotechnology industry have significant valuations despite having no product revenue because their products are in the early stages of development. In the past 10–15 years, investors have bid up the stock prices of companies that show promise of developing a blockbuster drug. This phenomenon is similar to the more recent rise in stock prices of Internet start-up companies, most of which have shown losses throughout their existence.Methods used in real-options valuation can be used to assess the value investors place on companies with promise but no current revenue. The value of the company is derived from the expected profits of the company's current products and services together with the potential for growth of the company into one with many profitable products and services. Real-options valuation methods can be applied to estimate the value of individual projects, but the problem addressed in our article is how to use real-options valuation models to assess the value of a company when it is viewed as a portfolio of projects.We explain decision-tree and binomial-lattice methods and use them to the compute the value of a biotechnology company, Agouron Pharmaceutical, as the sum of the values of its current projects. We find each project's real-options value by using the two real-options valuation methods. We then compare our computed values of Agouron with the actual market values at selected points in time during the development of the company's Viracept product, a drug used to treat HIV-positive patients.Our intention is to illustrate how real-options valuation methods can be used for financial analysis. Because in our analysis we used data based on results from prior studies (primarily, industry averages), the results reflect the value of Agouron under the assumption that its situation matches that of a typical research-intensive pharmaceutical company in the 1980s and early 1990s. We discuss some of the ways in which Agouron's situation differed from that assumed by the models, which a securities analyst would no doubt understand. We found that the methods used here worked best to find the value investors were placing on Agouron when all its drugs were in early stages of development. As a drug's market potential becomes clearer in the later stages of development, securities analysts with access to more specific information than we had could improve the results of using these methods. As projects progress and new information becomes available, a financial analyst who is following a particular stock closely is likely to have better estimates of the important inputs.The real-options approach outlined here can be a powerful addition to a security analyst's toolbox. In addition, financial analysts in pharmaceutical companies can use the methods to value projects at their companies and compare the projects' relative worth for capital-budgeting purposes. Executive managers of pharmaceutical companies can use these methods to increase their understanding of the value of their projects and convey that value to investors. Finally, for academic readers, this case study provides empirical evidence of the usefulness of real-options valuation methodologies.
Journal: Financial Analysts Journal
Pages: 76-84
Issue: 3
Volume: 56
Year: 2000
Month: 5
X-DOI: 10.2469/faj.v56.n3.2362
File-URL: http://hdl.handle.net/10.2469/faj.v56.n3.2362
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:3:p:76-84




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# input file: UFAJ_A_12047228_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Derivatives: A PowerPlus Picture Book (a review)
Abstract: 
 This interactive picture book on a compact disc combines text and slides to explain a difficult subject from a unique perspective. 
Journal: Financial Analysts Journal
Pages: 85-86
Issue: 3
Volume: 56
Year: 2000
Month: 5
X-DOI: 10.2469/faj.v56.n3.2363
File-URL: http://hdl.handle.net/10.2469/faj.v56.n3.2363
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:3:p:85-86




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# input file: UFAJ_A_12047229_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: John Neff on Investing (a review)
Abstract: 
 This book includes a highly entertaining memoir, a treatise on investment principles, and an exhaustive report on the author's tenure as manager of the Windsor Fund. 
Journal: Financial Analysts Journal
Pages: 86-87
Issue: 3
Volume: 56
Year: 2000
Month: 5
X-DOI: 10.2469/faj.v56.n3.2364
File-URL: http://hdl.handle.net/10.2469/faj.v56.n3.2364
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:3:p:86-87




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# input file: UFAJ_A_12047230_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin A. Nowak
Author-X-Name-First: Martin A.
Author-X-Name-Last: Nowak
Author-Name: Karl Sigmund
Author-X-Name-First: Karl
Author-X-Name-Last: Sigmund
Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Title: Cooperation versus Competition
Abstract: 
 Three models of reciprocity are discussed that are grounded in the idea that cooperation is no less crucial for human evolution than competition and survival of the fittest. Darwin's theory of evolution is based on competition and survival of the fittest. It does not easily account for altruistic behavior. Yet, many animals, most notably humans, engage in cooperative interactions. Indeed, the emergence of cooperative behavior was a crucial step for the evolution of human societies.Theories of cooperation are based on kin selection, group selection, and reciprocal altruism. We present three frameworks for the evolution of reciprocal altruism: (1) direct reciprocity, (2) spatial reciprocity, and (3) indirect reciprocity.Direct reciprocity is based on the idea that repeated encounters between the same individuals allow for the return of an altruistic act by the recipient. The standard way to formulate direct reciprocity is in terms of the iterated Prisoner's Dilemma. One of the best strategies for this game is “Tit for Tat”. We discuss the strengths and weaknesses of TFT and show that in evolutionary settings, TFT is often outcompeted by other strategies. Examples are Generous TFT, a more forgiving variant of TFT, and win-stay, lose-shift. The win-stay, lose-shift strategy follows a completely different pattern from the TFT strategies, but the pattern is still simple: Stay with your move whenever you are doing well; change your move whenever you are not doing well.Another possible mechanism for the emergence and stability of cooperation is spatial reciprocity. Players occupy cells on spatial grids and interact with their nearest neighbors. Simple rules of these spatial games can lead to enormously complex behaviors. Cooperators and defectors can coexist indefinitely in ever-changing chaotic patterns in time and space.Finally, we present a theoretical framework developed more recently than the other two, one that is based on indirect reciprocity and does not require the same two individuals ever to meet again. Natural selection can favor cooperative strategies directed toward recipients that have helped others in the past. Cooperation pays because it confers the reputation on the player of being a valuable community member. We discuss computer simulations and models to specify the conditions for the evolutionary stability of indirect reciprocity. In particular, we show that the probability of knowing the reputation of the recipient must exceed the cost-to-benefit ratio of the altruistic act.
Journal: Financial Analysts Journal
Pages: 13-22
Issue: 4
Volume: 56
Year: 2000
Month: 7
X-DOI: 10.2469/faj.v56.n4.2370
File-URL: http://hdl.handle.net/10.2469/faj.v56.n4.2370
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:4:p:13-22




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# input file: UFAJ_A_12047231_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Louis K.C. Chan
Author-X-Name-First: Louis K.C.
Author-X-Name-Last: Chan
Author-Name: Jason Karceski
Author-X-Name-First: Jason
Author-X-Name-Last: Karceski
Author-Name: Josef Lakonishok
Author-X-Name-First: Josef
Author-X-Name-Last: Lakonishok
Title: New Paradigm or Same Old Hype in Equity Investing?
Abstract: 
 The recent relative stock-price performance of six U.S. equity asset classes (classified by size and by value-versus-growth style) differs markedly from the historical pattern. Large-capitalization growth stocks have apparently taken the place of small-capitalization and value stocks in investors' hearts. Have the size and value premiums of the past vanished for good? We explore three explanations of recent market behavior—the “rational-asset-pricing” hypothesis, the “new-paradigm” viewpoint, and the “behavioral” or “institutional” explanation. In our study, we examined the operating performance of the equity classes to see which hypothesis accounts for the recent behavior of returns. Our findings provide the most support for the behavioral explanation. The recent relative stock-price performance of equity asset classes based on size and value-versus-growth orientation differs markedly from the historical pattern. On the one hand, large-capitalization growth stocks earned dramatically higher returns than the other equity classes in the 1996–99 period, and at the time this article was written, the relative valuations of the large-cap growth group of companies stood at record levels. On the other hand, the recent disappointing performance of small-cap and value stocks has left scars on many active money managers. Value-oriented money managers are coming under pressure to become more growth oriented, and some plan sponsors have simply given up on active managers and shifted to indexing.Have the apparent size and value premiums vanished for good? Whether the recent experience represents a long-lasting shift in relative equity valuations or a string of unexpected temporary shocks has important implications for portfolio allocation decisions. This article explores three explanations for the recent relative performance of the six size and value-versus-growth equity classes—the “rational-asset-pricing” hypothesis, the “new-paradigm” viewpoint, and the “behavioral” or “institutional” explanation. To see which, if any, of these explanations can account for the recent behavior of returns, we examined the stock-price returns and operating performance of the different classes for 1970 through 1999.We found that, contrary to the rational-asset-pricing hypothesis, the recent large gains in the stock prices of large-cap growth stocks cannot have been triggered by their operating performance as measured by variables that included sales growth and growth in earnings. For example, over the 1996–98 period, a portfolio of large-cap growth stocks grew in sales by an average of 6 percent a year, whereas the mean for the 1970–98 period was 10.3 percent a year. Stock returns for this equity class over the 1996–98 period averaged 34 percent a year, whereas they averaged 11.6 percent for 1970–1998. We also found that the disappointing returns on small-cap and value stocks are not likely to be the result of poor operating performance on their part.Our conclusions are based on recent experience versus long-run patterns. Of course, future patterns of growth in profitability may be radically different from the past, but justification of today's valuations of large-cap growth stocks requires heroic assumptions about the sustainability of high growth and superior operating performance by this group of companies. Thus, the most likely explanation for the recent behavior of the relative prices of U.S. equity classes is a behavioral or institutional one.
Journal: Financial Analysts Journal
Pages: 23-36
Issue: 4
Volume: 56
Year: 2000
Month: 7
X-DOI: 10.2469/faj.v56.n4.2371
File-URL: http://hdl.handle.net/10.2469/faj.v56.n4.2371
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:4:p:23-36




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# input file: UFAJ_A_12047232_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Edward S. O'Neal
Author-X-Name-First: Edward S.
Author-X-Name-Last: O'Neal
Title: Industry Momentum and Sector Mutual Funds
Abstract: 
 Recent academic research has ascribed the intermediate-term (3-month to 12-month) momentum present in U.S. stock returns to an industry effect. In the intermediate term, strong (weak) industry performance is followed by continued strong (weak) industry performance. The industry-specific aspect of momentum gives rise to profitable trading strategies that use industry-sector mutual funds. In this study, strategies of buying previous intermediate-term top-performing sector funds outstripped the S&P 500 Index over the 10-year period from May 1989 through April 1999 on a total-return basis. These strategies entailed greater total and systematic risk, however, than the index. U.S. stock returns exhibit momentum over 3-month to 12-month time frames. This tendency for intermediate-term performance to persist has recently been ascribed in the academic literature to an industry effect: Well-performing industries continue to outperform while poor-performing industries continue to lag.Can practitioners exploit this industry momentum? The jump from identification of patterns in stock market returns to strategically capitalizing on the patterns is difficult in many cases. Academic studies often rely on the formation of hedge portfolios that require extensive short selling, a strategy that some practitioners may be hesitant to use. In addition, such studies often use the entire universe of stocks, whereas practitioners are limited (because of the sheer size of the universe) to a subset of all traded stocks. Finally, the market-impact costs caused by trading large numbers of stocks are often difficult to measure. For practitioners, therefore, an industry momentum strategy that uses industry-sector mutual funds has two advantages: It minimizes the number of securities that must be followed, and the trading costs are known. It also has two disadvantages: Sector funds are actively managed (and thus do not represent a passive or pure play on an industry) and sector funds charge significant annual fees. To determine whether the advantages outweigh the disadvantages, I examined the success of various portfolio strategies designed to use sector funds to exploit industry momentum.The methodology entailed a rolling procedure of forming portfolios of sector funds over a series of lag and hold periods. I used 10 years worth of historical data covering the period May 1989 through April 1999. The portfolios were formed on the basis of the returns in a lag period of 3, 6, or 12 months. These portfolios were then assumed to be bought and held over a subsequent holding period of 3, 6, or 12 months. At the end of the holding period, the portfolios were sold and new portfolios were formed on the basis of the most recent lag period. I calculated annualized returns and risk measures for the portfolios.Over the 10-year period, industry momentum was strong in sector mutual funds. Depending on the length of the holding period, portfolios of previous top-performing sector funds outperformed previous bottom performers by as much as 14 percentage points a year on average. Industry momentum appears to have been strongest for holding periods of 12 months but was also evident for 3- and 6-month holding periods. Of potentially greatest interest to practitioners is the performance of the strategies that bought previous top performers when compared with the performance of relevant market indexes: Ten out of twelve strategies with holding periods of 12 months outperformed the S&P 500 Index over the sample period, and the strategies performed even better against benchmarks from the mutual fund universe.The sector mutual fund strategies entailed greater total risk, however, than the market indexes used in the study. Sharpe ratio comparisons indicate that the sector fund portfolios failed to outperform the S&P 500 after compensating for total risk as quantified by standard deviation. The sector fund strategies also led to higher systematic risk, but the returns to the strategies completely compensated for the additional systematic risk.Finally, I found industry momentum to be significantly related to economywide default risk premiums. Industry momentum was strongest in an environment of declining default risk, which suggests that the market views top-performing industries as relatively risky investments that benefit when default risk premiums decline.
Journal: Financial Analysts Journal
Pages: 37-49
Issue: 4
Volume: 56
Year: 2000
Month: 7
X-DOI: 10.2469/faj.v56.n4.2372
File-URL: http://hdl.handle.net/10.2469/faj.v56.n4.2372
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# input file: UFAJ_A_12047233_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Duen-Li Kao
Author-X-Name-First: Duen-Li
Author-X-Name-Last: Kao
Title: Estimating and Pricing Credit Risk: An Overview
Abstract: 
 In the past five years, many sophisticated models for pricing credit risk have been developed. The rapid progress in this area is primarily a result of the growth of credit derivatives, securitized asset pools, and other structured products. Factors such as regulatory concerns and the availability of empirical data on default, rating changes, and asset recovery have also sparked interest in credit-risk-pricing models. This article reviews the development of modeling and pricing credit risk during the last three decades. It starts with a discussion of the statistical properties of credit spread behavior over time. It then reviews various quantitative models for assessing a company's creditworthiness and default probabilities. Next, it focuses on the ultimate objective of credit-risk assessment—how credit risk should be priced. First, the basic building blocks of a credit-risk-valuation model—interest rates, default/rating migration, and recovery rates—are discussed. Then, based on these building blocks, the article compares two primary credit-risk-pricing approaches—the structural (firm-value) and the reduced-form models—and reviews several other simple but popular pricing approaches. The article concludes with a brief discussion of credit-risk-pricing applications and possible future research directions. Traditionally, fundamental credit research is the main method practitioners have used to assess a company's credit risk. The pricing of credit risk, however, has been somewhat disconnected from such practitioner credit research; instead, it has relied mostly on trending relationships or anecdotal evidence about credit spreads. Estimating and pricing credit risk via quantitative methods has been largely ignored. In the past five years, however, U.S. market participants have witnessed several credit/liquidity crises, the rapid development of credit derivatives and securitized assets, the increasing availability of credit data, and increasing regulatory scrutiny. Against this backdrop, investors and academic researchers have shown a renewed interest in credit-risk pricing and have developed several sophisticated quantitative models.To construct a sensible and practical credit-risk-pricing model, one must understand the properties of credit-risk behavior over time. I examine several significant factors underlying changes in credit spread properties: the level and slope of the U.S. Treasury yield curve, interest rate option volatility, LIBOR, swap spreads, equity returns, and equity return volatility. Multivariate relationships seem to describe the dynamic nature of credit-risk changes better than a single factor.Quantitative credit-risk models are often used to estimate a company's statistical likelihood of bankruptcy or financial distress over time. These models use various statistical techniques, such as multiple discriminant analysis, survival analysis, neural networks, and recursive partitioning. Input variables are normally derived from balance sheets, income statements, equity information, and macroeconomic data. Quantitative credit-risk models as complements to traditional fundamental credit research have been empirically proven to effectively assess a company's creditworthiness in the United States and abroad.Recently developed credit-risk-pricing methodologies can be categorized as “structural” or “reduced form.” In the structural (or firm-value) approach, debt is treated as a contingent claim on firm value. Default risk estimation and credit pricing rely on examining the relationship between firm value and debt value over time. The reduced-form approach bypasses company valuation and extracts the value of credit risk directly from market information (e.g., credit spreads and rating transitions). For each approach, the models can be compared on the basis of each of the following three modeling components: interest rate process, default process, and asset-recovery process. Variations of the models can be viewed according to how the default risk is determined, how default intensity and the recovery rate are defined, how the pricing process is presented, and how the elements of the process are implemented.Following the model descriptions, I review the relevant published empirical results and provide comments about the strengths and weaknesses of the model variations. In addition, I briefly discuss other approaches popular with practitioners.I conclude that the recently developed credit-risk-pricing models still find their primary applications in valuing credit derivatives; they remain theoretical as far as other applications are concerned. To extend these modeling approaches to pricing a broader array of instruments, as well as to gain wider acceptance of the models by practitioners, more empirical studies are needed. Increased empirical research would require a database, however, with detailed and frequently updated information about individual corporate issues and the issuers' capital structures, which is not easily obtainable. Moreover, a credit-risk-pricing model that would provide practitioners with an intuitively appealing solution would have to link the basic characteristics of an issuer and debenture to the model's parameters.
Journal: Financial Analysts Journal
Pages: 50-66
Issue: 4
Volume: 56
Year: 2000
Month: 7
X-DOI: 10.2469/faj.v56.n4.2373
File-URL: http://hdl.handle.net/10.2469/faj.v56.n4.2373
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# input file: UFAJ_A_12047234_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Lea V. Carty
Author-X-Name-First: Lea V.
Author-X-Name-Last: Carty
Title: Corporate Credit-Risk Dynamics
Abstract: 
 The lack of widely available and comprehensive data of default activity on the corporate level has encouraged the advance of theories of corporate credit risk far beyond related empirical work. This article addresses this deficit by examining a unique data set—corporate bond defaults and credit ratings compiled by Moody's Investors Service since 1920. The article investigates the time inhomogeneity of company default risk—that is, the pattern in which the risk of default for a company changes over time. The empirical analysis addresses company default risk within a regression framework of competing risks, or hazards. The analysis identifies (and quantifies) variations in default risk with macroeconomic conditions, with industries, and through time—an important characterization for many approaches to measuring and managing credit risk. The characterization, measurement, and management of credit risk are of increasing interest to academics, policy makers, and practitioners. After having focused resources on interest rate, exchange rate, and other financial risks, market participants and academicians alike have turned their attention to the treatment of credit risk. Critical to measuring and managing credit risk is a thorough understanding of credit-risk dynamics.In the absence of widely available and comprehensive databases of corporate bond prices and defaults, theoretical research into credit risk has progressed much more rapidly than empirical research. Existing models generate a diversity of term structures for credit risk—term structures that are in some cases dependent on macroeconomic variables—and these term structures imply a variety of patterns in the default dynamics of the underlying debtors. This article reports empirical research into historical credit-risk patterns.The unit of research in previous studies was either the individual bond or its par value. The unit of research in this article is the issuing company. The data came from Moody's Investors Service's unique data on corporate bond-rating histories and defaults during the 77-year period from 1920 through 1996. I used these data to estimate a model capable of incorporating the effects of changing business conditions and capable of generating a variety of patterns for company credit-risk dynamics.The hazard regression model used was flexible enough to incorporate the salient features of default data. It allowed for companies to exit the market without defaulting and for companies not to have exited the market at all as of the 1996 compilation date of the research database.The model revealed significant dependence of default risk on several macroeconomic variables. The effects of the macroeconomic variables have important consequences for the development of methods for both the measurement and management of credit risk. In addition, the model found that when macroeconomic effects were controlled for, default risk exhibited significant time inhomogeneity. That is, for U.S. nonfinancial corporations entering the public debt market for the first time with the Baa, Ba, and B ratings in the period studied, and conditional on prevailing business conditions, the risk of default had a hump-shaped pattern: It initially increased with time to some point, after which it decreased. In a hypothetical situation of constant business conditions (GDP growth, real and nominal interest rates, and expected future profits), the model predicted that the risk of default for newly issuing B rated manufacturing companies is initially about 3 percent a year. For nondefaulting companies, that risk climbs to about 8 percent a year within six years but after about 22 years, falls back down to nearly zero.
Journal: Financial Analysts Journal
Pages: 67-81
Issue: 4
Volume: 56
Year: 2000
Month: 7
X-DOI: 10.2469/faj.v56.n4.2374
File-URL: http://hdl.handle.net/10.2469/faj.v56.n4.2374
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:4:p:67-81




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# input file: UFAJ_A_12047235_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Sankarshan Acharya
Author-X-Name-First: Sankarshan
Author-X-Name-Last: Acharya
Title: A New Method for Credit-Enhancement Standards
Abstract: 
 A new approach, based on corporate bond default data, is proposed to determine the quantity of new equity capital a bond issuer must consistently raise (or the amount of current debt it must retire) to enhance its bond ratings. The current approach of the rating industry to determine such standards for upgrading bond ratings assumes that the probability of bond default by the issuer is unaffected by the new equity capital or retiring of debt. The specification in the new approach relaxes this assumption. The estimates show dramatically different standards for bond-rating upgrades between the approach suggested here and the standard industry approach. Presented is a new approach for determining the quantity of new equity capital any bond issuer needs to add (or the amount of current debt it must retire) to enhance its bond rating. Because expected losses on bonds depend on the value of the borrower's future assets, this method specifies a distribution for the random future value of assets. Consistent with a large body of finance literature and practical applications, the assumption is that the future payoff to assets backing bonds (return per dollar of current asset value) in each rating category is distributed lognormally. Thus, the random (continuously compounded) rate of return on investment in assets of an entity has a normal distribution. Different return distributions for assets backing differently rated bonds make default probabilities and expected bond loss rates specific to each rating category.In the first step of the new procedure, the observed means and variances of losses on bonds in each Moody's Investors Service rating category are used to estimate the parameters of the lognormal distributions. The theoretical mean and variance of losses are then equated to the estimated mean and variance of losses to solve for the two parameters of the asset value distribution for each rating category. The parameter estimates identify the underlying asset-value distribution for each rating category. In the second step, these identified distributions are used to solve for the amount of equity capital infusion needed to reduce the current expected loss on bonds of an issuer to the expected loss for higher rated bonds.Next is a new calculation of the equity capital infusions needed for enhancing ratings of bonds aged three, four, and five years as reckoned from the date of issuance. The capital infusion estimates obtained from this new approach are much smaller than those obtained by the standard approach used by rating agencies. For example, the new approach finds that to enhance bond rating Baa to bond rating Aaa, the issuer must raise new equity capital equal to 3.02 percent of its current assets; in the standard industry approach, the new capital must be 55.71 percent of current assets. The main reason is that the new approach, unlike the standard industry approach, accounts for the fact that the default probability decreases because of the equity capital infusion.This methodology can help the rating industry revise its bond rating standards. It can also be applied to set bank capital standards. Bank regulators have recently expressed a serious interest in enforcing such standards by requiring banks to have their assets rated by public rating agencies.
Journal: Financial Analysts Journal
Pages: 82-89
Issue: 4
Volume: 56
Year: 2000
Month: 7
X-DOI: 10.2469/faj.v56.n4.2375
File-URL: http://hdl.handle.net/10.2469/faj.v56.n4.2375
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# input file: UFAJ_A_12047236_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Capital Ideas and Market Realities: Option Replication, Investor Behavior, and Stock Market Crashes (a review)
Abstract: 
 This historical case study is intended to warn investors about new market-destabilizing option strategies.
Journal: Financial Analysts Journal
Pages: 90-91
Issue: 4
Volume: 56
Year: 2000
Month: 7
X-DOI: 10.2469/faj.v56.n4.2376
File-URL: http://hdl.handle.net/10.2469/faj.v56.n4.2376
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:4:p:90-91




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# input file: UFAJ_A_12047237_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Dodging Bullets: Changing U.S. Capital Structure in the 1980s and 1990s (a review)
Abstract: 
 This book explores the economically important deleveraging that followed the aggressive leveraging of U.S. corporations in the 1980s. 
Journal: Financial Analysts Journal
Pages: 91-92
Issue: 4
Volume: 56
Year: 2000
Month: 7
X-DOI: 10.2469/faj.v56.n4.2377
File-URL: http://hdl.handle.net/10.2469/faj.v56.n4.2377
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# input file: UFAJ_A_12047238_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard Bookstaber
Author-X-Name-First: Richard
Author-X-Name-Last: Bookstaber
Title: Understanding and Monitoring the Liquidity Crisis Cycle
Abstract: 
 Commonly used tools are limited for assessing the risk of a liquidity crisis; an alternative considers hedge fund risk, leverage, and effective liquidity. A market crisis is not simply a “bad draw” from the distribution of day-to-day price moves. The genesis and dynamics of market crises have little to do with the information and the market flows that affect prices on typical days. A market crisis is a crisis of liquidity far more than it is a crisis born of surprising information.The characteristics that lead to potential crises do not rest entirely with the ability of a fund to take open-ended leverage or with its ability to take large risks or invest in illiquid markets. If a fund is highly levered but is in instruments that have low risk and high liquidity, the fund not only poses little risk to the market, it poses little risk to its investors. If it is in risky instruments but is unlevered, the fund's failure may be unfortunate for the investors but it does not have systemic implications. If the fund is in very illiquid instruments but not levered and has stability of capital, it is no more of a concern than an insurance company that holds real estate in its portfolio.What matters is the cycle that begins with the confluence of risk, leverage, and illiquidity—risk of loss coupled with leveraged positions, resulting in a need to liquidate into a market that cascades downward in price because of the rise in liquidation orders and the reduction in liquidity providers. The first stage in a liquidity crisis cycle is a loss that acts as the triggering event. The second is a need to liquidate positions to meet creditors' margin requirements. The third is a further drop in the fund's asset value as the market reacts to the fund's attempts to sell in too great a quantity or too quickly for market liquidity to bear. The drop in prices caused by the need to liquidate precipitates a further decline in the fund's mark-to-market value and leads, in turn, to yet further liquidation for margin or redemption purposes.This article provides a qualitative description of these stages of a crisis and discusses the limitations of transparency and common risk measures—such as value at risk—for yielding insights into the crisis. For example, VAR is of limited value in assessing the risk of market crises because during a crisis, correlations between assets can change dramatically and unexpectedly, with the result that positions that were thought to be diversifying—or even hedging—end up compounding risk.I propose a simple ratio to test for vulnerability to a liquidity crisis: the ratio of risk to capital divided by the standard deviation of that ratio. The numerator measures the likelihood that a change in asset prices will require a liquidation of a fund's position. The denominator indicates how easily the market can absorb any liquidation and measures the ability and willingness of the fund managers to change its exposure. A high ratio suggests a high risk of crisis.The role of liquidity in market crises has not been widely studied. One reason is that the role is difficult to investigate empirically. Market and economic information is widely available, but liquidity demand and supply are not observable. The role of liquidity in market crises is also difficult to model analytically because it is fraught with the complexities inherent in any dynamic process. In addition, market behavior during a liquidity-based crisis can seem at odds with economic rationality; rather than being based on market information or economic relationships, price behavior during a liquidity crisis depends on who holds what and who must liquidate. Thus, the market dislocations of a liquidity-based crisis are not only unpredictable; they are not even drawn from a stable distribution. The distribution will change every time a fund changes its positions or leverage.
Journal: Financial Analysts Journal
Pages: 17-22
Issue: 5
Volume: 56
Year: 2000
Month: 9
X-DOI: 10.2469/faj.v56.n5.2385
File-URL: http://hdl.handle.net/10.2469/faj.v56.n5.2385
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# input file: UFAJ_A_12047239_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Tarun Chordia
Author-X-Name-First: Tarun
Author-X-Name-Last: Chordia
Author-Name: Richard Roll
Author-X-Name-First: Richard
Author-X-Name-Last: Roll
Author-Name: Avanidhar Subrahmanyam
Author-X-Name-First: Avanidhar
Author-X-Name-Last: Subrahmanyam
Title: Co-Movements in Bid-Ask Spreads and Market Depth
Abstract: 
 Quoted spreads, quoted depth, and effective spreads move together with market- and industrywide liquidity. After controlling for well-known individual liquidity determinants, such as volatility, volume, and price, we found that common influences remain significant and material. For well-diversified size-based portfolios, more than half the variation in quoted spreads is explained by variations in market average trading costs. Daily movements in the average depth of the market explain more than 80 percent of depth variations in size-based portfolios. When portfolios are turned over frequently, transaction expenses can accumulate to a relatively large decrement in total return. Because money managers often trade several securities simultaneously, knowing whether trading costs are correlated across securities is important to them. Yet, research on trading costs has focused almost exclusively on individual securities. Typically, portfolio managers do not think of illiquidity in a marketwide context, and the classic models of market microstructure involve a dealer in a single stock who provides immediacy at a cost that arises from inventory-holding risk or from the specter of trading with an investor with superior information. Empirical work also deals solely with the trading patterns of individual assets, most often equities sampled at high frequencies.Trading costs can, however, be correlated across securities for a variety of reasons. For example, if trading volume exhibits correlated changes in response to broad market movements, this pattern should induce a correlation in liquidity costs. Similarly, variations in the cost of holding inventory could be correlated across securities because it depends, in part, on movements in market interest rates. Also, the imminent revelation of various types of information that is pertinent for most companies in an industry sector could influence the liquidity of several securities simultaneously. In fact, sudden changes in systemwide liquidity appear to have been important in some well-known financial episodes. The international stock market crash of October 1987, for example, was associated with no identifiable major news event but was characterized by a temporary reduction in liquidity. And during the summer of 1998, a liquidity crisis appears to have simultaneously affected several mid- to low-grade bonds. This crisis, in turn, seems to have precipitated financial distress in certain highly levered trading firms.We used transaction data on NYSE stocks to analyze the extent of variation and covariation in trading costs. We found that trading costs—represented by quoted spreads, quoted depth, and effective spreads-exhibit significant intertemporal variation. Depth exhibits much more intertemporal variation than bid-ask spreads. Trading costs also move together with market- and industrywide liquidity. Specifically, after controlling for well-known cross-sectional liquidity determinants (such as volatility, volume, and price), we found that the influence of industry average liquidity remains significant and material. In addition, for well-diversified size-based portfolios, more than half the time-series variation in quoted spreads was explained by variations in market average trading costs. Daily movements in the average depth of the market explained more than 80 percent of depth variations in size-based portfolios. Overall, the results indicate that simultaneous trades of several securities are likely to incur correlated trading costs. Furthermore, the trading costs incurred by broadly diversified portfolio managers are likely to move together significantly through time.The results also suggest that the risks of unexpected changes in average liquidity contain a strong market component. Co-movements in liquidity suggest that transaction expenses might be better managed with appropriate timing. Thus, our results indicate that a strategy of trading when average portfolio spreads are low can allow for increased portfolio turnover without compromising portfolio return performance.
Journal: Financial Analysts Journal
Pages: 23-27
Issue: 5
Volume: 56
Year: 2000
Month: 9
X-DOI: 10.2469/faj.v56.n5.2386
File-URL: http://hdl.handle.net/10.2469/faj.v56.n5.2386
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# input file: UFAJ_A_12047240_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jin-Wan Cho
Author-X-Name-First: Jin-Wan
Author-X-Name-Last: Cho
Author-Name: Edward Nelling
Author-X-Name-First: Edward
Author-X-Name-Last: Nelling
Title: The Probability of Limit-Order Execution
Abstract: 
 Market orders and limit orders are the two main types of orders investors use to buy or sell U.S. equities. In choosing between the types, investors must weigh the price improvement associated with a limit order against the probability that the order will not be executed. In the study reported here, we examined the probability of limit-order execution and the expected benefit to limit orders for a sample of stocks traded on the NYSE. Results indicate that the longer a limit order is outstanding, the less likely it is to be executed. The probability of execution is higher for sell orders than for buy orders, lower when the limit price is farther away from the prevailing quote, lower for large trades, higher when spreads are wide, and higher in periods of high price volatility. Order-placement strategy and trade execution are important issues in equity investing. The two main types of orders that investors use to buy or sell U.S. equities are market orders and limit orders. Effective trading with limit orders requires the investor to judge the costs and benefits of using limit orders versus market orders. The goal of our research was to estimate the benefit associated with limit orders-a benefit that may be offset by the opportunity cost of immediacy provided by market orders and the probability that the limit order will not be executed. This assessment of execution probability is likely to be influenced by a number of factors in the market, including the desired price, the prices at which other investors are willing to buy or sell the security, and the size of the intended trade.We used the TORQ (trades, orders, revisions, and quotes) data for NYSE securities to address execution probability. These data contain detailed order, transaction, and quote information on 144 NYSE stocks for the period November 1990 through January 1991. Because of the large number of observations, we randomly selected 10 stocks to study. We examined the waiting time until order execution by using duration analysis, a statistical technique that is appropriate when examining the passage of time until an event occurs.We found that the longer a limit order is outstanding, the less likely it is to be executed. The probability of execution is higher for sell orders than for buy orders, lower when the limit price is farther away from the prevailing quote, lower for large trades, higher when spreads are wide, and higher in periods of great price volatility. We also found that the average expected price improvement from a limit order over a market order is greater at the beginning of the trading day, in periods of high price volatility, in the presence of wide bid–ask spreads, and for large orders.Our results suggest that investors seeking the best possible order-placement approach should carefully consider the probability of limit-order execution. More formal attempts to quantify this probability might be useful, especially for large orders. Investors might also wish to attempt to quantify the opportunity costs of immediate trade execution, which they forgo when they place a limit order instead of a market order.
Journal: Financial Analysts Journal
Pages: 28-33
Issue: 5
Volume: 56
Year: 2000
Month: 9
X-DOI: 10.2469/faj.v56.n5.2387
File-URL: http://hdl.handle.net/10.2469/faj.v56.n5.2387
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# input file: UFAJ_A_12047241_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Sean P. Baca
Author-X-Name-First: Sean P.
Author-X-Name-Last: Baca
Author-Name: Brian L. Garbe
Author-X-Name-First: Brian L.
Author-X-Name-Last: Garbe
Author-Name: Richard A. Weiss
Author-X-Name-First: Richard A.
Author-X-Name-Last: Weiss
Title: The Rise of Sector Effects in Major Equity Markets
Abstract: 
 Historically, country effects have been dominant in explaining variations in global stock returns, even in the developed markets, and investors have segmented their allocations accordingly. We set out to investigate whether this situation still prevails. We found a significant shift in the relative importance of national and economic influences in the stock returns of the world's largest equity markets. In these markets, the impact of industrial sector effects is now roughly equal to that of country effects. In addition to supporting the notion of increasing global capital market integration, these findings suggest that country-based approaches to global investment management may be losing their effectiveness. The degree to which global economies and capital markets are integrated plays a critical role in the relative importance of country and sector factors in global stock returns. Higher levels of integration blur national borders and diminish the significance of country factors vis-a-vis sectors. The historical dominance of country effects in explaining variations in global stock returns suggests that global capital markets have been relatively segmented. Accordingly, country-oriented strategies have been the most common approach to global equity management. Our research found evidence that country effects no longer dominate sector effects to the extent they have historically.We studied 10 sector indexes within each of the seven largest global equity markets over a 20-year period. Using weighted least-squares regression, we decomposed the indexes for each country and sector into their respective global, country, and sector return components. The estimated coefficients from these regressions represent the “pure” return elements of each type of component. We examined the amount of variation explained by the time series of estimated country coefficients and sector coefficients to determine their relative importance.Through the early 1990s, pure country returns exhibited roughly two to three times the variation of pure sector returns. The differential has narrowed dramatically, however, in the last several years. Since mid-1995, the ratio of average country coefficient variance to average sector coefficient variance has dropped from 3.10 to 1.23. The pronounced gap that existed earlier has been virtually eliminated.For the most recent four-year period, the average pure country variance for the seven markets studied was 12.02 percent and the average pure sector variance was 9.76 percent, but the difference was not statistically significant even at a 50 percent confidence level. In other words, over the most recent four years, the importance of industrial sector classification has been roughly equal to that of country of domicile in the major equity markets.We address the issue raised in previous studies that sector effects account for much less of the variation in country indexes than country effects do in sector indexes. We “reconstructed” the global country and sector indexes using the output from our weighted regression analysis. In contrast to the findings of previous studies, we found that neither of these cross-effects contributes meaningfully to global country or sector return variation.Our findings indicate that over the past 20 years, the influence of country-based components on return variation has declined while the impact of sector-based components has either increased or remained relatively constant.We discuss several factors that may explain the difference between our conclusions and those of previous studies. These factors include the time period studied, the specific countries included, the breadth of the industrial classification scheme, and the treatment of currencies. Studies that draw inferences from longer historical time periods than ours did or include less-developed markets will tend to find that country effects are more important than our study found. The use of broad industrial classifications, as in our study, may understate sector variation.This study suggests that the world's major equity markets may be more integrated than was previously believed. For those practitioners whose current global strategies assume that national equity markets remain significantly segmented, these results represent both an admonition and an opportunity.
Journal: Financial Analysts Journal
Pages: 34-40
Issue: 5
Volume: 56
Year: 2000
Month: 9
X-DOI: 10.2469/faj.v56.n5.2388
File-URL: http://hdl.handle.net/10.2469/faj.v56.n5.2388
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# input file: UFAJ_A_12047242_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Stefano Cavaglia
Author-X-Name-First: Stefano
Author-X-Name-Last: Cavaglia
Author-Name: Christopher Brightman
Author-X-Name-First: Christopher
Author-X-Name-Last: Brightman
Author-Name: Michael Aked
Author-X-Name-First: Michael
Author-X-Name-Last: Aked
Title: The Increasing Importance of Industry Factors
Abstract: 
 Previous studies of the relative importance of industry and country factors in determining equity returns generally concluded that country factors dominate industry factors. We present evidence that industry factors have been growing in relative importance and may now dominate country factors. Furthermore, our evidence suggests that over the past five years, diversification across global industries has provided greater risk reduction than diversification by countries. These findings suggest that industry allocation is an increasingly important consideration for active managers of global equity portfolios and that investors may wish to reconsider home-biased equity allocation policies. Accelerating globalization of business enterprise and integration of capital markets are altering the equity investment environment. We consider whether these global changes have affected the relative importance of industry and country factors to equity returns. We present new evidence demonstrating a marked structural change in the factors determining global equity returns during recent years. We show that industry factors have been growing in relative importance and may now even dominate country factors. Thus, in the future, investors may increasingly perceive an integrated global equity market rather than a collection of separate country markets.We review the growing literature aimed at measuring the importance of industry and country factors. On balance, the studies suggest that industry factors have been relatively less important than country factors. These conclusions are sensitive, however, to the model estimated, the countries considered, the industry definitions used, and the time period analyzed.We present a factor model of global equity returns. The data cover 21 countries that constitute the MSCI World Developed Markets universe and, to measure the performance of portfolios of securities belonging to the same industry within a country, 36 industry-level national total return indexes of the FT/S&P Actuaries World Index. We fit a multiple-factor model to these data to estimate the return contribution emanating from exposure to either pure country factors or pure global industry factors for the period 1986 through 1999.We used the mean factor-return estimates from this model to measure the opportunities for outperforming the world index with systematic industry- or country-based tilts. We found that since early 1997, the return opportunities from industry tilts have dominated those emanating from country tilts.We also used the factor model estimates to draw inferences about the relative merits of international strategies involving diversification by industry and/or by country. For the most recent decade, we found a rising correlation of country factor returns, which suggests diminishing gains from diversifying by country. Conversely, industry factor correlations were relatively stable over the decade. By 1999, when we used the most recent 52-week window of data, the capitalization-weighted correlation of industry factor returns equaled that of countries. Our factor model estimates suggest that the gains from diversifying by industry are now larger than the gains from diversifying by country. Clearly, however, diversifying by both factors is optimal.The increasing importance of industry factors as a determinant of global equity portfolio risk and return has several investment implications. First, unintended industry exposures that result from using equity benchmarks biased toward the home market may result in increasingly inefficient global asset allocations. Second, active global equity investment managers will increasingly need to balance the return-to-risk trade-offs of global industry allocations as well as of country allocations. Finally, stock selection opportunities may increasingly be found in comparisons of stocks among countries but within common global industries.
Journal: Financial Analysts Journal
Pages: 41-54
Issue: 5
Volume: 56
Year: 2000
Month: 9
X-DOI: 10.2469/faj.v56.n5.2389
File-URL: http://hdl.handle.net/10.2469/faj.v56.n5.2389
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# input file: UFAJ_A_12047243_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Björn Hansson
Author-X-Name-First: Björn
Author-X-Name-Last: Hansson
Author-Name: Mattias Persson
Author-X-Name-First: Mattias
Author-X-Name-Last: Persson
Title: Time Diversification and Estimation Risk
Abstract: 
 The recommendation that investors with long investment horizons tilt their portfolios toward stocks is commonplace. We used a nonparametric bootstrap approach to investigate whether in a mean-variance-efficient portfolio, the weights for U.S. stocks and U.S. T-bills vary in a systematic manner with investment horizon. This approach allowed us to analyze the impact of estimation risk on the optimal weights of stocks and fixed-income securities. The results show that an investor can gain from time diversification: The weights for stocks in an efficient portfolio were significantly larger for long investment horizons than a one-year horizon. Practitioners commonly recommend that investors with long investment horizons tilt their portfolios toward stocks and away from fixed-income securities. This behavior is an important example of putting into practice the concept of time diversification, which implies that a systematic relationship exists between the portfolio weights for a particular asset class and investment horizon.We analyzed whether mean-variance-efficient portfolio weights for stocks and bills vary significantly with the investment horizon for a buy-and-hold strategy. In this analysis, we kept the risk price, the slope of the efficient frontier, constant while varying the investment horizon from 1 year to 5 years to 10 years. The data were real U.S. return data from 1900 to 1997 for a well-diversified stock portfolio and a short-term, nominally risk-free rate.We presupposed that investors form optimal investment strategies based only on historical estimates of the following parameters or inputs to the optimization problem—means, variances, and covariances. The model we used is an unconditional model in the sense that agents do not explicitly try to model any possible time-series relationships among the assets. We implicitly accounted for any possible time dependencies in the observed return-generating processes, however, by resampling a great number of return series from the original data through the use of a computer-intensive method called “bootstrapping.” In particular, we used a nonparametric moving block bootstrap with a block length of 60 months in which serial dependence and cross-sectional correlation were preserved within the blocks. The real bonus of the bootstrap approach is the possibility of generating empirical distributions of optimal weights. Thus, we could not only analyze the existence of time diversification but could also test whether time diversification is significant in a statistical sense (i.e., if significant statistical differences exist between the optimal weights for different investment horizons).With the bootstrap approach, we could also study the impact of estimation risk (meaning that the true parameters of the return distributions are unknown) on the optimal weights of stocks and bills. In a mean-variance context, estimation risk implies that the inputs to the mean-variance model are only sample estimates, not the true parameters.The results show that estimation errors increase with the risk price and with the investment horizon. The first effect is a result of error maximization, which implies that the optimization framework chooses assets with overestimated expected returns and underestimated risks. The second effect is partly a result of fewer nonoverlapping observations existing at longer investment horizons than at shorter horizons.We provide strong evidence that for all risk prices, the weights of stock in an efficient portfolio are significantly larger for the longer horizons. A tentative explanation is that for certain investment horizons, the return-generating process for stocks is mean reverting and/or the process for bills is positively autocorrelated. Because the return spread between stocks and bills is almost constant over the investment horizons, the change in portfolio weights might stem from the fact that with longer investment horizons, the standard deviation for stocks falls whereas the standard deviation for bills increases.Our evidence supports the existence of time diversification: The weights for stock in efficient portfolios are significantly higher for long investment horizons than for a one-year horizon.
Journal: Financial Analysts Journal
Pages: 55-62
Issue: 5
Volume: 56
Year: 2000
Month: 9
X-DOI: 10.2469/faj.v56.n5.2390
File-URL: http://hdl.handle.net/10.2469/faj.v56.n5.2390
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Author-Name: Arun S. Muralidhar
Author-X-Name-First: Arun S.
Author-X-Name-Last: Muralidhar
Title: Risk-Adjusted Performance: The Correlation Correction
Abstract: 
 Current measures of risk-adjusted performance, such as the Sharpe ratio, the information ratio, and the M-2 measure, are insufficient for making decisions on how to rank mutual funds or structure portfolios. This article proposes a new measure, called the M-3, that accounts for differences in (1) standard deviations between a portfolio and a benchmark and (2) the correlations of mutual fund portfolios and their benchmarks for an investor's relative-risk target. This technique facilitates portfolio construction to optimally achieve investors' objectives by combining the risk-free asset, the benchmark, and mutual funds. A form of three-fund separation, this paradigm provides optimal mixes of active and passive management based on the ability of fund managers rather than on individual biases about market inefficiency. This article provides support for the claim that leverage may not be bad if it is used to structure portfolios to achieve the highest risk-adjusted performance. The mutual fund industry has experienced spectacular growth in assets and number of funds in the past two decades, and as this use of third parties to manage funds has increased, so has the need to measure the performance of these vendors-relative not only to their own benchmarks but also to their peers. A new methodology is presented here to measure the risk-adjusted performance of a mutual fund and to permit effective ranking among peers.The new measure, called the M-3, accounts for differences in (1) standard deviation between a portfolio and a benchmark and (2) the correlations of mutual fund portfolios and their benchmarks for an investor's relative-risk target. Correlations are important for two reasons: They serve both as measures of covariance with other assets for optimal portfolio selection and as forward-looking risk measures.The M-3 measure facilitates comparison of mutual funds and can be used to create optimal risk-adjusted portfolios. It is superior to the information ratio, the Sharpe ratio, and the M-2 measure (shown to be a special case of the M-3 measure), which may be inappropriate to adjust for risk. The information ratio by itself is not a useful measure of outperformance or for ranking portfolios. It is valid only when leverage is not permitted. The M-2 measure is appropriate only for reviewing historical performance or if one ignores the issues created when agents manage portfolios for others, and it fails the test on a forward-looking basis or when adding the benchmark can improve risk-adjusted performance. By exploiting the role of correlation as a measure of forward-looking risk, the proposed M-3 measure provides rankings of portfolios that are different from those of other techniques. Furthermore, the information ratio and Sharpe ratio are unable to indicate how portfolios should be structured to achieve a target tracking error.To demonstrate the superiority of the M-3 measure, I first applied the M-3 measure to 10 years of mutual fund data from a previous study. This exercise demonstrates the differences in rankings the three analytical methods provide. Next, I chose 10 mutual funds with high annualized absolute returns relative to the S&P 500 Index for the period September 1989 through August 1999 and compared these funds on a risk-adjusted basis. I show that when this technique is used to adjust for risk, the rankings of the mutual funds change from rankings provided by other measures. In fact, this comparison reveals that some of the funds that underperformed on a risk-adjusted basis when the M-2 method is used outperform when the M-3 method is used. I show that the M-2 measure or the Sharpe ratio can lead to incorrect rankings because they ignore correlations and thus are not forward-looking measures. They also ignore the possibility of investing passively in the benchmark to improve risk-adjusted performance. Leverage is found to be useful when it is used to structure portfolios of the highest risk-adjusted performance and when it can be created through shorting the risk-free asset or the benchmark.The M-3 technique provides an accurate measure of risk-adjusted performance by correcting for differences in standard deviations and for differences in correlations. The M-3 measure facilitates optimal portfolio construction to achieve investors' objectives by combining the risk-free asset, the benchmark, and mutual funds. This paradigm, a type of three-fund separation, provides an optimal mix of active and passive management based on the skill of fund managers rather than individual biases concerning market inefficiency. Furthermore, whereas the information ratio and Sharpe ratio are unable to indicate how portfolios should be structured to achieve a target tracking error, the M-3 measure provides such guidance. Thus, when agents manage portfolios on behalf of principals or principals are structuring their own portfolios, the M-3 measure is the most appropriate way to adjust for risk.
Journal: Financial Analysts Journal
Pages: 63-71
Issue: 5
Volume: 56
Year: 2000
Month: 9
X-DOI: 10.2469/faj.v56.n5.2391
File-URL: http://hdl.handle.net/10.2469/faj.v56.n5.2391
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Author-Name: The Editors
Title: ERRATA
Abstract: 
 This material provides a correction to “Socially Responsible Mutual Funds” by Meir Statman which appeared in the May/June 2000 issue. 
Journal: Financial Analysts Journal
Pages: 14-16
Issue: 5
Volume: 56
Year: 2000
Month: 9
X-DOI: 10.2469/faj.v56.n5.2392
File-URL: http://hdl.handle.net/10.2469/faj.v56.n5.2392
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# input file: UFAJ_A_12047246_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: H. Gifford Fong
Author-X-Name-First: H. Gifford
Author-X-Name-Last: Fong
Title: From the Editor
Abstract: 
 The Editorial Board of the Financial Analysts Journal plays a vital role. Each member devotes considerable time and expertise to a review process that not only ensures the quality of the articles that are published but also provides authors, irrespective of whether the paper is published, with critiques that are intended to assist the authors with their papers. Every manuscript we publish goes through this referee procedure, which is a double-blind process. The paper is reviewed by an anonymous referee who has specialized in the area covered by the paper, and the author remains anonymous to the referee. The goal is an unbiased referee report that evaluates the paper for specific qualities (such as technical correctness and appropriateness for our readership) and provides comments and suggestions from the referee. The objective is to promote the highest quality research that also has practical relevance. To instill a continued renewal in the process, we must (no matter how reluctantly) make periodic change to the Editorial Board. Such change not only renews the FAJ's perspective; it also creates the opportunity for participation by more members of our wide academic and professional readership. We are very thankful to the outgoing Editorial Board members, all of whom have served us well and will be missed: Keith Ambachtsheer, André Perold, Jay Shanken, and Kenneth Singleton. We would like to welcome the new additions to the board: Guilford C. Babcock, Sanjiv Das, Massimo Fuggetta, Frank J. Jones, Cyrus A. Ramezani, and Meir Statman. The Financial Analysts Journal is indeed fortunate to have had the wisdom of those leaving the board, and we look forward to the contributions of those who are joining the team for the forthcoming year. The dedication and hard work of all have made and are making our publication the best. 
Journal: Financial Analysts Journal
Pages: 3-3
Issue: 5
Volume: 56
Year: 2000
Month: 9
X-DOI: 10.2469/faj.v56.n5.2393
File-URL: http://hdl.handle.net/10.2469/faj.v56.n5.2393
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# input file: UFAJ_A_12047247_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert Ferguson
Author-X-Name-First: Robert
Author-X-Name-Last: Ferguson
Author-Name: Dean Leistikow
Author-X-Name-First: Dean
Author-X-Name-Last: Leistikow
Title: Problems with Health Insurance
Abstract: 
 The absence of universal health insurance in the United States covering all illness at an “affordable” premium is widely viewed as a problem to be solved. Actually, health insurance makes some people better off and others worse off. Poor people are among the most likely to be worse off under existing and proposed health insurance systems, particularly universal health insurance, than they would be without the schemes. The media, politicians, and advocates of universal health insurance or nationalized health care perpetuate some common misconceptions about health insurance, including that health insurance is necessarily good for everyone and that universal coverage of all illness is possible at reasonable cost. They omit the loss of social welfare resulting from health insurance's inherent distortion of relative prices, the resulting excessive demand for health care, the consequent intolerable costs of health care, and the inevitable attempts to limit the costs through price controls, limited coverage, and so on.The absence of universal health insurance covering all illness at an “affordable” premium is widely viewed as a problem to be solved. In solving this problem, a useful base of comparison for any proposed solution is that it is “pareto-optimal”—a condition that leaves no possibility, in principle, of reallocating production and consumption to make at least one person better off without making anyone worse off. Existing and proposed health insurance systems are not pareto-optimal. Probably, universal health insurance systems that are close to pareto-optimal do not exist even in principle. With respect to realistic health insurance and health care systems, it is rational for some people not to want health insurance.Health insurance is viewed by many as too expensive and as providing too little coverage. A fundamental problem of health insurance is that participants regard premiums as a fixed cost; hence, they perceive a marginal price for health care that is well below marginal cost (a common copayment is only 20 percent of what providers receive). The result is far higher demand for health care than would exist if its marginal price were its marginal cost. A low marginal price does not change the fact that health care must be paid for. Thus, health insurance premiums are not a fixed cost for society. Consequently, health care demand exceeds what it should be given its cost. This price distortion and its effect may be why many health insurance participants feel that their premiums are too high and their coverage inadequate.Perceptions that health insurance premiums are too high lead to pressure to reduce them. Because health care must be paid for, only limiting supply or imposing price controls on providers can reduce premiums. Thus, a gap develops between the amount of health care demanded and the amount supplied, which reduces social welfare.Limitations in health care supply include the provision of some kinds of care only to specific groups, no provision of some kinds of care, and the delay of care. The resulting failure to cover virtually all health problems results in suffering that is exploited by the media and politicians. The result may be mandated coverage, as with patients' rights legislation. If so, participants are forced to pay for health care that they would not otherwise demand. It will be consumed, however, because of its perceived low marginal price. The resulting reduced social welfare goes unnoticed because the (otherwise unwanted) health care is consumed.Price controls may take the form of maximum fees for providers. This approach leads to inadequate supply to meet demand, including delayed or inadequate treatment. Again, the result is needless suffering and a reduction in social welfare.We apply basic microeconomic and insurance concepts to health insurance. To illustrate the concepts, we use relatively simple examples that will, we hope, convince readers that (1) the issues are more complex than public debate suggests and (2) much of conventional wisdom about health insurance is wrong.
Journal: Financial Analysts Journal
Pages: 14-29
Issue: 6
Volume: 56
Year: 2000
Month: 11
X-DOI: 10.2469/faj.v56.n6.2400
File-URL: http://hdl.handle.net/10.2469/faj.v56.n6.2400
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Author-Name: C. Barry White
Author-X-Name-First: C. Barry
Author-X-Name-Last: White
Title: What P/E Will the U.S. Stock Market Support?
Abstract: 
 The purpose of the study reported here was to determine the earnings multiple of the U.S. stock market (proxied by the S&P 500 Index) that can be justified by economic fundamentals at any given time. When price to earnings or earnings to price was used as the dependent variable, several regression models were found to be significant. The final E/P model had eight significant variables and explained more than 88 percent of P/E variation. This model indicates that today's multiples of 30 to 35 are not justified by current or expected economic conditions. Since 1926, the market P/E has ranged from a low of 5.9 (in 1949) to a high of about 35 (in 1999) and has averaged 14.4. Depending on conditions, $1 per share of earnings could be worth less than $6 or more than $30. How do investors know what price is fair, and what factors can be used to help predict a fair price? The study reported here attempted to develop a tool for estimating a fair P/E in given economic conditions. The article addresses, in particular, what earnings multiple can be justified for the S&P 500 Index given today's economic fundamentals.Several authors have written about the determinants of stock prices, returns, and P/Es. I used these works, together with theory and logic, as a basis for this study. Given the advantage of knowing which independent variables have been significantly related to P/E in past studies, I expected to be able to develop a model that explains a large portion of variation in P/E. To construct the model, I used significant independent variables from prior studies (inflation, the dividend payout ratio, dividend yield, T-bill rates, growth in the money supply, GDP growth, trailing earnings growth, long-term T-bond rates, and trailing volatility) plus two variables that no previous paper appears to have studied—the U.S. Federal Reserve P/E index and trailing S&P 500 returns. The Federal Reserve P/E index is the P/E that the Fed purportedly believes is justified by the current 10-year Treasury yield. The rationale for using trailing S&P 500 returns is that investors appear more likely to accept high prices (and high P/Es) following several years of superior returns.For this study (completed in mid–1999), I used quarterly time-series data from 1926 through 1997 for each variable. I chose this period because it includes the volatile 1930s and 1940s and because 1926 is as far back as comprehensive records are available for some variables. I used numerous independent variables in an effort to take into account everything that could help justify a high market P/E in economic conditions like those of today. The original 11 independent variables were reduced to 10 when I eliminated T-bills because of this factor's multicollinearity with bonds.The first model used P/E as the dependent variable and resulted in seven significant predictor variables (adjusted R2 of 83.0 percent). This model yielded a predicted P/E of 18.23 when early 1999 values were used for each variable. Then, because several previous studies surmised that earnings to price might produce a more linear relationship with various macroeconomic variables than price to earnings produces, I ran regressions with E/P as the dependent variable. I next applied various lags to obtain a still better fit. The final model used only eight significant variables (including lagged variables) to explain E/P and achieved an adjusted R2 of 88.5 percent. Only money supply and standard deviation of S&P 500 returns were not significant.Note that the use of ex post information and the addition of new variables probably caused this regression model to overstate the explanatory ability of the predictor variables on the earnings multiple. Nevertheless, when the same early 1999 values were used as were used for the P/E models, the justifiable E/P was found to be 0.0437. So, the estimated P/E would be 22.86, which is well below the 30–35 trailing earnings multiple experienced during much of 1998 and early 1999. The current market P/E thus appears to be an outlier even in relation to my most optimistic model. Investors should be very cautious.
Journal: Financial Analysts Journal
Pages: 30-38
Issue: 6
Volume: 56
Year: 2000
Month: 11
X-DOI: 10.2469/faj.v56.n6.2401
File-URL: http://hdl.handle.net/10.2469/faj.v56.n6.2401
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# input file: UFAJ_A_12047249_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard C. Grinold
Author-X-Name-First: Richard C.
Author-X-Name-Last: Grinold
Author-Name: Ronald N. Kahn
Author-X-Name-First: Ronald N.
Author-X-Name-Last: Kahn
Title: The Efficiency Gains of Long–Short Investing
Abstract: 
 Long–short strategies have generated controversy and institutional interest for more than 10 years. We analyzed the efficiency gains of long–short investing, where we defined efficiency as the information ratio of the implemented strategy (the optimal portfolio) relative to the intrinsic information ratio of the alphas. The efficiency advantage of long–short investing arises from the loosening of the (surprisingly important) long-only constraint. Long–short and long-only managers need to understand the impact of this significant constraint. Long–short implementations offer the most improvement over long-only implementations when the universe of assets is large, asset volatility is low, and the strategy has high active risk. The long-only constraint induces biases (particularly toward small stocks), limits the manager's ability to act on upside information by not allowing short positions that could finance long positions, and reduces the efficiency of traditional (high-risk) long-only strategies relative to enhanced index (low-risk) long-only strategies. Long–short strategies have generated controversy and institutional interest for more than 10 years. In the study reported here, we analyzed the efficiency gains of long–short investing, where we defined efficiency as the information ratio of the implemented strategy (the optimal portfolio) relative to the intrinsic information ratio of the alphas. The efficiency advantage of long–short investing arises primarily from the loosening of the (surprisingly important) long-only constraint. Moreover, long–short strategies also avoid the small-cap bias induced by the long-only constraint.Our discussion begins with a simple model characterized by a set of assets with uncorrelated residual risks that make up an equal-weighted benchmark. The long-only constraint affects assets with negative alphas below a threshold that depends on the portfolio's risk, the asset-level risk, and the number of assets in the benchmark. The impact of the constraint increases with portfolio risk and the number of assets and decreases with the riskiness of the individual assets. This model also identifies how the long-only constraint limits even an investor's ability to act on upside information by not allowing short positions that could finance long positions.To analyze more realistic models accounting for cap-weighted benchmarks, we next discuss the distribution of market capitalization. We used Lorenz curves to capture this distribution. We fit a one-parameter lognormal distribution of market capitalization to the assets that constitute several popular (cap-weighted) indexes. Doing so allowed us to model typical benchmarks and analyze how the impact of the long-only constraint changes as the parameter of fit varies over a realistic range.Armed with these results, we extended the simple model to account for cap-weighted benchmarks and we numerically simulated results as we varied portfolio risk, the number of assets in the benchmark, and asset-level risk. For each set of parameters (risks, asset numbers), we ran 900 simulations. Each simulation generated a set of alphas and built an optimal portfolio. We summarize these results by displaying the mean alpha and mean portfolio risk level from each set of simulations.The results clearly show that for long-only strategies, expected return does not increase linearly with active risk. Instead, each unit of additional risk generates less and less expected return. Viewed another way, long-only information ratios (and efficiencies) decrease with increasing active risk.This decrease in efficiency can be significant. A long-only strategy with a 500-asset universe and 4.5 percent active risk loses half its information ratio (efficiency = 49 percent) relative to a long–short strategy using the same information (same alphas). The impact is less severe at low risk levels: We found that an enhanced index strategy with the same universe but only 2 percent active risk has an efficiency of 71 percent.Our analysis also demonstrates a second significant effect of the long-only constraint—a bias toward small stocks. This bias arises because the constraint affects mainly the smaller-cap stocks that have less weight in the benchmark. The bias increases with the level of portfolio risk. For a strategy with a 500-asset universe and 4.5 percent active risk, this bias would have generated a loss of 235 basis points over the 10-year period ending September 1998 (when large-cap stocks outperformed small-cap stocks).In summary, long–short implementations offer the greatest advantage over long-only implementations when the universe of assets is large, asset volatility is low, and the strategy has high active risk. Among long-only strategies, enhanced index (low-risk) strategies offer better efficiency and less size bias than traditional higher-risk strategies.The preliminary empirical results we provide on U.S. equity managers demonstrate that, at the very least, long–short managers can achieve market neutrality.
Journal: Financial Analysts Journal
Pages: 40-53
Issue: 6
Volume: 56
Year: 2000
Month: 11
X-DOI: 10.2469/faj.v56.n6.2402
File-URL: http://hdl.handle.net/10.2469/faj.v56.n6.2402
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Author-Name: John A. Doukas
Author-X-Name-First: John A.
Author-X-Name-Last: Doukas
Author-Name: Chansog Kim
Author-X-Name-First: Chansog
Author-X-Name-Last: Kim
Author-Name: Christos Pantzalis
Author-X-Name-First: Christos
Author-X-Name-Last: Pantzalis
Title: Security Analysis, Agency Costs, and Company Characteristics
Abstract: 
 We appraise the monitoring activity of security analysis from the perspective of the manager–shareholder conflict. Using a data set of more than 7,000 company-year observations for manufacturing companies tracked by security analysts over the 1988–94 period, we found that security analysis acts as a monitor to reduce the agency costs associated with the separation of ownership and control. We also found, however, that security analysts are more effective in reducing managerial non-value-maximizing behavior for single-segment than for multisegment companies. In addition, the shareholder gains from the monitoring activity of security analysis are larger for single-segment than for multisegment companies. In spite of the general belief that the activities of security analysts affect firm value, little is known about whether analysts act as a monitoring mechanism in reducing the agency costs of manager–shareholder conflict. If security analysis exerts positive influence on firm value by restricting managers' non-value-maximizing activities, it should decrease agency costs. Thus, we carried out a direct testing of the relationship between security analysis and agency costs.Little is known also about whether the effectiveness of security analyst monitoring is related to the structure (diversification) of the company. This issue is important because recent studies have documented that diversified companies destroy shareholder value. Although a diversification discount is generally accepted, the mechanism through which diversification destroys firm value is not understood. Possible causes are that diversification encourages overinvestment, that it invites agency costs, and that diversified companies suffer from internal-capital-market inefficiencies associated with the misallocation of resources. We studied whether security analysis as an external monitor of managerial conduct, in the sense of reducing agency costs arising from informational asymmetries, works as well, less well, or better for nondiversified companies than for diversified companies.We examined the monitoring effectiveness of security analysts with a data set of 7,485 manufacturing company-year observations over the 1988–94 period. Based on the number of analysts following a company for forecasting horizons of (fiscal) one quarter, one year, and two years, our results consistently show that security analysis reduces agency costs (i.e., managers' non-value-maximizing behavior) while it increases firm value. We also found that the effectiveness of analysts' monitoring activity declines with industrial diversification, despite the fact that the number of analysts following diversified companies is substantially greater than the number following nondiversified companies. In addition, we show that the shareholder gains from the monitoring activity of security analysis are larger for nondiversified than for diversified companies.
Journal: Financial Analysts Journal
Pages: 54-63
Issue: 6
Volume: 56
Year: 2000
Month: 11
X-DOI: 10.2469/faj.v56.n6.2403
File-URL: http://hdl.handle.net/10.2469/faj.v56.n6.2403
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Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Title: Spread-Driven Dividend Discount Models
Abstract: 
 A key determinant of shareholder value is the franchise spread—the company's incremental return on new investments over the cost of capital. Explicitly incorporating this spread into the valuation process paves the way for a more compact, two-parameter formulation of the standard three-parameter dividend discount model. This transformation leads to a number of interesting implications. In particular, the spread-driven representation of the DDM (1) clarifies the role of growth-driven ROEs versus the role of spread-driven ROEs, (2) facilitates the development of two-phase models that reflect a typical company's earnings pattern, (3) shows how earnings growth and franchise spreads can underpin a wide range of P/E levels, (4) addresses the problem of artificially high P/Es being forced by low estimates for the risk premium and/or the inflation rate, (5) provides a useful expression for the growth rate of shareholder value, and (6) under certain stability conditions, leads to a pro forma equity duration that is—surprisingly—equal to the P/E itself. Three parameters—the discount rate, earnings growth, and the payout fraction—are explicit in the standard one-phase dividend discount model (DDM). A fourth parameter, however, plays a crucial role in any projection of shareholder value. This fourth parameter, “the franchise spread,” is the company's incremental return on new investments above and beyond its cost of capital. Without a positive franchise spread, growth adds nothing to shareholder value. Consequently, this fourth parameter may be the most significant factor in company valuation. The franchise spread never appears explicitly in standard DDM formulations, but it is always embedded somewhere in any DDM structure. Many valuation effects can be better understood by exploring the implied movements in this key parameter.The franchise spread can be readily incorporated into the standard dividend discount model to create a spread-driven DDM. This form may be used as a single-phase, stand-alone model or as the terminal stage of a multiphase model. Moreover, by making a clear distinction between growth-driven returns and spread-driven returns, this framework sheds new light on a number of current topics in valuation theory.For example, various studies have argued that P/Es far above historical norms are possible today because of the lower market discount rates that result from more controlled inflation and from reduced equity risk premiums. The standard one-phase DDM is often invoked as the analytical basis for such arguments. Outsized P/Es are generally computed by reducing the discount rate while simultaneously maintaining constant values for earnings growth and for the payout fraction.With the growth rate fixed in the standard DDM, however, a falling discount rate will automatically create a point-for-point increase in the embedded franchise spread, and this increased spread is what accounts for a large part of the P/E escalation. Because this effect is never made explicit, the DDM analyst may not be aware that the lower discount rates are automatically raising the franchise spread. Not only is this inverse “spread-discount rate” relationship questionable in itself, but it can also easily take the franchise spread to unreasonably high levels, especially within the long-term context of the single-phase DDM.When a more stable franchise spread is postulated, the DDM's sensitivity to discount rate changes (i.e., the equity duration) is greatly reduced. With spread stability, lower market rates lead to more moderate (and, some would say, much more reasonable) P/Es. Thus, even in the face of assumed reductions in the risk premium, the inflation rate, or both, franchise-spread considerations tend to undermine DDM-based arguments justifying stratospheric P/Es for the market as a whole.The concept of the franchise spread also has a number of useful byproducts in terms of the DDM model itself. First, it leads to a more comprehensive gauge of the company's growth in shareholder value. Moreover, with a stable franchise spread, this “value-growth rate” can be made independent of market discount rates. Second, using the value-growth rate, one can transform the standard three-parameter DDM into a compact, two-parameter spread-driven DDM. Third, the revised two-parameter DDM leads to a pro forma mathematical equity duration that—surprisingly—exactly coincides with the P/E itself!Finally, the most far-reaching outcome of the franchise-spread concept may be the cleaner distinction it makes between “spread-driven returns” that can be reasonably sustained over a long terminal phase and the supercharged “growth-driven returns” that high-P/E companies can enjoy over a limited front-end phase. This distinction readily leads, in turn, to multiphase models consisting of a growth-driven first phase segueing into a longer-term spread-driven phase. In particular, using a two-phase model of this “dual-driver” format, one can easily account for the high P/Es of growth stocks while obtaining a more palatable P/E response to lower discount rates. Thus, by explicitly incorporating the concept of the franchise spread and its associated value-growth rate, one can construct valuation models that are actually more intuitive in terms of their basic structure than the standard DDM, more readily specified in terms of input estimation, and more reasonable in terms of projected P/E patterns over a range of market scenarios.
Journal: Financial Analysts Journal
Pages: 64-81
Issue: 6
Volume: 56
Year: 2000
Month: 11
X-DOI: 10.2469/faj.v56.n6.2404
File-URL: http://hdl.handle.net/10.2469/faj.v56.n6.2404
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Handle: RePEc:taf:ufajxx:v:56:y:2000:i:6:p:64-81




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# input file: UFAJ_A_12047252_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Stuart C. Gilson
Author-X-Name-First: Stuart C.
Author-X-Name-Last: Gilson
Title: Analysts and Information Gaps: Lessons from the UAL Buyout
Abstract: 
 In addition to earnings forecasts and stock recommendations, analysts provide potentially useful information to investors in the form of written commentary and analysis. But how such fundamental research affects stock prices has been little studied. I investigate the role analysts' research played in the 1994 restructuring of UAL Corporation (parent of United Air Lines), in which employees acquired 55 percent of UAL stock in exchange for $4.9 billion in wage/benefit concessions. Focusing on the critical first two years of the buyout, my analysis suggests that analysts and investors, on average, initially gave the company little credit for the concessions. The transaction was controversial and complicated. Most analysts were negative or indifferent in their assessment of the deal. Some analysts also misinterpreted key terms of the deal. UAL managers responded by reporting an unconventional earnings measure that highlighted the financial concessions. UAL's stock price relative to the market and industry eventually doubled, but analysts' opinions of the deal did not change. Much academic research has found that sell-side analysts' earnings forecasts and stock recommendations provide information that is useful to investors for valuing corporate securities. Another potentially important source of information for investors is analysts' written commentary and analysis, but how such fundamental research affects stock prices has been little studied. Evaluating the quality and impact of this analysis is clearly difficult if traditional large-sample analysis is the method.I report an investigation into the role analyst research played in the 1994 restructuring of UAL Corporation (parent of United Air Lines), in which employees acquired 55 percent of UAL stock and certain control rights in exchange for $4.9 billion in wage/benefit concessions. My analysis drew on a unique database that included all sell-side analyst reports on UAL, internal company documents, corporate press releases, and interviews with key participants in the case. The UAL buyout was an interesting research site because the restructuring had no precedent and was extremely complicated. Therefore, information gaps were likely to be large and the opportunity existed for analysts to play an especially valuable role as information intermediaries between the company and investors. In addition, the success of the restructuring was highly dependent on the company's future stock price performance because many employees were initially concerned that they had paid too high a price for their stock.Focusing on the critical first two years of the buyout, my analysis suggests that analysts and investors initially gave the company little credit for the concessions. Most analysts were negative or indifferent in their assessment of the deal, and some also misinterpreted key deal terms or made incorrect, potentially misleading inferences about the buyout.For at least the first year of the deal, UAL's stock price performance was unexceptional. One reason may be that the managers were limited in what they could say publicly to address the market's concerns about the company's future; if they emphasized the size of the concessions, they risked antagonizing or alienating employees. In an effort to change investors' perceptions of the buyout, UAL managers devised a new method for reporting earnings (“fully distributed earnings”) that excluded a large noncash charge for employees' stock required under U.S. generally accepted accounting principles (GAAP). And eventually, although analyst opinion of the deal did not change, UAL's stock price relative to the market and industry doubled.The study has a number of important implications for practitioners and researchers. First, the written analyses and commentary that accompany analyst forecasts of earnings and stock prices provide potentially important information. The research may contain opinions about the company's future performance beyond the period covered by the analyst's financial forecasts. Investors may also take the quality of the research into account when weighing competing earnings forecasts. Studies of consensus analyst earnings forecasts and analysts' ability to forecast earnings do not capture the additional information that may be contained in analysts' fundamental research.A second contribution of the study is to broaden understanding of which companies benefit most (or least) from analyst coverage. The results suggest that the value of analyst coverage may be more limited when companies undergo complicated corporate transactions than in simpler situations.Finally, the study highlights some of the problems that managers may encounter when they try to improve their companies' valuations. The experience of UAL with introducing fully distributed earnings may be applicable to Internet companies that are attempting, to the concern of regulators, to use earnings measures that exclude GAAP-mandated charges for goodwill or marketing expenses. UAL's experience suggests that changing investor perceptions through such accounting innovations is difficult.
Journal: Financial Analysts Journal
Pages: 82-110
Issue: 6
Volume: 56
Year: 2000
Month: 11
X-DOI: 10.2469/faj.v56.n6.2405
File-URL: http://hdl.handle.net/10.2469/faj.v56.n6.2405
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# input file: UFAJ_A_12047253_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Victor S. Morris
Author-X-Name-First: Victor S.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: 2000 Pay to Win: How America's Successful Companies Pay Their Executives (a review)
Abstract: 
 This book provides information and guidance to enable shareholders to determine whether a compensation package is reasonable. 
Journal: Financial Analysts Journal
Pages: 111-112
Issue: 6
Volume: 56
Year: 2000
Month: 11
X-DOI: 10.2469/faj.v56.n6.2406
File-URL: http://hdl.handle.net/10.2469/faj.v56.n6.2406
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# input file: UFAJ_A_12047254_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing (a review)
Abstract: 
 This well-organized, lively volume makes the existing body of behavioral finance research accessible to nonacademic practitioners. 
Journal: Financial Analysts Journal
Pages: 112-113
Issue: 6
Volume: 56
Year: 2000
Month: 11
X-DOI: 10.2469/faj.v56.n6.2407
File-URL: http://hdl.handle.net/10.2469/faj.v56.n6.2407
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# input file: UFAJ_A_12047255_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bing Liang
Author-X-Name-First: Bing
Author-X-Name-Last: Liang
Title: Hedge Fund Performance: 1990–1999
Abstract: 
 Using a large database, I studied hedge fund performance and risk during an almost 10-year period from 1990 to mid-1999. The empirical results show that hedge funds had an annual return of 14.2 percent in this period, compared with 18.8 percent for the S&P 500 Index. The S&P 500 is much more volatile, however, than hedge funds as a whole. Annual survivorship bias for hedge funds was 2.43 percent. I examined year 1998 in detail because hedge funds were heavily affected by the global financial market tumble in that year. For example, the highest volatility for hedge fund returns occurred in 1998, and more funds died and fewer were born in 1998 than in any other year of the period studied. Few funds changed their fee structures. In those that did, the fee changes were performance related; poor performers lowered their incentive fees. In the study reported here, I used a database containing more than 2,000 hedge funds to examine their performance during the period from January 1990 to July 1999. The empirical results show that hedge funds had an annual return of 14.2 percent in this time period, compared with 18.8 percent for the S&P 500 Index. The S&P 500 was much more volatile, however, than the group of hedge funds as a whole. The standard deviation of the hedge fund returns was 1.67 percent a month, whereas the standard deviation for the index was 3.89 percent a month.This study documented an annual survivorship bias of 2.43 percent for hedge funds from 1994 to 1999. That is, studies based on current funds will overstate fund performance by only 2.43 percent on an annual basis. Because data vendors started to collect data on defunct funds only in 1994, survivorship studies are meaningful only if their data begin after 1993.The article examines 1998 in detail because hedge funds were heavily affected by the global financial market tumble in that year; hedge fund returns in 1998 were the most volatile of the period. The loss in August when Russian debt defaulted reached 4.88 percent for the funds as a group. More funds died and fewer funds were born in 1998 than in any other year during the 10-year period.Few hedge funds change their fee structures; their management fees and incentive fees tend to be stable over time. For example, of the 2,016 funds studied here, only 12 funds changed management and/or incentive fees from 1997 to 1998. The fee changes were performance related; poorly performing funds lowered their incentive fees.
Journal: Financial Analysts Journal
Pages: 11-18
Issue: 1
Volume: 57
Year: 2001
Month: 1
X-DOI: 10.2469/faj.v57.n1.2415
File-URL: http://hdl.handle.net/10.2469/faj.v57.n1.2415
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# input file: UFAJ_A_12047256_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: James L. Davis
Author-X-Name-First: James L.
Author-X-Name-Last: Davis
Title: Mutual Fund Performance and Manager Style
Abstract: 
 In this analysis of the relationship between equity mutual fund performance and manager style, two questions are addressed. First, does any investment style generate abnormal returns on average? Second, when funds are grouped by equity style, does any style exhibit performance persistence? The answers from this study are as follows: None of the styles earned positive abnormal returns during the 1965–98 sample period, and value funds realized negative abnormal returns of about 2.75 percentage points a year. Some evidence was found of short-run performance persistence among the best-performing growth funds and among the worst-performing small-cap funds. In this examination of the relationship between mutual fund performance and the investment style of the fund manager, I address two specific issues. First, does any equity investment style reliably deliver abnormal performance? Second, when funds with similar styles are compared, does any style exhibit performance persistence? The equity styles investigated in this study were classified along two general dimensions—value versus growth and small capitalization versus large capitalization.Data for the study came primarily from the Center for Research in Security Prices (CRSP) database of U.S. mutual funds for 1962 through 1998. This database is essentially free of the survivorship bias that plagues most studies of mutual fund performance. The sample constructed from this database contained nearly 4,700 domestic equity mutual funds.The benchmark against which mutual fund performance was measured was the three-factor model of Fama and French. I chose this model as the performance benchmark for two reasons. First, prior research has shown that the three factors in the model have explanatory power for stock returns because they are associated with risk. If the factors do measure risk, then the average returns of fund managers should be large enough to compensate for these risk factors. Second, passive buy-and-hold portfolios can be formed that allow investors to earn the premiums associated with the three factors of the Fama-French model. So, if active fund management has economic value, active managers should outperform such a passive strategy.None of the styles in the study generated positive abnormal returns relative to the Fama-French benchmark. Value funds generated negative abnormal returns during the sample period of about 2.7 percentage points a year. I found some evidence of performance persistence, but the abnormal performance tended to die out quickly. The best-performing growth managers tended to continue to perform well during the year after they were identified as good performers, and the worst-performing small-cap managers continued to generate negative abnormal returns after they were identified as poor performers.These results are not good news for investors who purchase actively managed mutual funds. The average fund, regardless of style, does not reliably outperform a passive benchmark that has similar style characteristics. Even the best-performing funds do not maintain superior performance for extended periods of time. Based on the performance of U.S. equity funds during the past three decades, a reliable payoff to active fund management was not realized.
Journal: Financial Analysts Journal
Pages: 19-27
Issue: 1
Volume: 57
Year: 2001
Month: 1
X-DOI: 10.2469/faj.v57.n1.2416
File-URL: http://hdl.handle.net/10.2469/faj.v57.n1.2416
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# input file: UFAJ_A_12047257_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard J. Bauer
Author-X-Name-First: Richard J.
Author-X-Name-Last: Bauer
Author-Name: Julie R. Dahlquist
Author-X-Name-First: Julie R.
Author-X-Name-Last: Dahlquist
Title: Market Timing and Roulette Wheels
Abstract: 
 Nobel laureate William F. Sharpe and others have alerted investors to the potential pitfalls of market timing. We also conclude from the study reported here that market timing is generally a difficult game. But the difficulty varies substantially over time-which has some intriguing implications for performance evaluation. Using a new measure of investment performance that we call the “roulette wheel” measure, we analyzed monthly, quarterly, and annual market-timing strategies in the 1926–99 period for six major U.S. asset classes. In the 1995–99 period, buying and holding large-capitalization stocks would have outperformed about 99.8 percent of the more than 1 million possible quarterly switching sequences between large-cap stocks and U.S. T-bills. In 1994, however, if 1,000 portfolio managers had made monthly random choices between large-cap stocks and T-bills, about 591 of them would probably have beaten a buy-and-hold strategy. If 650 of the 1,000 had beaten a buy-and-hold strategy, should all 650 have earned a bonus? Market timers attempt to maximize returns by making good decisions about whether to be in or out of particular asset classes. A market timer might make monthly, quarterly, or annual decisions about whether to be in, for example, stocks or U.S. T-bills. Nobel laureate William Sharpe and others have alerted investors to the potential pitfalls of market timing. We also conclude that market timing is generally a difficult game. But the difficulty varies substantially over time, which has some intriguing implications for performance evaluation.We introduce a new measure of investment performance—the roulette wheel (RW) measure—that is fairly intuitive and simple yet insightful. Picture a simple roulette wheel that consists of either two semicircles, one red and one black, or alternating segments of red and black in equal proportions. Assume that you are going to use this roulette wheel to make monthly decisions about whether to be in stocks or T-bills over the next 12 months. (We use a roulette wheel analogy rather than a coin toss because we also consider choices between more than two assets.) If “investment path” means a sequence of switches in and out of the two assets, the choice between two asset choices in each of 12 months produces 212, or 4,096, possible investment paths. To compute the RW measure for the strategy of buy-and-hold stocks (which is one of the 4,096 possible investment paths), one computes the returns for all 4,096 possible sequences and sorts them by ascending return. If the buy-and-hold strategy ranks 3,786 out of the 4,096 possible returns, this rank is converted (via a simple formula) to a number between 0 and 1. With a rank of 3,786 out of 4,096, the RW measure for this buy-and-hold strategy versus switching is 0.924.The RW measure is constructed in such a way that it averages 0.500 for repeated random choices. If the RW for a historical buy-and-hold strategy is 0.924 (which was true for large-capitalization stocks in 1997, based on monthly switching between large stocks and T-bills), then that strategy was outperforming approximately 92.4 percent of the 4,096 possible investment paths. Therefore, the buy-and-hold strategy performed quite well against alternative paths. In general, we found that buy-and-hold strategies have high RW measures.We report RW values for many combinations of major asset classes, but we will focus on large-cap stocks (with transaction costs not considered) in this digest. In these tests, the buy-and-hold asset in each case was large-cap stocks and the switching choice was between large-cap stocks and T-bills. We found the average RW value (based on 74 years of data from January 1926 through December 1999) for monthly switching over a one-year period to be 0.6622. When the switching choice was made quarterly over five-year periods, the average RW is 0.7539. For annual switches over decades, the average RW is 0.8041. Including transaction costs raises the RW values; a buy-and-hold strategy is even more attractive when switching is costly.The average results for large-cap stocks illustrate the general difficulty of outperforming the simple strategy of buying and holding assets. The averages, however, mask some highly intriguing variability over time. In the 1995–99 period, the buy-and-hold strategy for large-cap stocks was virtually impossible to beat. Based on quarterly switching, the RW is 0.9979 for that period; that is, only 0.2 percent of the 1,048,576 quarterly investment paths would have beaten the buy-and-hold strategy. In some other periods, however, such as 1970–1974, switching strategies would have beaten the buy-and-hold strategy more often.The results have some important implications for performance and reward systems. For example, how much should one reward a manager for beating an index in a period such as 1970–1974, when about 79 percent of randomly chosen quarterly switching paths would have outperformed the index?
Journal: Financial Analysts Journal
Pages: 28-40
Issue: 1
Volume: 57
Year: 2001
Month: 1
X-DOI: 10.2469/faj.v57.n1.2417
File-URL: http://hdl.handle.net/10.2469/faj.v57.n1.2417
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# input file: UFAJ_A_12047258_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Darrell Duffie
Author-X-Name-First: Darrell
Author-X-Name-Last: Duffie
Author-Name: Nicolae Gârleanu
Author-X-Name-First: Nicolae
Author-X-Name-Last: Gârleanu
Title: Risk and Valuation of Collateralized Debt Obligations
Abstract: 
 In this discussion of risk analysis and market valuation of collateralized debt obligations, we illustrate the effects of correlation and prioritization on valuation and discuss the “diversity score” (a measure of the risk of the CDO collateral pool that has been used for CDO risk analysis by rating agencies) in a simple jump diffusion setting for correlated default intensities. A collateralized debt obligation (CDO) is an asset-backed security whose underlying collateral is typically a portfolio of (corporate or sovereign) bonds or bank loans. A CDO cash flow structure allocates interest income and principal repayments from a collateral pool of different debt instruments to prioritized CDO securities (tranches). A standard prioritization scheme is simple subordination: Senior CDO notes are paid before mezzanine and lower subordinated notes are paid, and any residual cash flow is paid to an equity piece. CDOs form an increasingly large and important class of fixed-income securities. Our analysis may provide useful approaches to valuation and diagnostic measures of risk.We concentrate on cash flow CDOs-those for which the collateral portfolio is not subjected to active trading by the CDO manager. The implication of this characteristic is that the uncertainty regarding interest and principal payments to the CDO tranches is determined mainly by the number and timing of defaults of the collateral securities. We do not analyze market-value CDOs, those in which the CDO tranches receive payments based essentially on the marked-to-market returns of the collateral pool as determined largely by the trading performance of the CDO manager.In our analysis of the risk and market valuation of cash flow CDOs, we illustrate the effects of correlation and prioritization for the market valuation, “diversity score” (a measure of the risk of the CDO collateral pool that has been used for CDO risk analysis by rating agencies), and risk of CDOs in a simple jump diffusion setting for correlated default intensities. The main issue is the impact of the joint distribution of default risk of the underlying collateral securities on the risk and valuation of the CDO tranches. We also address the efficacy of alternative computational methods and the role of diversity scores.We show that default-time correlation has a significant impact on the market values of individual tranches. The priority of the senior tranche, by which it is effectively “short a call option” on the performance of the underlying collateral pool, causes its market value to decrease with the risk-neutral default-time correlation. The value of the equity piece, which resembles a call option, increases with correlation. Optionality has no clear effect on intermediate tranches. With sufficient overcollateralization, the option “written” (to the lower tranches) dominates, but it is the other way around for sufficiently low levels of overcollateralization.Spreads, at least for mezzanine and senior tranches, are not especially sensitive to the “lumpiness” of the arrival of information about credit quality, in that replacing the contribution of diffusion with jump risks (of various types), while holding constant the degree of mean reversion and the term structure of credit spreads, plays a relatively small role in determining the spreads.Regarding alternative computational methods, we show that if (risk-neutral) diversity scores can be evaluated accurately, which is computationally simple in the framework we propose, these scores can be used to obtain good approximate market valuations for reasonably well-collateralized tranches.
Journal: Financial Analysts Journal
Pages: 41-59
Issue: 1
Volume: 57
Year: 2001
Month: 1
X-DOI: 10.2469/faj.v57.n1.2418
File-URL: http://hdl.handle.net/10.2469/faj.v57.n1.2418
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# input file: UFAJ_A_12047259_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Stock Market Cycles: A Practical Explanation (a review)
Abstract: 
 This book describes the classic business cycle and its logical investment implications and includes a test of timing strategies. 
Journal: Financial Analysts Journal
Pages: 60-60
Issue: 1
Volume: 57
Year: 2001
Month: 1
X-DOI: 10.2469/faj.v57.n1.2419
File-URL: http://hdl.handle.net/10.2469/faj.v57.n1.2419
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# input file: UFAJ_A_12047260_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Capital Ideas and Market Realities: Option Replication, Investor Behavior, and Stock Market Crashes (a postscript)
Abstract: 
 This book provides a valid warning that price discontinuties occur more frequently than financial models generally assume. 
Journal: Financial Analysts Journal
Pages: 60-61
Issue: 1
Volume: 57
Year: 2001
Month: 1
X-DOI: 10.2469/faj.v57.n1.2420
File-URL: http://hdl.handle.net/10.2469/faj.v57.n1.2420
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# input file: UFAJ_A_12047261_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Power of Gold: The History of an Obsession (a review)
Abstract: 
 This book sheds light on gold's unavoidable role in the world's monetary system and recounts many colorful incidents in the yellow metals's long saga. 
Journal: Financial Analysts Journal
Pages: 61-62
Issue: 1
Volume: 57
Year: 2001
Month: 1
X-DOI: 10.2469/faj.v57.n1.2421
File-URL: http://hdl.handle.net/10.2469/faj.v57.n1.2421
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to the article “Financial Risk Management” by Kevin Dowd, which appeared in the July/August 1999 Financial Analysts Journal.
Journal: Financial Analysts Journal
Pages: 4-4
Issue: 1
Volume: 57
Year: 2001
Month: 1
X-DOI: 10.2469/faj.v57.n1.2422
File-URL: http://hdl.handle.net/10.2469/faj.v57.n1.2422
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# input file: UFAJ_A_12047264_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Eric Jacquier
Author-X-Name-First: Eric
Author-X-Name-Last: Jacquier
Author-Name: Alan J. Marcus
Author-X-Name-First: Alan J.
Author-X-Name-Last: Marcus
Title: Asset Allocation Models and Market Volatility
Abstract: 
 Asset allocation and risk management models assume at least short–term stability of the covariance structure of asset returns, but actual covariance and correlation relationships fluctuate dramatically. Moreover, correlations tend to increase in volatile periods, which reduces the power of diversification when it might most be desired. We propose a framework to both explain these phenomena and to predict changes in correlation structure. We model correlations between assets as resulting from the common dependence of returns on a marketwide factor. Through this link, an increase in market volatility increases the relative importance of systematic risk compared with the unsystematic component of returns. The increase in the importance of systematic risk results, in turn, in an increase in asset correlations. We report that a large portion of the variation in correlation structures can be attributed to variation in market volatility. Moreover, market volatility contains enough predictability to construct useful forecasts of covariance. Asset allocation and risk management models assume at least short–term stability of the covariance structure of asset returns, but actual covariance and correlation relationships fluctuate wildly, even over short horizons. Moreover, correlations increase in volatile periods, which reduces the power of diversification when it might most be desired. This phenomenon, often called “correlation breakdown,” has been widely recognized in the international context, but the pattern is even more characteristic of cross-industry correlations in a domestic context.We attempt to explain correlation breakdown and to present a framework for predicting short–horizon changes in correlation structure. We modeled correlations between assets as resulting from the common dependence of returns on a systematic, marketwide factor. Through this link, an increase in factor volatility increases the importance of systematic risk relative to the unsystematic component of returns. The result is an increase in asset correlations.We found that a simple index model with only one systematic factor can explain a surprisingly large portion of the short–horizon time variation in correlation structure. This finding suggests that univariate models of time variation in volatility, such as the ARCH (autoregressive conditional heteroscedasticity) model and its variants, which are already widely and successfully applied, can be integrated with the index model to form useful short–horizon forecasts of cross-sector correlations.We examined the source of correlation breakdown in the domestic context using returns on 12 industry groups and treating the value–weighted NYSE Index as the systematic factor; in the international context, we used returns on 10 major country indexes and treated the MSCI World Index as the systematic factor. We document that variation in cross-sector correlation is highly associated with market volatility (where “sector” means industry in the U.S. context and country in the international context). Using daily data within quarters to calculate both cross-sector correlations and the volatility of the market index, we measured the tendency for time variation in correlation (across quarters) to track time variation in market volatility. In both the domestic and international contexts, we found that correlation clearly fluctuates in line with market volatility.We found that short–term variation across time in the volatility of the market index can be used to forecast most of the time variation in correlation structure and thus guide managers in updating portfolio positions. The results are qualitatively the same in the international and domestic settings. We found considerably more country-specific volatility, however, than industry-specific volatility, which implies that, although the proposed methodology can be quite effective in the domestic setting, it will be less useful in the international setting.Having established that predictions of market volatility are useful in predicting correlation structure, we next examined the extent to which this methodology can be used in risk management applications. Can predictions of market volatility in conjunction with the index model be used to efficiently diversify portfolio risk? We compared the predictive accuracy of several forecasts of covariance and found that a constrained correlation using a simple autoregressive relationship to forecast next-quarter market variance from current-quarter market variance is highly accurate. In fact, the predictive accuracy of this model is equal to a model of “full-sample constant covariance” (i.e., a covariance estimate obtained by pooling all daily returns and calculating the single full-sample covariance matrix). This latter forecast obviously is not feasible for actual investors because it requires knowledge of returns over the full sample period. It turned out to be the best unconditional covariance estimator, but our constrained index model estimator conditioned on a forecast of market volatility was equally accurate.We conclude that portfolios constructed from covariance matrixes based on an index model and predicted market volatilities will perform substantially better than portfolios that do not account for the impact of time-varying volatility on correlation and covariance structure. The ability of market volatility to explain correlation structure suggests that univariate models of time variation in that volatility can be integrated with the index model to make useful short–horizon forecasts of cross-sector correlations.
Journal: Financial Analysts Journal
Pages: 16-30
Issue: 2
Volume: 57
Year: 2001
Month: 3
X-DOI: 10.2469/faj.v57.n2.2430
File-URL: http://hdl.handle.net/10.2469/faj.v57.n2.2430
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# input file: UFAJ_A_12047265_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Manuel Ammann
Author-X-Name-First: Manuel
Author-X-Name-Last: Ammann
Author-Name: Heinz Zimmermann
Author-X-Name-First: Heinz
Author-X-Name-Last: Zimmermann
Title: Tracking Error and Tactical Asset Allocation
Abstract: 
 We report results from our investigation of the relationship between statistical measures of tracking error and asset allocation restrictions expressed as admissible weight ranges. Tracking errors are typically calculated as annualized second moments of return differentials between a portfolio and a benchmark. In practice, however, constraints on tactical deviations from benchmark weights are often imposed on the portfolio manager to ensure adequate tracking. Simulating various investment strategies subject to such constraints, we illustrate how the size of acceptable deviations from the benchmark relates to the statistical tracking error. An example based on actual market data indicates that imposing fairly large tactical asset allocation ranges produces surprisingly small tracking errors. We also found that TAA restrictions should restrict not only the tactical ranges of the individual asset classes but also, and perhaps even more importantly, the tracking of the individual asset classes. We report our investigation of the relationship between measures of statistical tracking error and asset allocation restrictions expressed as admissible deviations from benchmark weights. This relationship is of significant practical relevance to analysts, investment strategists, and risk managers. The reason is that these practitioners often think in terms of tracking volatility or correlation whereas the actual allocation decisions by portfolio managers tend to be guided by recommendations and constraints on the weights of assets or asset classes in their portfolios.Typically, tracking errors are calculated either as second moments of return differentials between the tracking portfolio and some benchmark or as correlation coefficients. In practice, however, constraints on tactical deviations from benchmark weights are usually imposed on a portfolio manager to ensure adequate tracking and limit the active part of portfolio risk. These bounds define the maximum percentages by which the actual portfolio weights may deviate from the corresponding weights in the benchmark. For example, for an equally weighted benchmark portfolio consisting of five asset classes with strategic weights of 20 percent for each class, an active management contract might allow the portfolio manager to deviate from the weights within a range of ±10 percent for each class. Such a range implies a certain tracking-error range, so the active manager has the chance to earn abnormal portfolio returns.We took a simulation approach to quantifying the relationship between statistical tracking-error measures and constraints on weights: For given tactical asset allocation (TAA) ranges, we identified admissible tactical portfolio combinations and simulated for these portfolios return series based on historical data. We then calculated the correlations and tracking errors for the portfolios as though they had been managed according to various asset allocation strategies. The simplest allocation was static; the allocation remained unchanged for the entire observation period. We also studied three dynamic TAA strategies: random rebalancing each month, rebalancing based on return trends, and rebalancing so as to maximize tracking error while still remaining within the weight constraints. In addition, we investigated allocation strategies in which the individual asset classes were managed actively. In this case, the tracking error arose not only from the tactical asset-class allocation but also from the imperfect asset-class tracking.The asset classes came from international stock and bond markets. The benchmark portfolio for the main study consisted of U.S. stocks, European stocks, Japanese stocks, U.S. bonds, and Canadian bonds. The reference currency is the U.S. dollar, and the full period is 1985 to mid-1998. To test the robustness of the results, we also applied the analysis to different time periods and an alternative benchmark portfolio. The robustness tests confirmed our main findings.For given tactical ranges, we found that the lowest attainable correlation coefficients between the tactical portfolios and the benchmark are surprisingly high. Consequently, imposing a lower bound for admissible correlation between tracking portfolio and benchmark may not prevent portfolio managers from holding portfolios that differ greatly from their benchmarks in terms of asset-class weights. We also found that tracking errors and correlation coefficients are very sensitive to the tracking accuracy of the individual asset classes. Thus, restrictions imposed to control the deviation of TAA strategies from benchmarks should not only restrict the weighting of the individual asset classes (i.e., the determination of tactical ranges), as is often done in practice, but should also control the error arising from the tracking of the individual asset classes.We also applied our tracking-error analysis to the valuation of performance fees. Allowing for a higher tracking error increases the value of a performance fee contract to a portfolio manager because of the greater flexibility for the implementation of active strategies and thus the higher potential rewards. For given tactical ranges, we identified the highest corresponding tracking error in our simulation results and then used a pricing model for exchange options to compute the value of the performance fee contract. We found that the value of the contract is roughly proportional to the width of the tactical allocation ranges.
Journal: Financial Analysts Journal
Pages: 32-43
Issue: 2
Volume: 57
Year: 2001
Month: 3
X-DOI: 10.2469/faj.v57.n2.2431
File-URL: http://hdl.handle.net/10.2469/faj.v57.n2.2431
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# input file: UFAJ_A_12047266_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Edward Qian
Author-X-Name-First: Edward
Author-X-Name-Last: Qian
Author-Name: Stephen Gorman
Author-X-Name-First: Stephen
Author-X-Name-Last: Gorman
Title: Conditional Distribution in Portfolio Theory
Abstract: 
 We present a new method to obtain a conditional mean vector and a conditional covariance matrix when given an investor's view about return profiles of certain assets. The method extends earlier results that were limited to the conditional mean. The new method allows an investor to express views on return means, volatilities, and correlations. An application of our results illustrates how a single anticipated volatility shock spreads to other assets and increases the correlation coefficients among assets. Another application shows how a flight-to-quality event affects volatilities and correlations. Based on the conditional mean and covariance matrix, we then derive analytically an optimal mean–variance portfolio and discuss its implications for asset allocation. Asset allocation managers in search of diversification have a difficult time constructing portfolios based on mean–variance optimization. The reason is that the outcome of a mean–variance optimization is very sensitive to its inputs. Given a covariance matrix and a risk-aversion factor, a set of seemingly reasonable forecasts often gives rise to a portfolio that is overwhelmingly concentrated in a few assets. This conflict between diversification and mean–variance optimization needs to be resolved.Current methodology that resolves the conflict first chooses implied equilibrium expected returns (extracted inversely from observed market value weights) as a reference point. The investor must express views on a few assets relative to this reference. Conditional distribution theory is then used to adjust the entire mean vector to reflect the active views. This conditional adjustment is crucial; without it, small differences between the equilibrium expected returns and the investor's forecasts again result in nondiversified portfolios. By adjusting the mean vector, this method uses the mean–variance optimization to obtain portfolios that not only reflect investor expectations but also provide a diversified mix of assets.The limitation of this method is that it deals only with active views on the expected returns. In practice, some investors also have opinions on the volatilities of certain assets and correlations among assets. So, conditional adjustment to the covariance matrix is as important as conditional adjustment to the mean vector.We present a theoretical framework that unifies conditional adjustments for the mean vector and the covariance matrix that is markedly different from the current Bayesian approach. We first derive the multivariate regression relationship implied by conditional distributions; we incorporate the fact that an investor has active views on certain assets. We assume that this regression relationship remains valid when the returns of certain assets change from the equilibrium to the distribution dictated by the investor's view. On the basis of this assumption, we deduce the expected returns and covariance matrix for all assets that are consistent with the investor's view.Our result for the conditional mean vector is equivalent to that of the current method, but the result for the conditional covariance matrix is new. And it is found to be consistent with observed market dynamics. When a volatility shock is anticipated in one asset, our result indicates increases in the volatilities of all assets and increases in correlations between the one asset and other assets.
Journal: Financial Analysts Journal
Pages: 44-51
Issue: 2
Volume: 57
Year: 2001
Month: 3
X-DOI: 10.2469/faj.v57.n2.2432
File-URL: http://hdl.handle.net/10.2469/faj.v57.n2.2432
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# input file: UFAJ_A_12047267_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark J.P. Anson
Author-X-Name-First: Mark J.P.
Author-X-Name-Last: Anson
Title: Performance Presentation Standards: Which Rules Apply When?
Abstract: 
 The U.S. SEC, the Commodity Futures Trading Commission, and AIMR have each established financial reporting requirements for the market participants within their regulatory scope. The performance presentation standards promulgated by these three bodies are compared in this presentation. Particular attention is paid to the issue of which standards are most applicable to hedge funds. Also considered are whether different regulatory target markets justify different performance standards. The financial disclosure standards in the U.S. investment management industry lack uniformity. The U.S. SEC, the Commodity Futures Trading Commission (CFTC), and AIMR have each established performance-reporting requirements for their regulatory constituents. The SEC regulates the reporting requirements for mutual funds and their portfolio managers under the Investment Company Act of 1940. The CFTC regulates the reporting requirements for commodity trading advisors and commodity pool operators under the 1974 Commodity Exchange Act. AIMR regulates the reporting requirements for investment managers claiming compliance with the AIMR Performance Presentation Standardsâ„¢ (AIMR-PPSâ„¢) or with the Global Investment Performance Standardsâ„¢ (GIPSâ„¢).The similarities and differences in performance presentation standards promulgated by these three regulatory bodies are presented and discussed in this article. The six categories of standards are performance history, relative performance, leverage, risk management, fees, and derivatives. The disclosures required in these six categories vary considerably among the three regulatory authorities. For example, the CFTC has no disclosure requirements for derivative use because the firms it regulates use derivatives as primary investment vehicles. The SEC focuses on disclosure of investment strategy rather than a listing of derivative instruments used, and the AIMR-PPS and GIPS standards require disclosure of the use, frequency, and characteristics of derivatives.The article addresses specifically which performance-reporting requirements are most applicable to hedge funds. Hedge funds are difficult to classify because they generally operate outside the regulatory boundaries of the SEC, CFTC, and AIMR. Nonetheless, I conclude that the performance-reporting standards promulgated by the CFTC are the standards most applicable to hedge funds. This conclusion is based on the similarities between hedge fund investment programs and the programs of commodity trading advisors and commodity pool operators.Finally, this article addresses the question of whether different regulatory targets justify different performance-reporting requirements. I argue that reporting requirements should be synchronized to enhance transparency and to reduce informational barriers between different investment markets.
Journal: Financial Analysts Journal
Pages: 53-60
Issue: 2
Volume: 57
Year: 2001
Month: 3
X-DOI: 10.2469/faj.v57.n2.2433
File-URL: http://hdl.handle.net/10.2469/faj.v57.n2.2433
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# input file: UFAJ_A_12047268_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Leslie Hodder
Author-X-Name-First: Leslie
Author-X-Name-Last: Hodder
Author-Name: Mary Lea McAnally
Author-X-Name-First: Mary Lea
Author-X-Name-Last: McAnally
Title: SEC Market-Risk Disclosures: Enhancing Comparability
Abstract: 
 In 1997, the U.S. SEC mandated through Financial Reporting Release No. 48 (FRR48) the disclosure of forward-looking market risk information. Because of the recency of the required risk disclosures, little has been written about them or about how analysts might use them. FRR48 allows three disclosure formats—sensitivity measures, value at risk, and a tabular format. The issue is that variations among the disclosure formats and the discretion allowed about assumptions underlying sensitivity and VAR measures may impair analysts' use of the disclosures. We demonstrate how sensitivity and VAR measures can be derived from the tabular format. Our methodology allows financial analysts to derive risk measures based on consistent assumptions among companies. Tabular data provide a common denominator by which companies may be compared and provide a means of overcoming the limitations of sensitivity and VAR measures. In 1997, the U.S. SEC issued Financial Reporting Release No. 48 (FRR48) requiring companies to disclose qualitative and quantitative market-risk information. The release defines market risk as the risk of loss arising from adverse changes in market rates and prices, such as interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates. Companies may disclose market risk using one of three presentation formats—sensitivities, value at risk (VAR), or a tabular format.We describe the FRR48 disclosure requirements and discuss obstacles analysts may encounter in using them. We demonstrate how comparable and reliable sensitivity and VAR measures can be derived from the tabular format.Sensitivities are measures of the potential losses arising from hypothetical changes in market rates. FRR48 permits companies to choose any reasonably possible near-term rate change to use in calculating sensitivity. They may measure loss in terms of fair value, cash flow, or income. Companies may report the loss they consider most informative if all three are material.Value at risk is the largest loss a company could experience from its market-risk-sensitive instruments in a given holding period under normal market conditions with a specified probability (typically no greater than 5 percent). Companies have leeway in selecting VAR models and assumptions. As with sensitivity, FRR48 permits companies to measure VAR in terms of cash flows, earnings, or fair value. Companies must report backtesting results—the number of times during the year that actual daily losses exceeded the reported VAR or the range of actual daily losses over the year.In the tabular format, risk is not explicitly quantified. Rather, a table lists the attributes of market-sensitive assets and liabilities (including instrument type, book value, maturity, average rate, strike price, and fair value) according to exercise date or time-to-maturity. The tabular format is intended to provide sufficient information to determine the cash flows from the company's financial instruments—presumably, to allow analysts to compute summary risk measures.FRR48 does not require risk disclosures for commodity positions or derivative contracts that settle in “other than cash,” but companies may choose to include such positions in their reported sensitivities or VARs. Consequently, what instruments or positions are covered by management-reported risk measures is not always obvious.FRR48 requires a point estimate for the sensitivity or VAR measure. Analysts, however, typically consider a broad range of outcomes. Analysts cannot easily convert sensitivity disclosures to reflect different hypothetical rate changes. For example, if a company provides a 10 percent sensitivity when analysts believe that a 30 percent change is likely, tripling the number will provide a biased estimate because expected losses are not always linear in rate changes—especially for companies with significant option positions. Few companies report multiple loss sensitivities or VARs, and even fewer companies report gains.Analysts cannot directly compare disclosures in the same format because companies select their own hypothetical rate changes, time horizons, outcome likelihoods, and modeling techniques. Analysts cannot accurately assess a company's models and assumptions because disclosures are cryptic. Furthermore, companies are permitted to define loss in terms of fair values, net income, or cash flow, each of which measures a fundamentally different type of risk.Even more difficult—in fact, inappropriate—is comparing FRR48 disclosures among formats. Sensitivities and VARs are inherently dissimilar risk constructs; directly comparing them will result in erroneous risk assessments. Therefore, analysts need a way to calculate sensitivities and VARs from FRR48 tabular data and publicly available market rates. We demonstrate such a method. Our methodology allows analysts to generate a range (or distribution) of risk measures that reflects consistent assumptions and models.We provide an example of the conversion methodology that uses actual FRR48 disclosures. Although interest rate risk is the focus of the example (because it is the most common form of market risk), the methodology is equally applicable to foreign currency exposure, equity-price risk, and commodity risk. We also discuss applying the method to a number of more complex issues, including derivative positions.
Journal: Financial Analysts Journal
Pages: 62-78
Issue: 2
Volume: 57
Year: 2001
Month: 3
X-DOI: 10.2469/faj.v57.n2.2434
File-URL: http://hdl.handle.net/10.2469/faj.v57.n2.2434
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# input file: UFAJ_A_12047269_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It (a review)
Abstract: 
 This useful account of the brief but spectacular story of LTCM (reviewed together with When Genius Failed: The Rise and Fall of Long-Term Capital Management) provides comprehensive coverage of the academic and practitioner aspects. 
Journal: Financial Analysts Journal
Pages: 80-82
Issue: 2
Volume: 57
Year: 2001
Month: 3
X-DOI: 10.2469/faj.v57.n2.2435
File-URL: http://hdl.handle.net/10.2469/faj.v57.n2.2435
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:2:p:80-82




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# input file: UFAJ_A_12047271_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Investments—Volume 1: Portfolio Theory and Asset Pricing; Volume 2: Securities, Prices and Performance (a review)
Abstract: 
 This collection contains a significant portion of the life's work of two prolific researchers. Volume 1 is appropriate for the reader with mathematical expertise; Volume 2 concentrates on the empirical uses of asset-pricing models. 
Journal: Financial Analysts Journal
Pages: 82-83
Issue: 2
Volume: 57
Year: 2001
Month: 3
X-DOI: 10.2469/faj.v57.n2.2437
File-URL: http://hdl.handle.net/10.2469/faj.v57.n2.2437
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# input file: UFAJ_A_12047272_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Famous First Bubbles: The Fundamentals of Early Manias (a review)
Abstract: 
 In this book, the author continues his crusade to debunk the irrationality of the tulip bulb craze and other historical manias. 
Journal: Financial Analysts Journal
Pages: 84-85
Issue: 2
Volume: 57
Year: 2001
Month: 3
X-DOI: 10.2469/faj.v57.n2.2438
File-URL: http://hdl.handle.net/10.2469/faj.v57.n2.2438
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# input file: UFAJ_A_12047273_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Douglas B. Sherlock
Author-X-Name-First: Douglas B.
Author-X-Name-Last: Sherlock
Title: Problems with Health Insurance: A Comment
Abstract: 
 This material comments on “Problems with Health Insurance”.
Journal: Financial Analysts Journal
Pages: 12-14
Issue: 3
Volume: 57
Year: 2001
Month: 5
X-DOI: 10.2469/faj.v57.n3.2445
File-URL: http://hdl.handle.net/10.2469/faj.v57.n3.2445
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# input file: UFAJ_A_12047275_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark Rubinstein
Author-X-Name-First: Mark
Author-X-Name-Last: Rubinstein
Title: Rational Markets: Yes or No? The Affirmative Case
Abstract: 
 With the recent flurry of articles declaiming the death of the rational market 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 assumption is clearly an expository device not to be taken seriously. 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, abnormal profit opportunities still may not exist. In that case, markets may be said to be “minimally rational.” I maintain that not only are developed financial markets minimally rational, they are, with two qualifications, rational. I contend 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. I also argue that investor irrationality, to the extent that it affects prices, is particularly likely to be manifest through overconfidence, which in turn, is likely to make the market “hyper-rational.” To illustrate, the article reexamines some of the most serious historical evidence against market rationality. With the recent flurry of articles declaiming the death of the rational market hypothesis, now is a good time 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 assumption is clearly an expository device not to be taken seriously. What is in contention is whether or not markets are rational, in the sense that prices are set as if all investors are rational. Even if we conclude that markets are not rational in this sense, abnormal profit opportunities still may not exist. In that case, the markets may be said to be “minimally rational.” I maintain here that developed financial markets are minimally rational and, with two qualifications, even achieve the higher standard of rationality.The philosophical basis for rational markets has a long and illustrious history. It derives from the ancient Greeks, was strengthened during the Enlightenment, bolstered by Darwinian evolutionary theory, and given its most profound exposition in the 20th century by Nobel laureate Friedrich Hayek, who saw the price system as an efficient and continuously functioning gigantic polling mechanism.Several factors lead to minimally rational markets—the self-destruction of profitable trading strategies, self-destruction of irrational traders, exposure of irrational traders by performance measurement, and cross-cancellation of irrational trades. The most telling reason, however, follows from the key type of irrationality emphasized in behavioral finance—investor overconfidence. Overconfidence leads to excessive investment in research and to market prices that are, in a sense, hyper-rational. This assertion is empirically supported by the long history of studies of mutual fund performance showing that the average mutual fund underperforms an index fund, thereby effectively squandering its research expenses. In addition, little evidence has been found that even one mutual fund has outperformed the average more than would have been expected by chance. The superior historical performance of U.S. equity index funds weighs heavily against the list of reported market anomalies because it is the result of actual, not paper or imagined, strategies.Nonetheless, the case for market rationality is even stronger if the most important reported anomalies—excess volatility, the risk-premium puzzle, the size anomaly, closed-end fund discounts, calendar effects, and the 1987 stock market crash—can be directly countered. This article tackles that challenge by arguing that the anomalies can be best explained within the hypothesis of market rationality. In some cases, the anomaly turns out to be an empirical illusion; in others, the models that fail to explain the anomaly contain unrealistic assumptions. For example, a key failing of most academic models is the assumption that investors know with certainty the characteristics of other investors in the market. This assumption, which has nothing to do with market rationality, needs to be dropped before the models can realistically explain the anomalies.
Journal: Financial Analysts Journal
Pages: 15-29
Issue: 3
Volume: 57
Year: 2001
Month: 5
X-DOI: 10.2469/faj.v57.n3.2447
File-URL: http://hdl.handle.net/10.2469/faj.v57.n3.2447
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# input file: UFAJ_A_12047276_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ron Lazer
Author-X-Name-First: Ron
Author-X-Name-Last: Lazer
Author-Name: Baruch Lev
Author-X-Name-First: Baruch
Author-X-Name-Last: Lev
Author-Name: Joshua Livnat
Author-X-Name-First: Joshua
Author-X-Name-Last: Livnat
Title: Internet Traffic and Portfolio Returns
Abstract: 
 We examined whether traffic data on sites owned by publicly listed Internet companies provide information about the future of those companies that is useful in portfolio management. The study shows that when Internet companies are classified into portfolios according to above-median and below-median traffic data, the more popular sites provide significantly better stock returns than the less popular sites. These results may be explained by the superior ability of popular sites to attract advertising revenues and extract greater compensation from affiliated sites. They may also indicate investors' perceptions that the more popular sites have greater network externalities (in which the value of being a part of the network increases with the number of members already in the network) and have the ability to generate higher future profits and cash flows. These results carried through to offline companies with Internet sites in 1999 but not in 2000, possibly because the online operations of offline companies were still not a material component of the companies' revenues and cash flows. The primary purpose of this study was to determine whether the market rewards Internet companies that have high traffic relative to companies that have lower traffic. Portfolio managers may use the results of this study to select Internet stocks that are likely to provide superior returns.Prior studies have shown that measures of Internet traffic can be useful beyond historical revenues in the prediction of future revenues of online companies. Prior research has also shown that traffic measures are important variables, in addition to traditional financial measures, for the contemporaneous valuation of Internet companies. No prior studies, however, have examined whether knowledge of the traffic data can help a portfolio manager select companies for a portfolio that will systematically earn superior future returns.We used reported Media Metrix traffic data for 15 months in 1999 and 2000 to classify Internet companies into two groups—those with above-median traffic and those with below-median traffic. The particular traffic measures we used included number of different individuals that visited the site, percentage of total Web users that visited the site, and an intensity measure of the average number of days during a month that a user visited the site. We then analyzed the returns to the portfolios after holding them for a month following portfolio formation.This study shows that the traffic measures do classify Internet companies into those with superior future returns—during both the Internet boom of March 1999 to December 1999 and the period of disillusionment, January 2000 to May 2000, when many Internet companies had negative returns. Examination of the returns of the two groups in the month after Media Metrix's release of the traffic data and portfolio formation indicates that the portfolio of above-median-traffic companies enjoyed significantly higher returns than those with low traffic. The results indicate that a portfolio manager could have obtained superior portfolio returns from Internet stocks during the period studied by buying access to the ranking data and focusing on the companies with the higher traffic measures.An explanation for these results is that high traffic may translate immediately into greater advertising revenues—one of the most important revenue sources for sites that primarily provide content to their users. Furthermore, high traffic may indicate that the size of the potential market for the site's products and services is larger than for low-traffic sites and that the companies have the potential for greater revenues and cash flows. Finally, the site's ability to attract traffic may indicate the ability of the company managers to implement and execute their online strategies. Companies that were able to attract and build traffic in spite of volatile conditions characterizing the study period may be more likely to continue doing so in the future. Traffic measures may thus be complements to, or even substitutes for, the generally accepted but elusive “value drivers” of Internet companies (such as sales growth). Our results also indicate that even companies that do not generate most of their revenues from the Internet outperformed their counterparts when they had higher traffic into their Web sites in 1999 but not in 2000.
Journal: Financial Analysts Journal
Pages: 30-40
Issue: 3
Volume: 57
Year: 2001
Month: 5
X-DOI: 10.2469/faj.v57.n3.2448
File-URL: http://hdl.handle.net/10.2469/faj.v57.n3.2448
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:3:p:30-40




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# input file: UFAJ_A_12047277_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert Tumarkin
Author-X-Name-First: Robert
Author-X-Name-Last: Tumarkin
Author-Name: Robert F. Whitelaw
Author-X-Name-First: Robert F.
Author-X-Name-Last: Whitelaw
Title: News or Noise? Internet Postings and Stock Prices
Abstract: 
 The anecdotal evidence is growing that postings in Internet financial forums affect stock prices, either because the postings contain new information or because they represent successful attempts to manipulate stock prices. From an investment perspective, knowing whether this phenomenon is pervasive is important. We examined the relationship between Internet message board activity and abnormal stock returns and trading volume in the period from mid-April 1999 to mid-February 2000. Our study focused on the RagingBull.com discussion forum, an extremely popular site whose format permits the construction of an objective measure of investor opinions. For stocks in the Internet service sector, we found that on days with abnormally high message activity, changes in investor opinion correlated with abnormal industry-adjusted returns. These event days also coincided with abnormally high trading volume, which persisted for a second day. However, we found that message board activity did not predict industry-adjusted returns or abnormal trading volume, which is consistent with market efficiency. Growing anecdotal evidence indicates that postings in Internet financial forums affect stock prices. Clearly, if forums such as message boards contain new information activity, they may help predict stock returns. Even in the absence of any value-relevant information, large numbers of investors may follow the buy and sell recommendations of message board users, thereby inducing deviations in prices from their efficient levels. Furthermore, day traders may recognize the momentum generated by investors who use message boards, thus exaggerating this effect. From an investment perspective, therefore, knowing whether postings affect prices is important.Researchers have begun to explore both the valuation of Internet stocks and the effects of Internet activity on equity valuation, but the focus has been on using accounting data or Web traffic to explain prices. In contrast, we examine directly whether the changes in opinions contained in Internet forums can predict stock returns and/or trading volume.Our study focused on the RagingBull.com discussion forum, an extremely popular site whose format permits the construction of an objective measure of investor opinion. We limited the analysis to stocks in the Internet service sector because they are natural candidates for the most discussion and thus most likely to be affected by information in Internet forums. We present both the event study and the vector autoregression analysis of the data that we carried out.The event study examined abnormal stock returns and trading volume around days with abnormal message board activity in the period from mid-April 1999 to mid-February 2000. An “event day” was defined as a day when the number of message postings exceeded the five-day moving average number of message postings by two standard deviations. The results show that days with strongly positive changes in message board opinions are preceded by a small abnormal increase in stock price. We also found that message board opinion and abnormal returns on the event day are related. We found little evidence, however, that opinion predicts future returns. Trading volume increased significantly on the event day and generally remained high for one day thereafter.The vector autoregression analysis examined whether daily returns, trading volume, the number of messages posted, and opinion can be used to predict these variables one day in the future. Consistent with the results from the event study, we found that it is not possible to predict returns using any of the variables. After controlling for the well-known effect that trading volume is positively related to the previous day's trading volume, we found message board activity to have no predictive power for trading activity.Our overall conclusion is that no causal link exists from message board activity to stock returns and volume. In fact, we found that it is market information that influences message board activity rather than the other way around. These results are completely consistent with market efficiency. They may also provide some comfort to investment professionals that the value of their portfolios may not be subject to the notoriously fickle opinions of the Internet community.
Journal: Financial Analysts Journal
Pages: 41-51
Issue: 3
Volume: 57
Year: 2001
Month: 5
X-DOI: 10.2469/faj.v57.n3.2449
File-URL: http://hdl.handle.net/10.2469/faj.v57.n3.2449
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:3:p:41-51




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# input file: UFAJ_A_12047278_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert Ferguson
Author-X-Name-First: Robert
Author-X-Name-Last: Ferguson
Author-Name: Dean Leistikow
Author-X-Name-First: Dean
Author-X-Name-Last: Leistikow
Title: Valuing Active Managers, Fees, and Fund Discounts
Abstract: 
 We use risk-neutral valuation to value a portfolio and decompose the value into the components accruing to its stakeholders—service providers, portfolio managers, and the owners. The analysis incorporates managers' expected performance and contract-renewal issues. It provides a paradigm for valuing active portfolio management. A managed portfolio's economic value is shown to differ from its net asset value. The article provides an improved foundation for computing fair closed-end fund discounts and a partial explanation of equilibrium in the markets for open- and closed-end mutual funds. The article implies that changes in closed-end fund discounts are the analog of open-end fund inflows. It also shows that closed-end fund discounts are relatively sensitive to small changes in anticipated fund performance. We use risk-neutral valuation to value a portfolio and decompose the value into the components accruing to its stakeholders—service providers, portfolio managers, and the owner. The work extends an earlier model for valuing investment management fees. In particular, the analysis incorporates the portfolio manager's expected performance, allows the portfolio's value to change over time, takes account of management fees paid from the fund and from external sources, and incorporates the portfolio's distributions (e.g., yield) and expenses (e.g., nonmanagement fees).We also provide a paradigm for valuing active portfolio management. Active management's value to the manager is the difference between the fee structure's value obtained by assuming the manager's true talent minus the value obtained by assuming no talent. Active management's value to the client is the difference between the value of the client's interest obtained by assuming the manager's true talent minus the value obtained by assuming no talent. Active management's total value is the sum of its value to the manager, the client, and the other stakeholders. Active management's value can be positive, zero, or negative, depending on the manager's talent.A by-product of the analysis is a partial explanation of equilibrium in the market for open- and closed-end mutual funds. For closed-end funds, the fund's economic value reflects the marginal shareholder's expected performance. Because the number of shares outstanding is fixed and investors are heterogeneous, the marginal shareholder's expected performance generally will not imply an economic value equal to the fund's net asset value. Thus, closed-end funds will sell at discounts or premiums to NAV. For open-end funds, generally, the economic value may seem not to be NAV, and hence not the market price of the stock, but equilibrium in the open-end fund market requires only that the marginal shareholder's computation of economic value yield NAV. If the existing marginal shareholder's expected performance implies an economic value above NAV, then contributions will continue until the new marginal shareholder's expected performance implies an economic value equal to NAV. If the existing marginal shareholder's expected performance implies an economic value below NAV, then redemptions will occur until the performance expected by the new marginal shareholder implies an economic value equal to NAV. Thus, an open-end fund's size is determined by the distribution of the fund's expected performance among investors. The implication is that as long as investors' performance expectations are positively correlated with measures of past performance, a positive relationship will exist between past performance and open-end fund (relative) net inflows. Indeed, researchers have documented empirically a positive relationship between past performance and open-end fund (relative) net inflows. The analysis also implies that changes in closed-end fund discounts are the analog of open-end fund inflows.As we demonstrate, closed-end fund discounts are relatively sensitive to small changes in anticipated fund performance. Thus, contrary to the literature, the existence of discounts and the fact that they are volatile does not imply inefficiency in the closed-end fund market.We have elsewhere presented empirical support for the model described here. In this article, we present evidence consistent with the theory to explain how the initial public offering of an equity closed-end fund can sell at a premium when existing funds sell at a discount and why the initial IPO premiums decay after the IPO. Tests on (1) the relationship between relative-premium changes and investment performance following IPOs, (2) relative-premium mean reversion following management changes, and (3) net redemptions following closed-end fund open endings for funds trading at pre-open-ending announcement discounts strongly support the theory.
Journal: Financial Analysts Journal
Pages: 52-62
Issue: 3
Volume: 57
Year: 2001
Month: 5
X-DOI: 10.2469/faj.v57.n3.2450
File-URL: http://hdl.handle.net/10.2469/faj.v57.n3.2450
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:3:p:52-62




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# input file: UFAJ_A_12047279_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Heiko Leschhorn
Author-X-Name-First: Heiko
Author-X-Name-Last: Leschhorn
Title: Managing Yield-Curve Risk with Combination Hedges
Abstract: 
 The method presented here to evaluate and regulate the risk exposure of default-free bonds generalizes the traditional duration concept by taking nonparallel changes in the term structure of interest rates into account. The article shows how to immunize a default-free bond by hedging with two standard hedging instruments (a combination hedge) and how to replicate a diversified bond portfolio by using a few standard hedging instruments. This standard hedging instrument representation can provide comprehensive information about the risk structure of the portfolio, and trading the standard hedging instruments can help fine-tune a position. Managing the yield-curve risk of bond or swap portfolios consists of two tasks: (1) quantifying the risk exposure of the portfolio with respect to a change in the yield curve and (2) adjusting the risk in a predetermined way (i.e., the hedging problem). Useful methods for attacking the first problem, evaluating the risk exposure, are the three-factor approach based on a principal-components analysis of historical data, the concept of key-rate durations, and value at risk. But these methods are less helpful for solving the hedging problem; thus, many market participants (and electronic trading and information systems) still use the traditional duration concept to calculate a risk measure (basis point value) and hedge quantities. The duration concept has the severe weakness, however, that it considers only parallel yield-curve shifts.The approach proposed here enables traders and portfolio managers to quantify and regulate the risk in a single bond investment or a bond portfolio. The approach generalizes the duration concept by introducing a flexible model for nonparallel shifts of the yield curve, which are triggered by the yield changes of standard hedging instruments—for example, bond futures. In this article, I derive a combination hedge for a bond consisting of two neighboring standard hedging instruments with maturities, respectively, shorter than and longer than the maturity of the bond. For example, a 7-year bond would be hedged with a certain ratio of a 5-year hedging instrument and a 10-year instrument. The difference between the duration hedge and the hedge ratios based on this approach is that the yield spreads come into play in this approach, which immunizes against slope changes in the yield curve.An empirical study performed with several German government bonds shows that hedging a single bond with two instruments results in a better hedge than hedging with only one instrument. Furthermore, the analysis demonstrates that the hedge ratios can be used to price a single bond and thereby assess whether the market price of the bond allows arbitrage.A portfolio consisting of bonds whose maturities lie between the maturities of two standard hedging instruments can be hedged with those two instruments. The notional amount is given by the sum of the hedge quantities for a single bond. To hedge a portfolio of bonds with a wide range of maturities, three or more instruments typically have to be considered. I show how to represent a portfolio of default-free bonds by a set of at least two standard hedging instruments—that is, standard hedging instrument representation (SHIR). A historical analysis demonstrates that the profit/loss of a diversified portfolio consisting of German government bonds with maturities between 2 and 10 years is approximately equal to the P/L of the SHIR consisting of a 2-year, a 5-year, and a 10-year standard hedging instrument. The SHIR of the portfolio serves as a risk measure because the risk exposures of the standard hedging instruments are known from their durations or from other methods. The SHIR nicely represents what yield-curve movement traders and portfolio managers speculate on, and it enables them to fine-tune their positions by trading the liquid standard hedging instruments.
Journal: Financial Analysts Journal
Pages: 63-75
Issue: 3
Volume: 57
Year: 2001
Month: 5
X-DOI: 10.2469/faj.v57.n3.2451
File-URL: http://hdl.handle.net/10.2469/faj.v57.n3.2451
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:3:p:63-75




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# input file: UFAJ_A_12047280_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Darrell Duffie
Author-X-Name-First: Darrell
Author-X-Name-Last: Duffie
Author-Name: Jun Liu
Author-X-Name-First: Jun
Author-X-Name-Last: Liu
Title: Floating–Fixed Credit Spreads
Abstract: 
 We examine the term structure of yield spreads between floating-rate and fixed-rate notes of the same credit quality and maturity. Floating–fixed spreads are theoretically characterized in some practical cases and quantified in a simple model in terms of maturity, credit quality, yield volatility, yield-spread volatility, correlation between changes in yield spreads and default-free yields, and other determining variables. We show that if the issuer's default risk is risk-neutrally independent of interest rates, the sign of floating–fixed spreads is determined by the term structure of the risk-free forward rate. We discuss the term structure of yield spreads between floating-rate and fixed-rate notes of the same credit quality and maturity. Floating–fixed spreads are theoretically characterized in some practical cases and quantified in a simple model in terms of maturity, credit quality, yield volatility, correlation between changes in yield spreads and default-free yields, and other determining variables.We show that if the issuer's default risk is risk-neutrally independent of interest rates, the sign of the floating–fixed spread is determined by the term structure of the risk-free forward rate. For example, if the term structure of default-free rates is increasing up to some maturity, then spreads on floating-rate debt are larger than spreads on fixed-rate debt. Conversely, under the same independence assumption, if the default-free term structure is inverted, floating-rate spreads are smaller than fixed-rate spreads.Intuitively, if the term structure is upward sloping, investors anticipate that floating-rate coupons are likely to increase with time. Default risk for a given issuer increases with time because the issuer cannot survive to a particular time unless it also survives to each time before that date. Because the higher anticipated coupon payments of later dates are also the more likely to be lost to default, investors must be compensated by a floating-rate spread that is slightly larger than the fixed-rate spread.In terms of magnitude, however, in most practical cases, floating–fixed spreads are small, typically (as is shown by example) a few basis points at most. Our persistent queries to market practitioners have generated no examples in which market participants make a distinction between par floating-rate spreads and par fixed-rate spreads except for certain cases in which one of these forms of debt is viewed as “more liquid” than another, an issue that we do not pursue.For example, consider an issuer whose credit quality implies a fixed-rate spread on five-year par-coupon debt of 100 basis points (bps) over the rate on default-free five-year par-coupon fixed-rate debt. Suppose changes in credit quality are not correlated with state prices (in a sense that is made precise). In a typical upward-sloping term-structure environment, based on the steady-state behavior of a two-factor Cox–Ingersoll–Ross model fitted to LIBOR swap rates recorded during the 1990s, floating-rate debt of the same credit quality and maturity would be issued at a spread of roughly 101 bps. This is, of course, not to say that the issuer should prefer to issue fixed-rate rather than floating-rate debt but, rather, that a slightly higher credit spread is required to compensate investors paying par for floating-rate debt.As suggested by this example, the magnitude of the floating–fixed spread associated with default risk is sufficiently small that one could safely attribute any nontrivial differences that may exist in actual fixed and floating rates of the same credit quality to institutional differences between the fixed- and floating-rate note markets.For our model, the floating–fixed spread is roughly linear in the issuer's fixed-rate credit spread, roughly linear in the slope of the yield curve, roughly linear in the level of the yield curve, and roughly linear in the correlation between changes in default-free yields and fixed-rate yield spreads. The floating–fixed spread is nonlinear in maturity. When the slope is held constant, there is essentially no dependence in the level of the yield curve. The floating–fixed spread is greatest at high-yield-spread volatility and at high correlation between yield spread and default-free yields.
Journal: Financial Analysts Journal
Pages: 76-87
Issue: 3
Volume: 57
Year: 2001
Month: 5
X-DOI: 10.2469/faj.v57.n3.2452
File-URL: http://hdl.handle.net/10.2469/faj.v57.n3.2452
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:3:p:76-87




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# input file: UFAJ_A_12047281_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bruce I Jacobs
Author-X-Name-First: Bruce I
Author-X-Name-Last: Jacobs
Title: Capital Ideas and Market Realities: Option Replication, Investor Behavior, and Stock Market Crashes (Postscript: Author's Comment)
Abstract: 
 In this comment, the book's author responds to a revised review of his book. 
Journal: Financial Analysts Journal
Pages: 88-88
Issue: 3
Volume: 57
Year: 2001
Month: 5
X-DOI: 10.2469/faj.v57.n3.2453
File-URL: http://hdl.handle.net/10.2469/faj.v57.n3.2453
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:3:p:88-88




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# input file: UFAJ_A_12047283_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Daren E. Miller
Author-X-Name-First: Daren E.
Author-X-Name-Last: Miller
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Early History of Financial Economics, 1478–1776: From Commercial Arithmetic to Life Annuities and Joint Stocks (a review)
Abstract: 
 This wide-ranging volume traces the distant roots of modern financial economics across Europe (with emphasis on the major commercial centers) and through time, from the Renaissance to the Enlightenment. 
Journal: Financial Analysts Journal
Pages: 89-90
Issue: 3
Volume: 57
Year: 2001
Month: 5
X-DOI: 10.2469/faj.v57.n3.2455
File-URL: http://hdl.handle.net/10.2469/faj.v57.n3.2455
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:3:p:89-90




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# input file: UFAJ_A_12047284_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Puzzles of Finance: Six Practical Problems and Their Remarkable Solutions (a review)
Abstract: 
 This set of essays teaches some key fundamentals of finance through intriguing paradoxes and anomalies. 
Journal: Financial Analysts Journal
Pages: 90-91
Issue: 3
Volume: 57
Year: 2001
Month: 5
X-DOI: 10.2469/faj.v57.n3.2456
File-URL: http://hdl.handle.net/10.2469/faj.v57.n3.2456
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:3:p:90-91




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# input file: UFAJ_A_12047285_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Rise of Fiduciary Capitalism: How Institutional Investors Can Make Corporate America More Democratic (a review)
Abstract: 
 This useful book spells out the growing power of the managers of public and private pension funds, mutual funds, and other fiduciary accounts and shows their impact on the equity markets and on the national economy. 
Journal: Financial Analysts Journal
Pages: 91-93
Issue: 3
Volume: 57
Year: 2001
Month: 5
X-DOI: 10.2469/faj.v57.n3.2457
File-URL: http://hdl.handle.net/10.2469/faj.v57.n3.2457
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:3:p:91-93




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# input file: UFAJ_A_12047286_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The ValueReportingâ„¢ Revolution: Moving Beyond the Earnings Game (a review)
Abstract: 
 This book provides a valuable critique of the status quo in financial reporting and securities analysis and calls for corporations to step up their reporting of nonfinancial data. 
Journal: Financial Analysts Journal
Pages: 93-95
Issue: 3
Volume: 57
Year: 2001
Month: 5
X-DOI: 10.2469/faj.v57.n3.2458
File-URL: http://hdl.handle.net/10.2469/faj.v57.n3.2458
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# input file: UFAJ_A_12047287_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: H. Gifford Fong
Author-X-Name-First: H. Gifford
Author-X-Name-Last: Fong
Title: From the Editor
Abstract: 
 In 1977, Oldrich Vasicek published his seminal paper “An Equilibrium Characterization of the Term Structure” in the Journal of Financial Economics (November, pp. 177–188). It established the first theoretically rigorous framework for modeling the behavior of interest rates over time. From this starting point, a new path of inquiry has evolved with important implications for all current fixed-income analysis. In the next few issues of the Financial Analysts Journal, we will showcase a number of articles that highlight important developments in modeling the term structure of interest rates. We start in this issue with two survey articles. The Hong Yan article provides an overview of the theoretical developments found in the literature; the article by David Chapman and Neil Pearson provides a review of the empirical studies. In subsequent issues, we will have additional articles from leading fixed-income researchers who extend the coverage of this important area. The mission of the FAJ is to publish high-quality research relevant to the practitioner. Term-structure modeling is an area that is fundamental to the understanding and analysis of interest rates and one that has a rich theoretical and empirical foundation. I would like to extend a special thanks to the authors who participated in this effort, which is intended to provide a sound reference perspective and stimulate application based on state-of-the-art research. 
Journal: Financial Analysts Journal
Pages: 15-15
Issue: 4
Volume: 57
Year: 2001
Month: 7
X-DOI: 10.2469/faj.v57.n4.2460
File-URL: http://hdl.handle.net/10.2469/faj.v57.n4.2460
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:4:p:15-15




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Author-Name: Hans R. Stoll
Author-X-Name-First: Hans R.
Author-X-Name-Last: Stoll
Title: Market Fragmentation
Abstract: 
 Linking of various competing markets should be implemented through improvements in upstairs order routing, not downstairs mechanishms. Market fragmentation is in the news. U.S. SEC Chairman Arthur Levitt has spoken against the harmful effects of market fragmentation, and the SEC has asked for comments on possible solutions to fragmentation in markets. The SEC has also requested plans for linking options markets and has approved a plan submitted by the Amex, Chicago Board Options Exchange, and International Securities Exchange. The heads of major brokerages have testified on the need for a national central limit-order book (CLOB) that would consolidate all order flow and assure price/time priority across all markets. The NYSE opposes both any new CLOB and the continuation of the old Intermarket Trading System (ITS), which links the NYSE and the regional exchanges.How serious is market fragmentation? Should the SEC impose a regulatory solution? Should the various competing markets be linked into one market? I discuss the importance and extent of market fragmentation, the difficulties of directly linking downstairs markets, and a possible solution to lack of links in the markets.Market fragmentation arises when investors send their orders to a market where the orders do not interact with orders from other markets. Price priority (by which the order receives the best price in any market) is maintained in fragmented markets when each market promises to match the national best bid or offer. Time priority (by which the order goes to the market or dealer that first displays the best price), however, is frequently violated. And even price priority can be difficult to maintain if, for example, a large order in one market trades through prices in another market. Certain new electronic markets do not promise to match the best price elsewhere.Most proposed market-linking mechanisms are structured to link downstairs trading floors and trading facilities after a customer order has reached a particular market. The idea is that a market receiving a customer order would take control of that order, either executing it or sending it via a direct linking mechanism to another market. Linking markets by a downstairs linking mechanism should, however, be questioned.First, requiring trading markets to link up directly is undesirable because it reduces competition among the markets. If markets must belong and conform to a linking mechanism, innovation and competition among markets are likely to be impaired. Second, a downstairs linking mechanism is unlikely to be successful because no one would own it. It would be the common property of the linked markets, but no market would have an incentive to improve and update the mechanism. Third, the need for a downstairs mechanism to link markets has been overstated. Markets are already linked by upstairs order-routing systems. If a problem exists with the links, we should improve the current upstairs linking mechanism by increasing transparency and improving upstairs routing systems. Two implications of this approach are that the ITS should be allowed to wither away and that a formal linking mechanism for options markets, such as that recently approved by the SEC, is not necessary.The challenge for regulators is not what new linking system to construct but whether to impose rules on brokers for routing their orders. Regulators may want to specify more clearly what constitutes best execution for upstairs brokers, including rules for upstairs order routing that forge the desired links. Order routing according to strict price/time priority across markets would be detrimental to markets because it would create artificial incentives to start new markets.Requiring orders to be sent to a market with the best posted price, however, would be a reasonable step toward reducing market fragmentation. Such a rule would eliminate the option that now exists for market makers to match the best price for orders they wish to execute and fail to match the best price for orders they do not wish to execute. To work, the “best posted price” rule would need to be limited to orders that can be guaranteed execution by the market. The rule would make preferencing more difficult because a market maker would have to be ready to trade at the posted price vis-à-vis all comers, not simply preferenced orders. To the extent that a decline in preferenced order flow occurred, more orders would interact in price determination.
Journal: Financial Analysts Journal
Pages: 16-20
Issue: 4
Volume: 57
Year: 2001
Month: 7
X-DOI: 10.2469/faj.v57.n4.2461
File-URL: http://hdl.handle.net/10.2469/faj.v57.n4.2461
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:4:p:16-20




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# input file: UFAJ_A_12047289_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Gary L. Caton
Author-X-Name-First: Gary L.
Author-X-Name-Last: Caton
Author-Name: Jeremy Goh
Author-X-Name-First: Jeremy
Author-X-Name-Last: Goh
Author-Name: Jeffrey Donaldson
Author-X-Name-First: Jeffrey
Author-X-Name-Last: Donaldson
Title: The Effectiveness of Institutional Activism
Abstract: 
 We examined earnings-forecast revisions and stock returns after release of the Focus List of poorly performing companies by the Council of Institutional Investors. Using Tobin's q as a measure of a company's ability to improve performance, we found significant and positive abnormal forecast revisions and post-release stock returns for companies with q greater than 1. For companies with q less than 1, neither forecast revisions nor post-release stock returns were significantly different from zero. For the full sample of companies on the Focus List, regression analysis showed a significant positive relationship between forecast revisions and post-release stock returns. These findings support our proposition that institutional activism is effective for underperforming companies—but only those companies with the ability to respond to the challenge to improve performance. Is institutional activism effective in prodding companies to improve performance? The answer provided by previous research is that, although shareholders can influence governance decisions, such as the adoption of a poison pill, their actions have little influence on equity values. Representative examples of this line of research have found no stock market reaction to public announcements of shareholder-initiated proxy proposals and only insignificant abnormal returns around the date of proxy mailings by activist pension funds. Such studies provide seemingly convincing evidence that actions by institutional investors do not influence management performance in meaningful ways.We took a fresh look at the question by examining the announcement effects of being included on the Focus List published by the Council of Institutional Investors, an association of large pension fund management firms. The CII Focus List identifies underperforming companies. By doing so, the CII hopes that its members will focus attention on these companies and that a collaborative campaign by members will then compel an improvement in managerial efforts and company performance.Increased attention means little, however, to companies that lack the tools necessary to improve performance, tools that may include competitive positioning, cost advantages, and growth opportunities. To measure whether companies on the Focus List had the necessary tools, we used Tobin's q, the ratio of the market value of the company to the replacement value of its assets. We argue that those companies with Tobin's q greater than 1 have the needed tools to improve whereas companies with Tobin's q less than 1 do not.To test the effectiveness of the potential collaborative effort to encourage improvement in performance, we examined abnormal stock returns and revisions in analysts' earnings forecasts for the companies appearing on the Focus List. For the full sample, we report significant mean cumulative abnormal returns (CARs) of −12.33 percent in the three months leading up to release of the list, significant announcement-period returns of −0.91 percent, insignificant earnings forecast revisions, and insignificant post-release CARs. These results support the findings of previous studies.When we split the sample on the basis of q > 1 and q < 1, we found negative pre-release and announcement-period CARs for both groups. But the similarities end there. For the companies with Tobin's q > 1 (those with the necessary tools to improve performance), we found significant positive revisions in analysts' earnings forecasts and significant post-release stock returns of +7.01 percent. Thus, we conclude that the stock market considers being on the Focus List bad news for all companies, but analysts see a silver lining for the companies whose Tobin's q is greater than 1. The analysts apparently use appearance on the list as a sign that these companies will buckle down to improve performance and thus a sign to upgrade earnings forecasts for the companies. And subsequently, stock returns rise to reflect the improved earnings outlooks.For companies with Tobin's q < 1 (those without the tools to succeed), we found no such silver lining. Both earnings-forecast revisions and post-release equity returns were insignificantly different from zero.If we had not split our sample, we would have concluded, as previous researchers have, that institutional activism is ineffective in influencing manager efforts and company performance. Only when we recognized that the sample consisted of two distinct groups did we find evidence supporting the effectiveness of institutional activism. We conclude that institutional activism can be effective but only for those companies with the necessary tools to respond to the challenge to improve performance.
Journal: Financial Analysts Journal
Pages: 21-26
Issue: 4
Volume: 57
Year: 2001
Month: 7
X-DOI: 10.2469/faj.v57.n4.2462
File-URL: http://hdl.handle.net/10.2469/faj.v57.n4.2462
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# input file: UFAJ_A_12047290_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Greg Roth
Author-X-Name-First: Greg
Author-X-Name-Last: Roth
Author-Name: Andy Saporoschenko
Author-X-Name-First: Andy
Author-X-Name-Last: Saporoschenko
Title: Institutional Ownership of Bank Shares
Abstract: 
 U.S. bank regulations weaken the incentives for market-based monitoring of bank CEOs, and bank assets are difficult for outside investors to value. Therefore, we analyzed factors that might influence institutional holdings of bank shares. Our primary expectation was that alignment of the economic interests of bank CEOs with those of bank shareholders would be particularly important in determining which banks attract institutional investment funds. Our results suggest that the sensitivity of a bank CEO's compensation to shareholder wealth does have a positive influence on the proportion of a bank's shares held by institutional investors. Additional evidence suggests that bank size is positively related to institutional ownership whereas capital adequacy and stock variance are negatively related to institutional ownership. In general, the evidence implies that when a company's quality is difficult for outside investors to determine, portfolio managers consider the economic incentives of company managers. Professional money managers face unique challenges when selecting U.S. bank stocks to include in their portfolios. The existing finance literature suggests that bank assets are relatively difficult for outside investors to value. Additionally, U.S. bank regulations have historically weakened incentives for market-based monitoring of bank CEOs. In general, although some high-profile instances of U.S. institutional shareholder activism have occurred, notably by the California Public Employee's Retirement System, institutional investors are generally considered to be passive. When a bank stock is underperforming, most money managers would rather sell the shares than incur the costs of becoming involved in the bank's corporate governance.Faced with severe information asymmetries (i.e., situations in which company insiders have better information about the quality of company assets than do company outsiders) and weak incentives to influence CEOs, what variables do portfolio managers consider when investing in bank shares? To identify the factors that might affect money managers' decisions to hold individual bank shares, we gathered information on the following bank-specific characteristics: sensitivity of the CEO's total compensation to share performance, bank size, bank capital adequacy, variance of the bank stock's return, the proportion of directors who are outsiders, share ownership by outside directors, ownership of shares by blockholders affiliated with management (such as employee stock ownership plans), the market-to-book ratio, board size, whether the CEO is also the board chair, and whether the bank is a money center bank. We regressed the percentage of bank shares held by institutional investors on these bank-specific characteristics.The factor of primary interest to us was sensitivity of the CEO's compensation to share performance. Our thesis was that professional money managers will invest more heavily in banks in which the CEO's compensation package is sensitive to changes in bank shareholder wealth (i.e., pay–performance sensitivity). Such a compensation structure should demonstrate to portfolio managers the bank CEO's commitment to maximizing shareholder wealth and the CEO's confidence in the quality of the bank's assets. Our measure of CEO pay–performance sensitivity was the estimated dollar change in the CEO's wealth caused by a $1,000 change in the total market value of bank equity.We found that the sensitivity of bank CEO pay to share performance is positively related to the institutional ownership of banks. Bank capital adequacy, however, was found to be negatively related to the proportion of bank shares held by institutions. Several writers in the finance literature have argued that the interests of bank managers and bank shareholders are more likely to be closely aligned when bank leverage is high. Accordingly, the evidence concerning CEO compensation structure and capital adequacy is consistent with professional money managers investing more heavily in banks with low manager–shareholder conflict.Additional evidence suggests that the institutional ownership of banks is negatively related to bank stock return volatility and positively related to bank size. Return volatility is commonly considered a measure of idiosyncratic (stand-alone) risk, but the measure can also be interpreted as a measure of information asymmetry. Company size is a measure of stock liquidity, which is valued by institutional investors. Company size should also lower information asymmetry, however, because of the greater analyst following, regulatory scrutiny, and media attention large companies attract. Consequently, the evidence regarding volatility, size, and institutional holdings suggests that portfolio managers prefer the less risky bank stocks, liquid bank stocks, and/or the stocks of banks with relatively minor information asymmetry.In general, the evidence from this study implies that when company quality is difficult for outside investors to determine and when incentives for outside shareholders to monitor managers are weak, portfolio managers consider whether the economic interests of company managers are aligned with the economic interests of shareholders.
Journal: Financial Analysts Journal
Pages: 27-36
Issue: 4
Volume: 57
Year: 2001
Month: 7
X-DOI: 10.2469/faj.v57.n4.2463
File-URL: http://hdl.handle.net/10.2469/faj.v57.n4.2463
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# input file: UFAJ_A_12047291_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jeff Diermeier
Author-X-Name-First: Jeff
Author-X-Name-Last: Diermeier
Author-Name: Bruno Solnik
Author-X-Name-First: Bruno
Author-X-Name-Last: Solnik
Title: Global Pricing of Equity
Abstract: 
 Global equity management has historically been structured around country asset allocation. This approach was supported by the observations that the country factor is the major source of influence on stock-price behavior and that the correlation between equity and currency is close to zero and unstable. If a corporation is regarded as a portfolio of international activities, however, its stock price should be influenced by international factors in relation to the geographical breakdown of its activities rather than where its headquarters is located or its stock is traded. We examined a large cross-section of security prices and found that regional factors and currency factors have a strong influence on asset returns beyond that of domestic factors. Moreover, the sensitivity of individual company returns to nondomestic factors is closely related to the extent of their international activities, as proxied by the relative importance of foreign sales to total sales. We review the implications of these findings for the asset management profession. Global equity management has historically been structured primarily around country asset allocation. This approach was supported by the common observations that the country factor is the major influence on stock-price behavior and that the correlation between equity and currency is close to zero and unstable, so country exposure matches currency exposure. This logic breaks down, however, in a world where companies work and compete on a global basis and are recognized as doing so by investors when they price securities.As companies expand and diversify their international activities, the relative importance of domestic factors for the companies should decline. If a corporation is regarded as a portfolio of international activities, its stock price should be influenced by international factors in relation to the geographical breakdown of its activities. Similarly, the currency exposure should be influenced by the geographical distribution of the company's activities, rather than by the domicile of incorporation or by where the stock is mainly traded. In such integrated or “global” pricing, the market recognizes the value and changes to value of the foreign activities of the company. In essence, a French company with foreign activities can expect investors to value each stream of “national” earnings at the relevant national discount rate adjusted for the company's specific risk characteristics.We examined a large cross-section of security prices for companies in eight developed countries from mid-1989 through 1998 and found that regional factors and currency factors have a strong influence on asset returns beyond the influence of domestic factors. We found a relationship between the degree of domestic (international) stock exposure, as inferred from return data, and the company's domestic (international) sales. This finding corroborates our theoretical model of the value of the company: The greater the proportion of international sales, the greater the likelihood that the stock responds to foreign stock-price movements. (These results were less pronounced for U.S. companies.) We also found that foreign stock market exposures exceed foreign currency exposures, which suggests that some currency hedging takes place within the companies. Because the stock prices of some international companies are exposed to foreign currencies, when investors fully hedge their accounting currency exposures back to their home currencies, they risk overhedging.Our findings suggest that conventional methods of market and currency allocation used in asset management are problematic and biased. For instance, our analytical framework, in contrast to the traditional accounting-based portfolio measures of market exposure, demonstrates that a portfolio of the constituents of the Swiss market provides significant exposure to foreign factors. More importantly, this portfolio illustrates how home-biased allocations are poorly diversified from a global perspective; the lack of exposure to several major global industries is noteworthy.Global asset management has become a more complex task than in the past—and a task that cannot be addressed through simple shortcuts, such as stratifying the world into multinational and national companies. Analysis of the individual company and its diversity is critical; thus, analysts need a sound understanding of the geographical breakdown and currency practices of the company as well as the country and industry factors that affect its performance. This complexity provides opportunities to those with a good understanding of the global and domestic influences on stock pricing to achieve superior return and risk management.
Journal: Financial Analysts Journal
Pages: 37-47
Issue: 4
Volume: 57
Year: 2001
Month: 7
X-DOI: 10.2469/faj.v57.n4.2464
File-URL: http://hdl.handle.net/10.2469/faj.v57.n4.2464
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# input file: UFAJ_A_12047292_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark Hirschey
Author-X-Name-First: Mark
Author-X-Name-Last: Hirschey
Title: Cisco and the Kids (corrected)
Abstract: 
 The Nasdaq 100 Index is today's reincarnation of the Nifty Fifty. Many of today's institutional favorites feature extraordinary valuations, despite short operating histories, modest revenues, and sparse profits. At the market peak in 1972, Nifty Fifty stocks sold at an average P/E of 37.3—versus a market multiple of 18.2. At the 2000 peak, the Nasdaq 100 sold at an average P/E multiple roughly six to eight times greater than the highest P/E ever accorded Nifty Fifty stocks. Following a historic stock market correction of more than 70 percent, P/Es for Nasdaq 100 companies remain two to two and a half times higher than peak P/E valuations for the Nifty Fifty. The Nasdaq 100 Index has become today's reincarnation of the Nifty Fifty—a group of 50 premier growth stocks identified by Morgan Guaranty Trust as stock market darlings in the early 1970s. They represented the ultimate in one-decision stock investing. No matter how high Nifty Fifty stock prices seemed relative to current earnings, superior growth would bail out any buyer. Nifty Fifty investors could not lose—until, that is, the vicious bear market of 1972–1974. The ensuing plunge in Nifty Fifty stock prices is sometimes viewed as just punishment for overvalued stocks and the naive investors willing to buy them. Widely publicized research has reported, however, that the Nifty Fifty were only slightly overvalued relative to the market at their 1972 peak. Premier growth stocks are expensive but can be worth the price.In the late 1990s, this Nifty Fifty research was commonly cited as justification for the extraordinary valuations accorded to large-capitalization technology favorites. These citations neglected to note, however, the dismal long-run returns turned in by the highest-P/E stocks among the Nifty Fifty. They also neglected to note that Nifty Fifty tech stocks badly lagged the market and other Nifty Fifty companies.Today's Nifty Fifty—only more so—is the Nasdaq 100. At the 2000 market peak, the average P/E for profitable Nasdaq 100 stocks was a whopping 227.8. The peak median P/E for all profitable plus unprofitable Nasdaq 100 components was an astounding 226.9, and the weighted-average P/E for all profitable plus unprofitable Nasdaq 100 companies was an astounding 311.2. By any metric, peak P/Es accorded Nasdaq 100 companies, led by Microsoft, Cisco, and a squadron of other high flyers, greatly exceeded the highest P/Es ever accorded Nifty Fifty companies.Nasdaq 100 P/Es have remained high despite the 70 percent correction in prices since the peak in March 2000. The average P/E for 69 profit-making components of the Nasdaq 100 on March 30, 2001, stood at a lofty 71.5. The median P/E for all Nasdaq 100 components stood at 59.8; the weighted-average P/E for all profitable plus unprofitable Nasdaq 100 companies remained a lofty 97.7. The P/Es of Nasdaq 100 companies are two to two and a half times higher than peak P/E valuations for the Nifty Fifty.Although the P/Es remain high, experience shows that new highs in returns for the Nasdaq 100 may be a long time coming. For example, if Nasdaq 100 performance follows a pattern similar to that of Japan's Nikkei Index over the past decade, Nasdaq 100 investors can look forward to a sustained period of anemic stock market returns. For the Nasdaq 100 to trade in a broad range from 1,500 to 2,500 would not be surprising. Thus, with a market return of 13 percent a year, the Nasdaq 100 would need about 10.41 years to make a sustained recovery from the postcrash low and reclaim its market peak.
Journal: Financial Analysts Journal
Pages: 48-59
Issue: 4
Volume: 57
Year: 2001
Month: 7
X-DOI: 10.2469/faj.v57.n4.2465
File-URL: http://hdl.handle.net/10.2469/faj.v57.n4.2465
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# input file: UFAJ_A_12047293_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hong Yan
Author-X-Name-First: Hong
Author-X-Name-Last: Yan
Title: Dynamic Models of the Term Structure
Abstract: 
 In the past 25 years, tremendous progress has been made in modeling the dynamics of the term structure of interest rates, which play an instrumental role in determining prices and hedging portfolios of fixed-income derivative securities. This article reviews the theoretical development of the dynamic models of the default-free term structure and their applications in pricing interest rate options. Classic models, sometimes termed equilibrium models, and their multifactor extensions are outlined. These models provide clear economic intuitions connecting the term structure with economic fundamentals. They also lay a foundation for the framework of the arbitrage models that price interest rate derivatives on the basis of the market prices of bonds. This framework has been expanded and enriched by recent advances in directly modeling observable market rates through the market models and in incorporating an internally consistent correlation structure through the “infinite-dimensional” models. In the past 25 years, tremendous progress has been made in modeling the dynamics of the term structure of interest rates, which play an instrumental role in determining prices and hedging portfolios of fixed-income derivative securities. This article reviews the theoretical development of the dynamic models of the default-free term structure and their applications in pricing interest rate options.Classic models specify a stochastic process for the instantaneous short rate and a functional form for the market price of risk. These models and their multifactor extensions depict an interest rate process that reverts to its long-run mean, which may itself be a stochastic variable. Although the models differ in modeling how the expected changes in interest rates and the volatility of these rate changes are related to the levels of interest rates, they are all supported by a general equilibrium in a specific economy. This condition allows them to provide clear economic intuitions connecting the term structure with economic fundamentals. At the same time, the affine structure (signified by the linearity of the expected changes in interest rates and the variance of the rate changes in the state variables) allows near-analytic formulas for option prices. So, even though the models are not directly used by practitioners, they form the foundation for the development of the arbitrage models that do find widespread applications in pricing interest rate derivatives.The arbitrage models are used to evaluate interest rate derivative securities based on the prevailing market prices of bonds. The methodology is similar in spirit to the Black–Scholes model for pricing equity options. It specifies the dynamics of the evolution of the instantaneous forward rates from the current market forward curve and imposes the no-arbitrage condition to pin down the relationship between the drift and volatility of the forward-rate process. The assumption of a complete bond market (which states that all payoffs in the market can be replicated by combinations of traded securities) allows a practitioner to obtain the derivative prices through arbitrage pricing by replication techniques.The arbitrage pricing framework is very general and embeds many popular models as special cases. However, not all specifications that fit in this framework are useful. One of the desirable features to have is a Markov structure that will maintain a recombining tree for evaluating derivative prices. In addition, the need to ensure that the modeled nominal rates remain positive leads to a positive interest rate approach that is innovative but consistent with the original framework.Recent advances to efficiently implement models of interest rate dynamics and pricing of interest rate derivatives have expanded and enriched the original framework. On the one hand, market models directly describe rates observable in the LIBOR or swap markets by lognormal processes. This specification simplifies the formulation for option prices and justifies the industry practice of using a simple model to price caps or swaptions with guidance on the volatility input. On the other hand, “infinite dimensional” models incorporate an internally consistent correlation structure among the shocks to each point of the forward curve. This approach allows the models to match the forward curve with the market curve at all times while still maintaining a parsimonious parameterization. Further characterization and integration of these models may provide more intuitive and efficient ways to price fixed-income derivative products.
Journal: Financial Analysts Journal
Pages: 60-76
Issue: 4
Volume: 57
Year: 2001
Month: 7
X-DOI: 10.2469/faj.v57.n4.2466
File-URL: http://hdl.handle.net/10.2469/faj.v57.n4.2466
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# input file: UFAJ_A_12047294_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David A. Chapman
Author-X-Name-First: David A.
Author-X-Name-Last: Chapman
Author-Name: Neil D. Pearson
Author-X-Name-First: Neil D.
Author-X-Name-Last: Pearson
Title: Recent Advances in Estimating Term-Structure Models
Abstract: 
 In the past 10 years, increasingly sophisticated statistical techniques have been applied to the estimation of increasingly complex models of the term structure of interest rates. In reviewing this literature, we highlight the facts that have been established and the key unresolved issues. The data indicate that within a wide range of interest rates, mean reversion in rates is, at best, weak. Whether mean reversion is stronger for very high or very low levels of rates is an unresolved issue. The absolute volatility of rates increases as the level of rates increases, but the strength of this effect and the role and nature of either stochastic-volatility or regime-switching components in rates are still unclear. Unfortunately, these unresolved issues have important implications for fixed-income option pricing and risk measurement, including value-at-risk calculations. Models of the term structure of interest rates are widely used in pricing interest rate derivatives and instruments with embedded options, such as callable bonds and mortgage-backed securities. Many such models are based on the simplifying assumption that changes in interest rates of all maturities are driven by changes in a single underlying random factor, often taken to be the “short” or “instantaneous” rate of interest. Both the decision to use a one-factor model and the choices made within that framework are crucial. The evolution of interest rates over time, and thus the prices of options and other derivatives, is determined entirely by these choices. Models of interest rate volatility (sometimes implicit) also play key roles in risk measurement—for example, in value-at-risk calculations.Unfortunately, theory provides little guidance about the modeling choices. As a result, the last decade has seen the development of a large and growing academic literature devoted to estimating how expected changes and volatilities of interest rates are related to their levels and, sometimes, other variables. This literature is scattered in different places and often emphasizes the statistical and econometric techniques used rather than the implications of the analysis for interest rate models. Therefore, it is not easily accessible to many practitioners. This article is the first step in remedying this problem. We summarize in one place the substantive implications of the recent academic literature for dynamic models of the evolution of interest rates.Much of the recent academic literature we review focuses on one-factor models, but researchers have known for at least 10 years that at least three factors are needed to fully capture the variability of interest rates. Why then consider one-factor models? The answer is that research has shown that roughly 90 percent of the variation in U.S. Treasury rates can be explained by the first factor, which can be interpreted as corresponding to changes in the general level of interest rates. Thus, any relationship between the level of interest rates and their expected changes and volatilities will be dominated by the influence of this first factor. In one-factor models, this factor is typically identified with the instantaneous or short rate of interest. The recent academic literature studying the behavior of the yields on short-term bonds or deposits can be interpreted as a detailed explanation of the first factor by using the yield on a particular instrument (e.g., one-month LIBOR) as a proxy for the short rate.According to the recent literature, what model features appear to be essential in describing the fundamental properties of interest rates? First, the new literature does not provide conclusive evidence based solely on the data about whether interest rate levels tend to return to a constant long-run level and, if they do, whether this tendency is stronger for extreme levels of interest rates.Second, with respect to interest rate volatility, the “absolute” volatility of the short rate, defined as the standard deviation of rate changes scaled by the square root of the time between changes, clearly increases as the level of interest rates increases. Inferences about the relationship between the level and volatility of the short rate are sensitive, however, to the treatment of the years between 1979 and 1982, the years of the U.S. Federal Reserve's so-called experiment in targeting monetary aggregates rather than targeting interest rate levels. In particular, the data from this period suggest a strong relationship between volatility and the level of interest rates; when this period is excluded or treated as a distinct regime with a lower probability of occurring, the data suggest a much weaker relationship between interest rate level and volatility.Finally, modeling the volatility of interest rates requires more than a simple “level effect”; that is, some sort of stochastic-volatility effect seems to be in play. But the additional volatility component can be described adequately (in a statistical sense) in a variety of competing ways.
Journal: Financial Analysts Journal
Pages: 77-95
Issue: 4
Volume: 57
Year: 2001
Month: 7
X-DOI: 10.2469/faj.v57.n4.2467
File-URL: http://hdl.handle.net/10.2469/faj.v57.n4.2467
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# input file: UFAJ_A_12047295_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert H. Healy
Author-X-Name-First: Robert H.
Author-X-Name-Last: Healy
Title: Cisco and the Kids: A Comment
Abstract: 
 This material comments on “Cisco and the Kids”.
Journal: Financial Analysts Journal
Pages: 16-16
Issue: 5
Volume: 57
Year: 2001
Month: 9
X-DOI: 10.2469/faj.v57.n5.2475
File-URL: http://hdl.handle.net/10.2469/faj.v57.n5.2475
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:5:p:16-16




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# input file: UFAJ_A_12047297_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard S. Braddock
Author-X-Name-First: Richard S.
Author-X-Name-Last: Braddock
Title: The Internet: The Novel
Abstract: 
 Businesses that want to succeed in e-commerce in this chapter of Internet development had better learn the new rules of the game. In the first chapter of the Internet novel, Net stocks rose like rockets, and now in the second chapter, most have fallen like meteors. The commercialization of the Internet that was supposed to occur not only did not happen; it failed miserably—leaving investors broke, visionaries disillusioned, and many businesses bankrupt or heading for the virtual exits.What will Chapter 3 bring? Three scenarios are possible: The technology-led, Web-induced recession might force a moratorium on e-commerce; the more traditional and deep-pocketed bricks-and-mortar companies might step up to resurrect advertising and commerce on the Internet; a select few e-commerce pioneers might hang in the game long enough to leverage their first-mover advantage and firmly establish themselves as the preeminent brands for the next generation of Internet businesses.The first reality that analysts need to keep in mind is that the Internet is here to stay. The question is: What companies will profit from it? My thesis is that all three scenarios will come to pass. Online success is attainable for many aspiring businesses, not simply the brick-and-mortar companies or the traditional e-commerce mainstays, but only if the players apply what has been learned to date about consumer behavior, online commerce, and the Internet. This article discusses four rules based on the lessons companies should have learned about e-commerce:  Business models must incorporate revenue sources directly linked to actual customer behavior.Profitability must be attainable by using immediately available capital and revenue.Business models must be both appealing and sustainable.Business models must leverage the medium.The businesses that learn these rules and put them into practice will be the Internet winners in Chapter 4 of The Internet: The Novel.
Journal: Financial Analysts Journal
Pages: 17-19
Issue: 5
Volume: 57
Year: 2001
Month: 9
X-DOI: 10.2469/faj.v57.n5.2477
File-URL: http://hdl.handle.net/10.2469/faj.v57.n5.2477
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:5:p:17-19




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# input file: UFAJ_A_12047298_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ross Jennings
Author-X-Name-First: Ross
Author-X-Name-Last: Jennings
Author-Name: Marc LeClere
Author-X-Name-First: Marc
Author-X-Name-Last: LeClere
Author-Name: Robert B. Thompson
Author-X-Name-First: Robert B.
Author-X-Name-Last: Thompson
Title: Goodwill Amortization and the Usefulness of Earnings
Abstract: 
 This study provides evidence of the effect of goodwill amortization on the usefulness of earnings data as an indicator of share value for a large sample of publicly traded companies over the 1993–98 period. This issue is of special interest because the Financial Accounting Standards Board recently adopted new accounting standards that eliminate the systematic amortization of goodwill in favor of a requirement to review goodwill for impairment when circumstances warrant. We found that earnings before goodwill amortization explain significantly more of the observed distribution of share prices than earnings after goodwill amortization and that when share valuations are based on earnings alone, goodwill amortization simply adds noise to the measure. These results suggest that eliminating goodwill amortization from the computation of net income will not reduce its usefulness to investors and analysts as a summary indicator of share value. Analysts frequently face the problem of how to consider goodwill amortization in their financial analysis. For many years, financial statement preparers and users have criticized the accounting requirement to amortize purchased goodwill against revenues over a period not to exceed 40 years. Critics have argued that goodwill may not decline in value and that, even if it does, the arbitrary amounts recorded periodically as goodwill amortization are unlikely to reflect that decline. In this view, goodwill amortization simply adds noise to earnings, thereby reducing their usefulness to investors. Accounting standard setters, in contrast, have until recently maintained that goodwill is likely to be a wasting asset in most circumstances and that recording goodwill amortization makes reported earnings more useful to investors by reflecting its decline in value. We provide empirical evidence as to which of these views is more consistent with the way in which investors price securities.This issue is of current interest to investors and analysts because of a recent change in the accounting rules for purchased goodwill. Under Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, the reported earnings of acquiring companies will no longer include charges for goodwill amortization. Goodwill acquired in a business combination is recognized as an asset, as in the past, but once it is recognized, the asset remains on the balance sheet indefinitely, subject only to review for impairment when circumstances warrant. Thus, the question arises of whether excluding goodwill amortization from reported earnings will enhance or detract from its usefulness to investors.To investigate this issue, we document the extent to which variation in stock prices is explained by earnings before goodwill amortization and by reported earnings, which includes goodwill amortization. Our analysis, based on a large sample of publicly traded companies reporting purchased goodwill in the six-year period of 1993–1998, involved comparing R2s from two cross-sectional regressions—one of stock price on earnings per share before goodwill amortization and the other of stock price on reported earnings. In interpreting the results of these comparisons, we assumed that prices reflect all value-relevant public information, so the earnings measure that explains more of the variation in stock prices can be viewed as the more useful summary indicator of share value.Our results provide evidence consistent with the criticisms of the previous accounting rules for goodwill. In each year and for the six-year period as a whole, earnings before goodwill amortization explain more of the variation in share prices than reported earnings, and for each year, the difference in explanatory power is statistically significant. Moreover, when we regressed stock prices on earnings before goodwill amortization and on goodwill amortization, we found that the estimated coefficient (valuation multiple) on earnings before goodwill amortization was large and highly significant whereas the estimated coefficient on goodwill amortization was statistically indistinguishable from zero. This finding strongly suggests that goodwill amortization merely adds noise to reported earnings. Overall, these results indicate that the recently adopted reporting rules for purchased goodwill are likely to increase the usefulness of earnings as a summary indicator of share value.
Journal: Financial Analysts Journal
Pages: 20-28
Issue: 5
Volume: 57
Year: 2001
Month: 9
X-DOI: 10.2469/faj.v57.n5.2478
File-URL: http://hdl.handle.net/10.2469/faj.v57.n5.2478
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# input file: UFAJ_A_12047299_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Harindra de Silva
Author-X-Name-First: Harindra
Author-X-Name-Last: de Silva
Author-Name: Steven Sapra
Author-X-Name-First: Steven
Author-X-Name-Last: Sapra
Author-Name: Steven Thorley
Author-X-Name-First: Steven
Author-X-Name-Last: Thorley
Title: Return Dispersion and Active Management
Abstract: 
 The cross-sectional variation of U.S. stock returns has been unusually high in the past few years. The wide dispersion in security returns has led to correspondingly wide dispersion in fund returns. For example, the cross-sectional standard deviation of returns on actively managed domestic equity mutual funds was 24 percent in 1999, compared with only 5 percent in 1996. We argue that the wide dispersion in fund performance is a natural result of increased security return dispersion and has little to do with changes in the informational efficiency of the market or the range of managerial talent. The dramatic increase in return dispersion warrants a reexamination of traditional methodologies for measuring fund performance that implicitly assume constant dispersion. We show how performance benchmarking can be extended to incorporate the information embedded in return dispersion, as well as the benchmark mean return, by correcting fund alphas with a period- and asset-class-specific measure of security return dispersion. The cross-sectional variation in U.S. stock returns jumped to unusually high levels in the fall of 1998. The spread in returns between individual stocks was wider in 1999 and 2000 than at any other point in modern market history. The return spread is best measured by dispersion—the cross-sectional standard deviation of individual security returns within an asset class. Dispersion can be thought of as the cross-sectional analog to volatility—the standard deviation of returns on a security or portfolio over time.Economic historians believe that periods of wide equity return dispersion are associated with structural shifts in the underlying economy resulting from political or technological disruptions. The fundamental restructuring of the economic order leads to large corporate revaluations, with some companies going up in value while others decline. A possible candidate for the current episode of equity market dispersion is a technological shift—the emergence of new information technologies and the perceived changes in corporate competitive advantages associated with their use.The recent increase in security return dispersion has important implications for active management. Portfolio theory predicts that wide security dispersion will translate into wide dispersion of fund returns. We document the accuracy of this prediction. We found a very high correspondence between individual-security return dispersion and fund return dispersion on a year-to-year basis. For example, not only was 1999 a year of unusually wide dispersion for security returns, but it was also a year in which the dispersion of returns of actively managed domestic equity mutual funds was at an all-time high—24 percent compared with the typical range of 5–10 percent.An appreciation for the correspondence between dispersion in security and fund returns can help reverse some common misconceptions about active management. For example, publicity about the recently large spread in fund returns can be misinterpreted as evidence of a larger variation in managerial talent. In fact, it is simply an artifact of wider-than-normal return dispersion in the security pool from which managers can choose. Misunderstanding the cause of increased cross-sectional variation in fund performance can also lead to the counterintuitive conclusion that market efficiency has suddenly decreased. We reiterate Sharpe's logic that active management measured against marketwide benchmarks is a zero-sum game before costs and a negative-sum game after costs. The arithmetic of active management dictates that when the performance of all investor groups is properly accounted for, exactly half will outperform a total market index before costs. After research and transaction costs, fewer than half will outperform. Thus, the percentage of all actively managed funds that beat the market in any period is unrelated to market efficiency. Rather, it is determined by the magnitude of return dispersion around the mean and the costs of active management. We show that as return dispersion increases, the percentage of outperformers also increases.Perhaps the most important implication of intertemporal variation in return dispersion is in the area of individual-fund performance measurement. During a year with marketwide fund dispersion of 5 percent, a positive alpha (return in excess of the benchmark) of 10 percentage points is a significant achievement. In a year when fund dispersion is 20 percent, a 10 percentage point alpha means a lot less. Averaging alphas over time without consideration for intertemporal variations in dispersion can lead to a material misstatement of relative performance.We show how performance benchmarking can be extended to incorporate the information embedded in return dispersion, as well as information on the benchmark mean, by correcting fund alphas with a period- and asset-class-specific measure of security return dispersion. Weighting alpha observations by the inverse of return dispersion can be characterized as an econometric correction for heteroscedasticity. We argue that multiperiod performance statistics that correct for intertemporal variations in return dispersion are better indicators of managerial talent and may provide improved predictions of future added value. Return dispersion corrections are particularly relevant in the measurement of U.S. equity portfolio performance over the past several years.
Journal: Financial Analysts Journal
Pages: 29-42
Issue: 5
Volume: 57
Year: 2001
Month: 9
X-DOI: 10.2469/faj.v57.n5.2479
File-URL: http://hdl.handle.net/10.2469/faj.v57.n5.2479
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# input file: UFAJ_A_12047300_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mario Levis
Author-X-Name-First: Mario
Author-X-Name-Last: Levis
Author-Name: Manolis Liodakis
Author-X-Name-First: Manolis
Author-X-Name-Last: Liodakis
Title: Contrarian Strategies and Investor Expectations: The U.K. Evidence
Abstract: 
 The rationale for the superior performance of contrarian investment strategies remains a matter of lively debate. The orthodox view maintains that such strategies generate higher returns because they are fundamentally riskier, whereas the behaviorists suggest that the superior performance is a result of systematic errors in investors' expectations about the future. If the behavioral view is accepted, then the debate centers on what the underlying source(s) of such errors are—naive extrapolation of past performance or biased analysts' earnings forecasts. Using stocks listed on the London Stock Exchange, we found evidence consistent with the view that errors in expectations are more likely to be a result of biases in analysts' earnings forecasts than naive extrapolation of the past. We also found that positive and negative earnings surprises have an asymmetrical effect on the returns of low- and high-rated stocks. Positive earnings surprises have a disproportionately large positive impact on stocks that are priced low relative to four measures of operating performance; negative surprises have a relatively benign effect on such stocks. Evidence from the major stock markets suggests that over long time intervals, contrarian strategies have generated significant abnormal returns. Understanding the underlying drivers of such an apparently successful investment strategy is vital for designing appropriate processes to exploit it and for detecting any long-term behavioral changes that may influence its effectiveness. But in spite of the apparent robustness of contrarian strategies, the underlying rationale for their success remains a matter of lively debate, both in academic and practitioner communities.The orthodox view maintains that contrarian strategies generate higher returns because they are fundamentally riskier, whereas the behaviorists argue that the superior performance is a result of systematic errors in expectations about the future. The identity of the source(s) of such errors is the subject of a separate controversy. One source proposed in the literature is naive extrapolation of past performance; that is, investors base their decisions on extrapolations of companies' recent sales and earnings growth. The second source proposed is errors in analysts' forecasts of long-term earnings growth.We studied the drivers of the success of contrarian investing by using data on stocks traded on the London Stock Exchange in the past 30 years. First, we built portfolios based on five definitions of performance—book-to-price (B/P), earnings-to-price (E/P), cash flow to price (C/P), three years' past EPS growth, and three-year past cumulative rate of return—and examined the evolution of profitability and price performance around the time of portfolio formation. We tested the implication of the extrapolation hypothesis that the returns of stocks with low B/Ps, E/Ps, and C/Ps (growth stocks) and attractive past (three years) EPS growth will be lower than the returns of portfolios with similar valuation characteristics but poor past earnings performance (temporary losers). We also tested the related idea that if investors are naively extrapolating the past, the portfolios composed of stocks with high B/Ps, E/Ps, and C/Ps (value stocks) and low past-EPS-growth rates should outperform temporary winners (stocks with high B/Ps, E/Ps, and C/Ps but also high past EPS growth). We found that the market does not incorrectly extrapolate the past and that stock prices do not reflect the naive extrapolation of past earnings growth or returns.Second, we assessed the relationship between EPS forecasts, earnings surprises, and contrarian strategies. In contrast to previous studies of U.S. data, we did not attempt to investigate whether stock prices incorporate analysts' forecasts of long-term earnings growth. We concentrated on analysts' errors for high (low) -B/P, -E/P, and -C/P stocks immediately after portfolio formation as potential candidates for explaining their postformation return difference. Although we found larger average forecast errors for contrarian-based strategies, we nevertheless found more positive surprises, particularly among high-E/P and high-C/P portfolios.Third, we provide a direct test of the impact of earnings surprises on contrarian strategies. If investors are making systematic errors in their expectations, they are expecting growth stocks to do well in the future and value stocks to do poorly. Therefore, the market may regard a positive surprise to be good news for value stocks, and the surprise will have a more positive impact on value stocks' returns than on the returns of other stocks. Similarly, the market may consider a negative surprise to be bad news for growth stocks; thus, the surprise will have a negative impact on the growth stocks' returns while having only a minor effect on the returns of other stocks. Our regression results did indeed suggest that positive and negative surprises have asymmetrical effects on the returns of value and growth portfolios in favor of the value stocks in a fashion that is consistent with the errors-in-expectations hypothesis.
Journal: Financial Analysts Journal
Pages: 43-56
Issue: 5
Volume: 57
Year: 2001
Month: 9
X-DOI: 10.2469/faj.v57.n5.2480
File-URL: http://hdl.handle.net/10.2469/faj.v57.n5.2480
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# input file: UFAJ_A_12047301_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert Faff
Author-X-Name-First: Robert
Author-X-Name-Last: Faff
Author-Name: David Hillier
Author-X-Name-First: David
Author-X-Name-Last: Hillier
Author-Name: Justin Wood
Author-X-Name-First: Justin
Author-X-Name-Last: Wood
Title: Taxation and Black's Zero-Beta Strategy Revisited
Abstract: 
 Fischer Black's strategy of skewing portfolios to low-beta stocks makes sense in non-U.S. markets if a “flat” relationship between beta and return exists in those markets as it does in the U.S. market. Theory suggests, however, that for taxation reasons, the relationship between beta and return will be more steeply sloped in markets like that of Australia, where dividend-imputation taxation has been adopted, than in the U.S. market, where classical taxation prevails. We document empirically that the relationship between beta and return has been, in fact, more steeply sloped in the Australian market in the postimputation period. Moreover, we found a significantly positive excess return on the “zero-beta factor” in the preimputation period but a zero or significantly negative excess return on the zero-beta factor in the postimputation period. The implication is that following the zero-beta investment strategy in an economy that includes an imputation tax may not be successful. In response to findings of a flat relationship between realized average return and beta in the U.S. equity market, Fischer Black maintained that when the slope of the security market line is flat, beta can still be used as an investment tool to earn valuable returns from investments. In non-U.S. markets, however, a strategy of skewing portfolios to low-beta stocks makes sense only if a similar flat relationship between beta and return exists in those markets. Why might the risk–return relationship in some (even many) non-U.S. markets diverge from the relationship in the U.S. case? Different systems of taxation are one answer. Indeed, theory suggests that taxes may cause the relationship between beta and return to be more steeply sloped for markets in which a dividend-imputation tax system (where a tax credit accrues to the investor for taxes paid at the company level) prevails than in a market, such as the United States, in which classical taxation prevails (a system in which there is double taxation of dividends). Examples of countries with an imputation tax system are Australia, the United Kingdom, Canada, France, Germany, New Zealand, and Singapore.A major difficulty in distilling the impact of different taxation systems on the slope of the security market line is finding a country with sufficient market data under both the classical and imputation tax systems to allow a robust empirical analysis. In Australia, we found an ideal sample—not only because the country changed from a classical tax system to an imputation tax system in 1987 but also because the Australian version of the imputation tax is perhaps one of the purest attempts to neutralize the impact of taxation on equity versus debt income.We used monthly data spanning 22 years (1974 through 1995) on more than 700 Australian companies to examine the slope of the security market line for Australian stocks in the preimputation and postimputation periods. We found that the relationship between beta and return was more steeply sloped in the postimputation period. Moreover, following a battery of robustness checks—including analyses of the impact of the 1987 crash, differences in industrial sectors, and the effect of firm size and dividend yield—we conclude that the changed relationship between beta and return was driven by the tax change.Our evidence in favor of a changed beta–return relationship was reinforced by the consistent finding of a significantly positive excess return on the zero-beta factor in the preimputation period and a zero or significantly negative excess return on the zero-beta factor in the postimputation period. The implication is that following a zero-beta investment strategy in such an imputation tax environment may not be successful.Finally, the analysis in this study contributes to the current debate about the validity or lack of validity in blindly applying empirical findings based on U.S. data and market conditions to market environments and economies outside the United States.
Journal: Financial Analysts Journal
Pages: 57-65
Issue: 5
Volume: 57
Year: 2001
Month: 9
X-DOI: 10.2469/faj.v57.n5.2481
File-URL: http://hdl.handle.net/10.2469/faj.v57.n5.2481
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# input file: UFAJ_A_12047302_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jonathan Fletcher
Author-X-Name-First: Jonathan
Author-X-Name-Last: Fletcher
Author-Name: Joe Hillier
Author-X-Name-First: Joe
Author-X-Name-Last: Hillier
Title: An Examination of Resampled Portfolio Efficiency
Abstract: 
 We examined the out-of-sample performance of using resampled portfolio efficiency, an approach proposed in 1998, in international asset allocation strategies for the period January 1983 to May 2000. For most models we used to estimate expected returns, using strategies based on resampled portfolio efficiency provided some benefits, in terms of improved Sharpe ratios and abnormal returns, over using traditional mean–variance strategies. We found little evidence, however, that active mean–variance strategies or resampled efficiency strategies would have generated significantly positive abnormal returns for the time period we considered. Mean–variance portfolio theory is one of the major developments in finance, but it has limitations when implemented. The principal limitation is that the expected return vector and covariance matrix of asset returns are unknown. Researchers have argued that traditional mean–variance portfolios based on the use of sample data are unstable because the method maximizes estimation error. The assets with higher expected returns, negative correlations, and smaller variances will tend to receive the greater weight, and these assets may have the greatest estimation error. As a result, mean–variance optimization often leads to portfolios that are not meaningful to institutional investors.The concept of “resampled portfolio efficiency” was developed to reduce the impact of estimation risk on the standard mean–variance optimization. It follows the process of simulating statistically equivalent efficient frontiers for a given set of expected returns and covariance matrix inputs. The resampled efficient frontier was originally defined as the set of portfolios that are the average weights of the “rank-associated” portfolios of the various simulated efficient frontiers. Using the resampled efficient frontier tends to moderate the extreme weights that can arise from a single mean–variance optimization. Simulation evidence has suggested that using resampled efficient portfolios leads to higher Sharpe ratios than those produced by traditional mean–variance-efficient portfolios.We examined the benefits of using resampled portfolio efficiency as contrasted to mean–variance efficiency in international asset allocation strategies. We used various performance measures to evaluate the out-of-sample performance of the two strategies between January 1983 and May 2000 for a given estimator of expected returns and covariance matrix. We also explored the robustness of the results by using various models of expected returns, including the historical mean, the James–Stein estimator of expected returns, a one-factor capital asset pricing model, and a model that uses instrumental variables to predict expected returns.The three main findings of the study are as follows: First, in confirmation of previous simulation results, some benefit can be gained in terms of improved Sharpe performance and better abnormal returns from using resampled efficiency strategies rather than traditional mean–variance strategies. Second, this benefit holds across most models used to estimate expected returns and the estimation window used to estimate expected returns. Third, neither active mean–variance nor resampled efficiency strategies outperformed the passive benchmark for the time period considered.
Journal: Financial Analysts Journal
Pages: 66-74
Issue: 5
Volume: 57
Year: 2001
Month: 9
X-DOI: 10.2469/faj.v57.n5.2482
File-URL: http://hdl.handle.net/10.2469/faj.v57.n5.2482
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# input file: UFAJ_A_12047303_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert Jarrow
Author-X-Name-First: Robert
Author-X-Name-Last: Jarrow
Title: Default Parameter Estimation Using Market Prices
Abstract: 
 This article presents a new methodology for estimating recovery rates and the (pseudo) default probabilities implicit in both debt and equity prices. In this methodology, recovery rates and default probabilities are correlated and depend on the state of the macroeconomy. This approach makes two contributions: First, the methodology explicitly incorporates equity prices in the estimation procedure. This inclusion allows the separate identification of recovery rates and default probabilities and the use of an expanded and relevant data set. Equity prices may contain a bubble component—which is essential in light of recent experience with Internet stocks. Second, the methodology explicitly incorporates a liquidity premium in the estimation procedure—which is also essential in light of the large observed variability in the yield spread between risky debt and U.S. Treasury securities and the illiquidities present in risky-debt markets. The available models for pricing credit risk can be divided into two types—structural and reduced form. Structural models endogenize the bankruptcy process by explicitly modeling the asset and liability structure of the company. Reduced-form models exogenously specify an arbitrage-free evolution for the spread between default-free and credit-risky bonds.The two approaches seem to have partitioned the market data: Structural models use only equity prices, and reduced-form models use only debt prices. This partitioning is artificial and unnecessary. One particular parameterization of the structural approach—one of several that have been successfully implemented in professional software—uses only equity prices and balance sheet data to estimate the bankruptcy process parameters. The argument is that debt markets are too illiquid and debt prices too noisy to be useful; hence, they should be ignored. Unfortunately, this implementation of the structural approach ignores the possibility of stock price bubbles (e.g., as we have seen recently for Internet stocks) and the misspecification that such bubbles imply. At the same time, the existing literature on implementing reduced-form models concentrates on debt prices and ignores equity prices. Both markets provide relevant information about a company's default risk and parameters, however, and both should be used.The new methodology for implementing reduced-form models presented here includes both debt and equity prices in the estimation procedure. The methodology takes the approach of estimating recovery rates and the (pseudo) default probabilities implicit in debt and equity prices. The method is quite general; it allows default probabilities and recovery rates to be correlated and to be dependent on the state of the macroeconomy. This flexibility generates a reduced-form model that integrates market and credit risk with correlated defaults.My approach makes two contributions. First, the methodology explicitly incorporates equity prices in the reduced-form estimation procedure, which is unlike current models that use debt prices only. For a fractional recovery rate, the use of debt prices alone allows estimation of only the expected loss—that is, the multiplicative product of the recovery rate times the (pseudo) default probabilities. The introduction of equity prices enables one to separately estimate these quantities. Moreover, the procedure I use to include equity in the reduced-form model is one that is commonly used in portfolio theory literature. Simply stated, the equity price is viewed as the present value of future dividends and a resale value. The future resale value is consistent with the existence of equity price bubbles. In light of the recent market experience with Internet stocks, such an inclusion is necessary for accurate estimation of bankruptcy parameters using equity prices.The second contribution of the method is that it explicitly incorporates liquidity risk in the model and the estimation procedure. Debt markets are notoriously illiquid, especially in comparison with equity markets. Thus, a liquidity-risk adjustment is needed to accurately estimate the bankruptcy parameters from credit spreads. Liquidity risk introduces an important and necessary additional randomness in the yield spread between risky-bond prices and the prices of U.S. Treasury securities. In this methodology, liquidity risk is introduced through the notion of a “convenience yield,” a well-studied concept in the commodities pricing literature that is consistent with an arbitrage-free but incomplete debt market. Adding the randomness allows for the decomposition of the credit spread into a liquidity-risk component and a credit-risk component.
Journal: Financial Analysts Journal
Pages: 75-92
Issue: 5
Volume: 57
Year: 2001
Month: 9
X-DOI: 10.2469/faj.v57.n5.2483
File-URL: http://hdl.handle.net/10.2469/faj.v57.n5.2483
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# input file: UFAJ_A_12047304_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Sold Short: Uncovering Deception in the Markets (a review)
Abstract: 
 In telling his story, Asensio, a short seller and founder of Asensio and Company, provides valuable insight into the proactive approaches of those who buy long and those who sell short. 
Journal: Financial Analysts Journal
Pages: 93-94
Issue: 5
Volume: 57
Year: 2001
Month: 9
X-DOI: 10.2469/faj.v57.n5.2484
File-URL: http://hdl.handle.net/10.2469/faj.v57.n5.2484
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# input file: UFAJ_A_12047305_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ronald L. Moy
Author-X-Name-First: Ronald L.
Author-X-Name-Last: Moy
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Psychology of Money: An Investment Manager's Guide to Beating the Market (a review)
Abstract: 
 Ware discusses how investment advisors can analyze personality traits to understand themselves and their clients and how money management firms can enhance the creativity and intuition of their portfolio managers through teamwork. 
Journal: Financial Analysts Journal
Pages: 94-95
Issue: 5
Volume: 57
Year: 2001
Month: 9
X-DOI: 10.2469/faj.v57.n5.2485
File-URL: http://hdl.handle.net/10.2469/faj.v57.n5.2485
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:5:p:94-95




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Author-Name: H. Gifford Fong
Author-X-Name-First: H. Gifford
Author-X-Name-Last: Fong
Title: From the Editor
Abstract: 
 The Editorial Board of the Financial Analysts Journal plays a vital role. Each member devotes considerable time and expertise to a review process that not only ensures the quality of the articles that are published but also provides authors, irrespective of whether the paper is published, with critiques that are intended to assist the authors with their papers. Every manuscript we publish goes through this referee procedure, which is a double-blind process. The paper is reviewed by an anonymous referee who has specialized in the area covered by the paper, and the author remains anonymous to the referee. The goal is an unbiased referee report that evaluates the paper for specific qualities (such as technical correctness and appropriateness for our readership) and provides comments and suggestions from the referee. The objective is to promote the highest quality research that also has practical relevance. To instill a continued renewal in the process, we must (no matter how reluctantly) make periodic change to the Editorial Board. Such change not only renews the FAJ's perspective; it also creates the opportunity for participation by more members of our wide academic and professional readership. We are very thankful to the outgoing Editorial Board members, both of whom have served us well and will be missed: Michael Granito and Andrew Rudd. We would like to welcome the new additions to the board: K.C. Chan, Robert Goldstein, Ananth Madhavan, and Andrew J. Sterge. The Financial Analysts Journal is indeed fortunate to have had the wisdom of those leaving the board, and we look forward to the contributions of those who are joining the team for the forthcoming year. The dedication and hard work of all have made and are making our publication the best. 
Journal: Financial Analysts Journal
Pages: 15-15
Issue: 5
Volume: 57
Year: 2001
Month: 9
X-DOI: 10.2469/faj.v57.n5.2486
File-URL: http://hdl.handle.net/10.2469/faj.v57.n5.2486
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:5:p:15-15




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# input file: UFAJ_A_12047307_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Andrew W. Lo
Author-X-Name-First: Andrew W.
Author-X-Name-Last: Lo
Title: Risk Management for Hedge Funds: Introduction and Overview
Abstract: 
 Although risk management has been a well-plowed field in financial modeling for more than two decades, traditional risk management tools such as mean–variance analysis, beta, and Value-at-Risk do not capture many of the risk exposures of hedge-fund investments. In this article, I review several unique aspects of risk management for hedge funds—survivorship bias, dynamic risk analytics, liquidity, and nonlinearities—and provide examples that illustrate their potential importance to hedge-fund managers and investors. I propose a research agenda for developing a new set of risk analytics specifically designed for hedge-fund investments, with the ultimate goal of creating risk transparency without compromising the proprietary nature of hedge-fund investment strategies. Despite ongoing concerns regarding the lack of transparency and potential instabilities of hedge-fund investment companies, the hedge-fund industry continues to grow at a rapid pace. Lured by the prospect of double- and triple-digit returns and an unprecedented bull market, investors have committed nearly $500 billion in assets to alternative investments, and major institutional investors such as the trend-setting California Public Employees Retirement System are starting to take an interest in this emerging asset class. However, many institutional investors are not yet convinced that “alternative investments” is a distinct asset class, i.e., a collection of investments with a reasonably homogeneous set of characteristics that are stable over time. Unlike equities, fixed-income instruments, and real estate—asset classes each defined by a common set of legal, institutional, and statistical properties—“alternative investments” is a mongrel category that includes private equity, risk arbitrage, commodity futures, convertible bond arbitrage, emerging market equities, statistical arbitrage, foreign currency speculation, and many other strategies, securities, and styles. Therefore, the need for a set of risk management protocols specifically designed for hedge-fund investments has never been more pressing.Part of the gap between institutional investors and hedge-fund managers is the very different perspectives that these two groups have on the investment process. The typical manager's perspective can be characterized by the following statements: The manager is the best judge of the appropriate risk/reward trade-off of the portfolio and should be given broad discretion for making investment decisions.Trading strategies are highly proprietary and, therefore, must be jealously guarded lest they be reverse-engineered and copied by others.Return is the ultimate and, in most cases, the only objective.Risk management is not central to the success of a hedge fund.Regulatory constraints and compliance issues are generally a drag on performance; the whole point of a hedge fund is to avoid these issues.There is little intellectual property involved in the fund; the general partner is the fund.Contrast these statements with the following views of a typical institutional investor: As fiduciaries, institutions need to understand the investment process before committing to it.Institutions must fully understand the risk exposures of each manager and, on occasion, may have to circumscribe a manager's strategies to be consistent with the institution's investment objectives.Performance is not measured solely by return, but also includes other factors, such as risk, tracking error relative to a benchmark, and peer-group comparisons.Risk management and risk transparency are essential.Institutions operate in a highly regulated environment and must comply with a number of federal and state laws governing the rights, responsibilities, and liabilities of pension plan sponsors and other fiduciaries.Institutions desire structure, stability, and consistency in a well-defined investment process that is institutionalized and not dependent on any single individual.While there are, of course, exceptions to these two sets of views, they do represent the essence of the gap between hedge-fund managers and institutional investors. However, despite these differences, hedge-fund managers and institutional investors clearly have much to gain from a better understanding of each other's perspectives, and they do share the common goal of generating superior investment performance for their clients.In this article, I hope to contribute to the dialogue between hedge-fund managers and institutional investors by providing an overview of several key aspects of risk management for hedge funds, aspects that any institutional investor must grapple with as part of its manager-selection process. I start with some basic motivation for risk management in the context of hedge funds and discuss some of the limitations of existing risk metrics such as Value-at-Risk. While the risk management literature is certainly well-developed; nevertheless, there are at least five aspects of hedge-fund investments that pose unique challenges for existing risk management protocols and analytics: (1) survivorship bias, (2) dynamic risk analytics, (3) nonlinearities, (4) liquidity and credit, and (5) risk preferences. I describe each of these aspects in more detail in the article, propose analytics, and outline an ambitious research agenda for addressing them.
Journal: Financial Analysts Journal
Pages: 16-33
Issue: 6
Volume: 57
Year: 2001
Month: 11
X-DOI: 10.2469/faj.v57.n6.2490
File-URL: http://hdl.handle.net/10.2469/faj.v57.n6.2490
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# input file: UFAJ_A_12047308_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: John Hull
Author-X-Name-First: John
Author-X-Name-Last: Hull
Author-Name: Alan White
Author-X-Name-First: Alan
Author-X-Name-Last: White
Title: The General Hull–White Model and Supercalibration
Abstract: 
 Term-structure models are widely used to price interest rate derivatives, such as swap options and bonds with embedded options. We describe how a general one-factor model of the short rate can be implemented as a recombining trinomial tree and calibrated to market prices of actively traded instruments. The general model encompasses most popular one-factor Markov models as special cases. The implementation and the calibration procedures are sufficiently general that they can select the functional form of the model that best fits the market prices. This characteristic allows the model to fit the prices of in- and out-of-the-money options when there is a volatility skew. It also allows the model to work well with economies characterized by very low interest rates, such as Japan, for which other models often fail. Term-structure models are widely used to price interest rate derivatives, such as the options embedded in swaps and bonds. We describe how a general one-factor model of the short rate can be implemented as a recombining trinomial tree and calibrated to the market prices of actively traded options. The general model encompasses most popular one-factor Markov models as special cases. The implementation and the calibration procedures are sufficiently general that they can select the functional form of the model that best fits the market prices. This characteristic allows the model to fit the prices of in- and out-of-the-money options when there is a volatility skew.The calibration of the model involves choosing volatility parameters so that the model matches as closely as possible the market prices of actively traded instruments, such as caps and European swap options. The volatility parameters are usually parameterized as piecewise linear or step functions, and an algorithm is used to minimize the sum of the squared differences between the market prices and model prices of the actively traded instruments. What we term “supercalibration” is a procedure for extending the calibration to obtain a best-fit functional form of the short-term interest rate. Supercalibration is possible because brokers now provide quotes on not-at-the-money caps as well as at-the-money caps. The supercalibration methodology is analogous to the implied tree methodology that is popular for valuing exotic equity and foreign currency options. It enables the model to work well in economies with very low interest rates, such as Japan, where other models often fail.We illustrate each numerical procedure with a detailed example. A key issue is the extent to which one should add parameters to the model to fit market data. Academics have quite different views from practitioners on this point. Academics prefer a stationary volatility environment, whereas practitioners consider fitting all observed option prices important. As a result, practitioners often use a highly nonstationary model whose future behavior may be quite different from its current behavior. Our view is that a moderate approach should be taken in fitting a model to observed option prices. Usually, modest nonstationarity does not seriously affect the future behavior of a model and allows a good fit to today's prices.
Journal: Financial Analysts Journal
Pages: 34-43
Issue: 6
Volume: 57
Year: 2001
Month: 11
X-DOI: 10.2469/faj.v57.n6.2491
File-URL: http://hdl.handle.net/10.2469/faj.v57.n6.2491
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# input file: UFAJ_A_12047309_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Lawrence D. Brown
Author-X-Name-First: Lawrence D.
Author-X-Name-Last: Brown
Title: How Important Is Past Analyst Forecast Accuracy?
Abstract: 
 The Wall Street Journal rates analysts on the basis of past earnings forecast accuracy. These analyst ratings are important to practitioners who believe that past accuracy portends future accuracy. An alternative way to assess the likelihood of “more” or “less” accurate forecasts in the future is to model the analyst characteristics related to the accuracy of individual analysts' earnings forecasts. No evidence yet exists, however, as to whether an analyst characteristics model is better than a past accuracy model for distinguishing more accurate from less accurate earnings forecasters. I show that a simple model of past accuracy performs as well for this purpose as a more complex model based on analyst characteristics. The findings are robust to annual and quarterly forecasts and pertain to estimation and prediction tests. The evidence suggests that practitioners' focus on past accuracy is not misplaced: It is as important as five analyst characteristics combined. Practitioners often rely on the accuracy of analysts' past earnings forecasts to predict future forecast accuracy. A number of sources provide ratings or rankings of past accuracy. For example, the Institutional Investor All-America Research Team rankings and the StarMine SmartEstimate are based partly on past accuracy, and the ratings published annually in the Wall Street Journal are based entirely on past accuracy. An alternative way to assess the likelihood of “more” or “less” accurate forecasts in the future is to model the analyst characteristics related to the accuracy of analysts' earnings forecasts. No evidence yet exists, however, as to whether an analyst characteristics model is better than a past accuracy model for distinguishing more accurate from less accurate earnings forecasters. I addressed this issue in the study reported here.Consistent with Wall Street wisdom that past accuracy portends future accuracy, several researchers have shown that past accuracy is significantly positively correlated with current accuracy. Other academic researchers have identified numerous intuitively appealing analyst characteristics related to earnings forecast accuracy, including the analyst's company-specific experience, the analyst's general experience, the number of companies the analyst follows, the number of industries the analyst follows, and the size of the analyst's brokerage house. To investigate this issue, I used (1) a two-factor PASTACC (past accuracy) model consisting of forecast age and past accuracy and (2) a six-factor ANCHAR (analyst characteristics) model consisting of forecast age and the five analyst characteristics. I explored how these two models perform relative to each other.I used both quarterly and annual data and measured performance in two ways—estimation and prediction. The data are from the Thomson Financial I/B/E/S U.S. Detail file of annual and quarterly analyst earnings forecasts for the 13-year period 1986–1998; I used the last forecast made by each analyst prior to the earnings' announcement.I assessed the estimation performance of the models by comparing their adjusted R2s. The model with the greater explanatory power I considered the better model for estimation purposes. I used 12 years of data, for 1987–1998, based on the parameter estimates of each prior year to obtain predictive results. Using the estimated values of the dependent variable, I identified the two extreme deciles representing analysts expected to be the “most accurate” and “least accurate” earnings forecasters. I determined the mean actual values of the dependent variable in the extreme deciles to ascertain these same analysts' actual forecast accuracy, and I evaluated comparative predictive performance by determining which model was better at identifying actual analyst performance.I show that the PASTACC model performs as well as the ANCHAR model for both quarterly and annual data and in both the estimation and prediction tests. Therefore, the response to the query “how important is past analyst earnings forecast accuracy?” is that, when combined with forecast age, past accuracy is as important as the five analyst characteristics of forecast accuracy I examined.My evidence suggests that the Street's focus on past accuracy is not misplaced. Practitioners who wish to create weighted consensus estimates by using detailed analyst forecasts that are more accurate than a simple (unweighted) consensus can do just as well by using a two-factor model encompassing forecast age and past accuracy as they can using a six-factor model composed of forecast age and the five intuitively appealing analyst characteristics I examined.Foreknowledge of analyst forecast accuracy is valuable. Researchers have shown that “knowing” how likely the accuracy of a forecast of an upcoming quarterly earnings number is and buying stocks on the basis of whether a weighted consensus estimate exceeds a simple consensus estimate can be profitable. Of course, no model allows an investor or manager to “know” the future, but my evidence suggests that one is likely to make as much money using a simple model based on forecast age and past accuracy as one would by using a complex model based on forecast age and five analyst characteristics.
Journal: Financial Analysts Journal
Pages: 44-49
Issue: 6
Volume: 57
Year: 2001
Month: 11
X-DOI: 10.2469/faj.v57.n6.2492
File-URL: http://hdl.handle.net/10.2469/faj.v57.n6.2492
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:6:p:44-49




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# input file: UFAJ_A_12047310_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David T. Brown
Author-X-Name-First: David T.
Author-X-Name-Last: Brown
Author-Name: Philip H. Dybvig
Author-X-Name-First: Philip H.
Author-X-Name-Last: Dybvig
Author-Name: William J. Marshall
Author-X-Name-First: William J.
Author-X-Name-Last: Marshall
Title: The Cost and Duration of Cash-Balance Pension Plans
Abstract: 
 Controversy about the fairness of early transitions from traditional defined-benefit plans to cash-balance plans may have overshadowed the subtleties of funding a cash-balance pension liability. Because crediting rates of cash-balance liabilities float with market rates, the same techniques used to value and hedge floating-rate bonds provide the present value cost and effective duration of a cash-balance liability. The present-value cost of funding a liability varies dramatically across the menu of IRS-sanctioned crediting alternatives. For example, given the yield curve from November 15, 1999, the present value per $1.00 of cash balance of funding a liability paying off 30 years from now varies between $0.90 and $1.48. The effective duration of a cash-balance liability also varies dramatically according to various crediting rates; the effective duration is typically positive but much shorter than the expected time until retirement or other payment and, depending on the choice of crediting rate, can vary by a factor of five or so. These findings are useful for comparing the costs of plans, for comparing how various groups are treated in a plan conversion, or for evaluating the riskiness of any mismatch between assets and liabilities for various funding alternatives. Cash-balance pension plans have become popular since first introduced by Bank of America in 1984. An employee's “cash balance” is the lump-sum accrued pension benefit that depends on both “pay-related credits” linked to salary or wages and “interest-related credits” linked to a market rate. The market rate is a constant-maturity U.S. Treasury bond or bill yield or discount or the U.S. Consumer Price Index. The interest-related credit is at a rate equal to the market rate or the market rate plus a fixed premium.Controversy about the fairness of early transitions from traditional defined-benefit plans to cash-balance plans may have overshadowed the subtleties of funding a cash-balance pension liability. We analyze the market-value cost (i.e., the present value at appropriate market interest rates) of a liability at a fixed maturity represented by $1.00 of cash balance today. This cost, projecting only future interest-related credits and no pay-related credits, is the appropriate present value of the final payoff. The cost is the fair-market-value analog of the projected benefit obligation in a traditional defined-benefit plan.For a cash-balance liability, an increase in interest rates affects value through two channels: increases in the growth rate of the liability over time and increases in the rate at which the terminal value is discounted. Because these two channels have opposite impacts on the value and only the second channel influences the value of a traditional defined-benefit plan, the effective duration of a cash-balance liability is much lower than the effective duration of a comparable traditional defined-benefit liability. Furthermore, the extent to which future crediting rates are expected to increase following an interest rate increase depends critically on the time to maturity of the crediting asset. For example, the increase in projected future 10-year bond yields over the next 10 years following an upward shift in the term structure of interest rates is greater than the expected increase in the projected future 30-year bond yields over the same 10 years.Using the Vasicek model of interest rates with parameters consistent with historical observed yield curves, we show that a 20-year liability credited at the 1-year Treasury rate has an effective duration of 0.4 years. The duration of a 20-year liability credited at the 30-year par Treasury yield has an effective duration of about 4.5 years. The effective duration of a cash-balance plan increases as the maturity of the crediting asset increases and is much less than the duration of a 20-year traditional defined-benefit liability.The cost of funding a cash-balance liability depends on the slope of the term structure of interest rates, the maturity of the crediting asset, and any margin. Although any mismatch between cost and cash balance is most pronounced when yield curves are very steep or inverted, a significant discrepancy can occur even when the yield curve is relatively flat. Using a “benchmark” Treasury yield curve from November 15, 1999, we compute the market-value cost of a cash-balance liability maturing in 20 years and crediting at the 30-year par Treasury yield to be $0.92 per dollar of cash balance. The $0.08 discount to the $1.00 cash balance means that the cost of funding the liability is 41 basis points a year less than the 20-year rate. The market-value cost of this liability is $0.97 per dollar of cash balance if it credits at the 10-year yield or $1.18 per dollar of cash balance if it credits at the 1-year rate plus the U.S. Internal Revenue Service guideline margin. Interestingly, nonzero IRS guideline margins tend to dominate the other effects and make cash-balance liabilities expensive to fund.
Journal: Financial Analysts Journal
Pages: 50-62
Issue: 6
Volume: 57
Year: 2001
Month: 11
X-DOI: 10.2469/faj.v57.n6.2493
File-URL: http://hdl.handle.net/10.2469/faj.v57.n6.2493
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:6:p:50-62




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Author-Name: James A. Bennett
Author-X-Name-First: James A.
Author-X-Name-Last: Bennett
Author-Name: Richard W. Sias
Author-X-Name-First: Richard W.
Author-X-Name-Last: Sias
Title: Can Money Flows Predict Stock Returns?
Abstract: 
 “Money flow” is defined as the difference between uptick and downtick dollar trading volume. Despite little published research regarding its usefulness, the measure has become an increasingly popular technical indicator. Our analysis demonstrates that money flows are highly correlated with same-period returns. We also found strong evidence of “money flow momentum,” in that lagged money flows can be used to predict future money flows. Most important is our finding that money flows appear to predict cross-sectional variation in future returns. Their predictive ability is sensitive, however, to the method of money flow measurement (e.g., the exclusion or inclusion of block trades) and the forecast horizon. “Money flow,” defined as uptick dollar volume minus downtick dollar volume, is a technical indicator first developed in the 1970s. Although the measure has become increasingly popular in recent years, its efficacy has not yet been rigorously tested. In this research, we provide an analysis of the relationship between money flow and returns in the U.S. stock market. Our results suggest that money flow, measured properly, can assist portfolio managers in the security selection process.We began the study by computing three types of daily money flow for NYSE-listed companies: money flow based on all trades, money flow based on block trades, and money flow based on nonblock trades. We normalized each by dividing by the corresponding dollar volume of trading (e.g., normalized block money flow was calculated as block money flow divided by block volume) to create a total of six money flow measures. Although we found each of the six money flow measures to be positively correlated with same-period returns, we found normalized nonblock money flows to be most strongly related to returns.Given the strength of the relationship between contemporaneous money flows and returns, we next examined the predictability of money flows. Using cross-sectional regressions, we found that money flow displays strong persistence: Companies with high money flow in the past tend to have high money flow in the future. Specifically, we found positive relationships between cumulative money flow measured over 1-, 5-, 10-, 20-, 30-, and 40-day periods and lagged money flow measured over the past 1, 5, 10, 20, 30, and 40 days. The strength of the relationship increased with the interval length; that is, longer-term money flow exhibited greater predictability than shorter-term money flow. We show that money flow persistence can be exploited through the formation of stock portfolios that subsequently experience high money flows.We next examined whether money flows can be used to predict returns. Using cross-sectional regressions, we examined the relationships between future returns and past money flows (with combinations of past and future periods of various intervals). Our results reveal that future returns are positively related to past money flows. As when predicting money flows, the strength of the relationship increases with the length of the period over which money flows and returns are measured: Money flows measured over 40 days predict subsequent 40-day returns better than money flows measured over 5 days predict subsequent 5-day returns. Moreover, controlling for past money flows, we found that past returns contain little useful information regarding future returns but that past money flows, even after we controlled for past returns, do contain useful information for predicting future returns.As a final test of the usefulness of money flow, we formed portfolios of money flow “winners” and “losers.” We used 10-, 20-, 30-, or 40-day measurement periods to form the winners and losers and held the portfolios for the subsequent 10, 20, 30, or 40 days. Using the 16 possible combinations of measurement period plus holding period for each of the six money flow measures, we examined the outcomes of the self-financing strategy of taking long positions in money flow winners and short positions in money flow losers. The winner portfolios outperformed the loser portfolios in 74 of the 96 cases we examined.In summary, money flow contains information beyond the information contained in returns and can be a useful tool in security analysis and portfolio management.
Journal: Financial Analysts Journal
Pages: 64-77
Issue: 6
Volume: 57
Year: 2001
Month: 11
X-DOI: 10.2469/faj.v57.n6.2494
File-URL: http://hdl.handle.net/10.2469/faj.v57.n6.2494
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# input file: UFAJ_A_12047312_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Xavier Garza-Gómez
Author-X-Name-First: Xavier
Author-X-Name-Last: Garza-Gómez
Title: The Information Content of the Book-to-Market Ratio
Abstract: 
 This article explores whether the correlation between risk and the market value of equity can explain the premium obtained by investment strategies based on the ratio of book value to market value of equity (BV/MV). Using data from the Japanese stock market, I show that the relationship between BV/MV and risk is weak. I find that two factors contribute to this result. First, market value correlates not only with risk but also with variables measuring liquidity and past performance. Second, book value of equity has a strong correlation with financial risk. Overall evidence suggests that the high correlation between book value and risk reduces the role of market value as a risk proxy and makes other information contained in market value appear to be the main source of the BV/MV premium. The relationship between risk and the market value of equity (MVE) is now commonly accepted in the financial community. It has been used to explain the “size effect” and to construct risk factors for asset-pricing models. As defined by the discounted cash flow model, however, MVE reflects not only risk (the discount rate) but also current market expectations of future cash flows. Because two pieces of information are embedded in MVE, researchers who are trying to use the risk contained in MVE must incorporate a variable as a proxy for market expectations. The natural choices for proxies of future performance are accounting variables. When these variables are used, however, the discounted cash flow model implies that the strong association between stock returns and the ratios constructed with MVE and the accounting variables may be a result of the risk content of MVE. In the study reported here, I used 33 years of data from the Japanese stock market to explore this issue.The article starts with a discussion of the information content of MVE. Initial results show that the association between risk and MVE depends on the type of variable used to control for market expectations. When variables based on physical size (total assets, amount of sales, and so on) are used, the association between risk and MVE is strong. When variables based on earnings (net income, cash flows, book value of equity) are used, the relationship is weaker.Results shown here also indicate that when physical size is controlled for, MVE correlates with financial risk (measured by leverage and earnings volatility), with market risk (measured by market beta and volatility of stock returns), and with other signs of distress (such as the proportion of companies reducing dividends in the portfolio). In addition to these measures of risk, however, MVE also correlates with variables used to measure liquidity and with variables commonly used to form expectations, such as past growth and past returns. Moreover, additional tests suggest that the market extrapolates past performance. Therefore, the evidence here is that both risk and expectations are factors affecting MVE and, consequently, stock returns.I found also that when accounting variables are combined with MVE in a ratio, the physical size variables yield significant relationships between risk and the ratios. Nevertheless, if book value of equity is used to control for expected cash flows, the association between risk and the ratio of book value to market value (BV/MV) is low. Of the seven risk variables I used, only one presented a pattern consistent with the idea that the BV/MV premium arises from risk. To the contrary, I found the association between BV/MV and the variables for liquidity and past performance to be very strong, which suggests that such variables are the only cause of the BV/MV premium.To further investigate this issue, I explore the information content of book value of equity (BVE). My tests show that, beyond its association with physical size, this variable correlates strongly with the seven measures of risk I used in this research. Therefore, in addition to the relationship between MVE and expectations, the strong association between risk and BVE is a cause of the weak relationship between risk and BV/MV.Overall results discussed in the article suggest that the premium obtained by MVE and by ratios formed with accounting variables and MVE is caused not only by risk but also by such factors as liquidity and the market's expectations for the company's future. When book value of equity is used to control for expectations, however, the high correlation between BVE and risk automatically controls one part of the asset's total risk, causing MVE to function less as a risk proxy and more as a reflection of market expectations.
Journal: Financial Analysts Journal
Pages: 78-95
Issue: 6
Volume: 57
Year: 2001
Month: 11
X-DOI: 10.2469/faj.v57.n6.2495
File-URL: http://hdl.handle.net/10.2469/faj.v57.n6.2495
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Handle: RePEc:taf:ufajxx:v:57:y:2001:i:6:p:78-95




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Author-Name: George Leledakis
Author-X-Name-First: George
Author-X-Name-Last: Leledakis
Author-Name: Ian Davidson
Author-X-Name-First: Ian
Author-X-Name-Last: Davidson
Title: Are Two Factors Enough? The U.K. Evidence
Abstract: 
 Some studies in the 1990s documented that book value of equity to market value of equity (BV/MV) and the market value of equity (MVE) capture the cross-sectional variation of stock returns in the U.S. market in the 1963–90 period. Other researchers argued, however, that two other variables—the sales-to-price ratio (S/P) and the debt-to-equity ratio (D/E)—have more explanatory power for stock returns than BV/MV and MVE. The evidence in this article, from London Stock Exchange data, indicates that S/P and D/E do not entirely absorb the roles of BV/MV and MVE in explaining the cross-section of average stock returns in the U.K. market. We did find that S/P has significant explanatory power beyond the contribution of BV/MV and MVE, but the explanatory power of D/E is captured by S/P. The relationship between company-specific variables and subsequent stock returns has important practical applications—for portfolio selection and for other screening of individual stocks. The research into this topic has attracted considerable attention in the United States, but the extent to which the results obtained from U.S. stock data can be generalized to markets in other countries is a crucial question in asset pricing that has not received much attention. Resolving this issue is important not only for any person or organization diversifying investments internationally but also for the composition of domestic portfolios in the countries concerned.Our study is based on U.K. companies listed on the London Stock Exchange. The major U.S. studies on factor analysis provide the background to our analysis. In these studies, factors found to be influential in determining future stock returns are book value of equity to market value of equity (BV/MV), a size factor represented by market value of equity (MVE), the sales-to-price ratio (S/P), and the debt-to-equity ratio (D/E). We used data from the London Share Price Database and Datastream International to conduct an empirical analysis of the relationship of these factors to future returns for the period July 1980 through June 1996. Our final sample consisted of data for 1,420 nonfinancial U.K. companies.Accounting data for all fiscal year-ends in calendar year t − 1 were matched with market returns for July of year t to June of year t + 1. We used a company's accounting variables at the fiscal year-end t − 1 and formed portfolios as of the end of June of year t (for each year), which implies that we used only information that was available to the investor at the time of portfolio formation. We relied primarily on two methodologies in our empirical analysis—portfolio grouping and cross-sectional regression.In the portfolio-grouping approach, we formed portfolios by sorting stocks on this year's observable company-specific variables and comparing the portfolios' returns the following year. We formed the portfolios by (1) ranking the stocks on the basis of the chosen company-specific variable, (2) splitting the ranked list into 10 portfolios containing equal numbers of stocks, (3) calculating the average of the company-specific variable and the average of the following year's market return for the 10 portfolios, and (4) investigating the relationship between the average of the company-specific variable and the average of the following year's market return for each portfolio. We repeated this grouping procedure for the end of June of every year in the sample period; thus, the portfolios were rebalanced 16 times.Our findings for the London market were that BV/MV, MVE, S/P, and D/E are strongly related to future average stock returns. Some of the differences between the average returns of the first and tenth portfolios were striking. For example, when the stocks were sorted by BV/MV, the difference in returns between the top and bottom deciles turned out to be +18.8 percentage points (pps) annually. When MVE was used for the ranking, this return difference was −21.6 pps a year (i.e., smaller companies produced higher return). A similar exercise using S/P gave rise to a +18.6 pps a year difference, and using D/E produced a +15.2 pps a year difference.For the cross-sectional regressions, for each month of the sample period, we ran cross-sectional regressions of individual stock returns (not portfolio returns) on combinations of the company-specific variables. When we used data from the whole sample period, we found that, in contrast to evidence found in the U.S. stock market, the S/P and D/E variables did not absorb the roles of BV/MV and MVE in explaining the cross-section of average stock returns but that S/P has significant explanatory power beyond the contribution of BV/MV and MVE. We also found that the explanatory power of D/E was captured by S/P. To investigate the robustness of the cross-sectional regression results, we split the data into two subperiods and repeated the analysis. This time, S/P was significant for both subperiods but the influence of the other variables was less persistent; BV/MV was insignificant in Subperiod 1 but highly significant in Subperiod 2, and vice versa for MVE. The D/E factor was again dominated by S/P.Finally, we also ran regressions to test for an abnormal January influence. We did not find that a January effect was driving the results.
Journal: Financial Analysts Journal
Pages: 96-105
Issue: 6
Volume: 57
Year: 2001
Month: 11
X-DOI: 10.2469/faj.v57.n6.2496
File-URL: http://hdl.handle.net/10.2469/faj.v57.n6.2496
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# input file: UFAJ_A_12047314_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The EVA Challenge: Implementing Value-Added Change in an Organization (a review)
Abstract: 
 This excellent discussion of the benefits and objectives of EVA (reviewed together with EVA and Value-Based Management) is designed primarily for corporate managers but is of interest to investment professionals. 
Journal: Financial Analysts Journal
Pages: 106-108
Issue: 6
Volume: 57
Year: 2001
Month: 11
X-DOI: 10.2469/faj.v57.n6.2497
File-URL: http://hdl.handle.net/10.2469/faj.v57.n6.2497
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# input file: UFAJ_A_12047316_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Frank J. Jones
Author-X-Name-First: Frank J.
Author-X-Name-Last: Jones
Title: The New Faces of the Markets
Abstract: 
 The faces of Wall Street may be somber, but don't bet against them. On Monday, September 10, 2001, the Wall Street crowd was talking about capital expenditures, consumer confidence, the Federal Reserve Board, and when the George W. Bush tax cut would ripple through the economy. Seven days later, on Monday, September 17, there was a new face on the Street. This face was somber and wore a mask to protect against the smoky air, sported U.S. flags, watched the “rent-a-kilowatt” trucks accompanied by electrical generators, and set about making “patriotic buys.”Experts expected the opening of the NYSE on September 17 after four days of no trading to produce, at the least, “sloppy” trading and extreme volatility—if not an operational crisis and a meltdown. Instead, the NYSE opened in an orderly fashion and the Dow repriced in what was, under the circumstances, a moderate fashion.J.P. Morgan had it right when he said, “The man who is a bear on the future of the U.S. will always go broke.”
Journal: Financial Analysts Journal
Pages: 12-13
Issue: 1
Volume: 58
Year: 2002
Month: 1
X-DOI: 10.2469/faj.v58.n1.2505
File-URL: http://hdl.handle.net/10.2469/faj.v58.n1.2505
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# input file: UFAJ_A_12047317_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: Lottery Players/Stock Traders
Abstract: 
 The behavior of stock traders and lottery buyers can teach us about our common aspirations, thoughts, and emotions and help answer many questions of finance. “My investors insist on buying Treasury bonds because they find corporate bonds too risky,” says a financial advisor, “but they also insist on trading hot IPOs and buying lottery tickets. So, what are they—risk averse or risk seeking?” In fact, we are both risk averse and risk seeking, and our dual behavior reveals our aspirations, thoughts, and emotions.More than 50 years ago, Milton Friedman and Leonard Savage noted that risk aversion and risk seeking share roles in our behavior: People who buy insurance policies often also buy lottery tickets. A short time later, Harry Markowitz wrote two papers that reflect two very different views of behavior. In one, he created the mean–variance framework, and in the other, he extended the insurance–lottery framework. People in the mean–variance framework, unlike people in the insurance–lottery framework, never buy lottery tickets; they are always risk averse, never risk seeking.It is easier to banish risk seeking from our theory than from our behavior. Although mean–variance portfolio theory has become the basis of standard financial theory, investors continue to trade stocks and play the lottery.Lottery playing and stock trading are puzzles in standard financial theory because they are negative-sum games—games that combine high risk with negative expected returns. Lottery playing is a negative-sum game because the lottery authority keeps some of the money. Stock trading (as opposed to buying and holding) is a negative-sum game because brokers and market makers keep some of the money. So, why do people play? First, perhaps all lottery players and stock traders think they are above average, likely to win even in a negative-sum game. Second, perhaps lottery players simply like to play and stock traders simply like to trade. Third, perhaps lottery players play and stock traders trade because they aspire to move up in life, from the working class to the middle or the upper class. I discuss these three possible reasons for lottery playing and stock trading:We think we're above average. According to a 2001 survey of individual investors, the investors expected the stock market to provide a mean 10.3 percent return over the following 12 months, but they expected their own portfolios to provide a mean return of 11.7 percent. In other words, investors expected, on average, to be above average. The unrealistic optimism that people display in the lottery and trading arenas is similar to the unrealistic optimism they display in other arenas. People expect higher-than-average satisfaction in their first jobs, higher-than-average salaries, and a higher-than-average likelihood of having gifted children.We like to play. Lottery playing and stock trading allow players or traders to find “flow experiences.” Flow comes when high challenge meets high skill. It is the experience of an athlete “in the zone,” a slot machine player pulling the lever, or a day trader enthralled by the flickering colors of the monitor.We have aspirations. Some people who aspire to be millionaires can expect to reach their aspirations through steady contributions to IRAs and 401(k) accounts. For others, stock trading and lottery playing offer the only paths up. For example, “Betting on the Market,” a PBS Frontline program of 1997, showed a young couple who traded frequently and watched CNBC constantly: “This is our dream house . . .,” the wife says while pointing to blueprints of a fancy house. “We look at it when we are off to work in the morning and when we come home tired. . . . Isn't it beautiful?”The insurance–lottery framework is a keystone in behavioral portfolio theory. In the simple version of the theory, people have two goals—a “downside protection” goal and an “upside potential” goal. The prototypical purchase for downside protection is an equity participation note, which ensures that investors will at least get their money back. The prototypical purchase for upside potential is a lottery ticket. Lottery buyers are likely to lose their money, but they have a chance to obtain even multimillion dollar levels of upside.
Journal: Financial Analysts Journal
Pages: 14-21
Issue: 1
Volume: 58
Year: 2002
Month: 1
X-DOI: 10.2469/faj.v58.n1.2506
File-URL: http://hdl.handle.net/10.2469/faj.v58.n1.2506
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:1:p:14-21




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# input file: UFAJ_A_12047318_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: William Fung
Author-X-Name-First: William
Author-X-Name-Last: Fung
Author-Name: David A. Hsieh
Author-X-Name-First: David A.
Author-X-Name-Last: Hsieh
Title: Hedge-Fund Benchmarks: Information Content and Biases
Abstract: 
 We discuss the information content and potential measurement biases in hedge-fund benchmarks. Hedge-fund indexes built from databases of individual hedge funds inherit the measurement biases in the databases. In addition, broad-based indexes mask the diversity of individual hedge-fund return characteristics. Consequently, these indexes provide incomplete information to investors seeking diversification from traditional asset classes through the use of hedge funds. The approach to constructing hedge-fund benchmarks we propose is based on the simple idea that the most direct way to measure hedge-fund performance is to observe the investment experience of hedge-fund investors themselves—the funds of hedge funds (FOFs). In terms of measurement biases, returns of FOFs can deliver a cleaner estimate of the investment experience of hedge-fund investors than the traditional approach. In terms of risk characteristics, indexes of FOFs are more indicative of the demand-side dynamics driven by hedge-fund investors' preferences than are broad-based indexes. Therefore, indexes of FOFs can provide valuable information for assessing the hedge-fund industry's performance. We discuss the information content and potential measurement biases in hedge-fund benchmarks. Hedge-fund indexes built from databases of individual hedge funds inherit the measurement biases of the databases. Survivorship bias occurs when database vendors cannot observe the performance information of hedge funds that have ceased operation. Selection bias occurs because of self-reporting by hedge funds and the inclusion criteria of database vendors. What has been termed “instant history bias” occurs when a database vendor backfills a hedge fund's return when the fund enters the database.Broad-based indexes mask the diversity of individual hedge-fund return and risk characteristics. The characteristics of such indexes are dominated by the “popular bets” being made by hedge-fund managers. Recently, for example, the market environment has led to significant equity content in these indexes. Consequently, they lack information for investors seeking diversification from traditional asset classes through the use of hedge funds. For these investors, properly constructed subindexes of different hedge-fund styles are more helpful.As an alternative to indexes of individual hedge funds, we propose an approach to constructing hedge-fund benchmarks that is based on the simple idea that the most direct way to measure hedge-fund performance is to observe the investment experience of hedge-fund investors themselves—that is, the funds of hedge funds (FOFs). In terms of measurement biases, the data from the performance of FOFs are simpler and cleaner estimates of hedge-fund performance than are indexes that aggregate the performance of individual funds.In terms of risk characteristics, unlike indexes of individual hedge funds, which are designed to capture the supply-side dynamics of the hedge-fund universe, an index of FOFs is indicative of demand-side dynamics. In the absence of a liquid, traded market of hedge funds, there is little reason to assume that equilibrium between the supply of hedge funds and investors' demand is always achieved. Typically, hedge-fund managers react to market opportunities and their perception of investor preferences. Hedge-fund investors' preferences, however, are likely to be influenced by such factors as their overall asset allocation profiles. We argue that an FOF index thus provides additional valuable information for the assessment of the hedge-fund industry's performance.
Journal: Financial Analysts Journal
Pages: 22-34
Issue: 1
Volume: 58
Year: 2002
Month: 1
X-DOI: 10.2469/faj.v58.n1.2507
File-URL: http://hdl.handle.net/10.2469/faj.v58.n1.2507
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# input file: UFAJ_A_12047319_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Anne-Sophie Van Royen
Author-X-Name-First: Anne-Sophie
Author-X-Name-Last: Van Royen
Title: Financial Contagion and International Portfolio Flows
Abstract: 
 Financial contagion is an issue of interest to policymakers and portfolio managers. In the presence of contagion, the benefits of geographical diversification may be overstated. Contagion is defined independently of changes in macroeconomic fundamentals. It corresponds to a situation in which shocks in one country spread to another country in a significantly more pronounced manner than during quiet times. In the study reported here, I attempted to measure contagion from daily cross-border portfolio flows. Using data from State Street Bank and Trust Company, I constructed three indexes for 1996 through 2000. I found little statistical evidence of contagion, but the weighted index that measured the “contagiousness” of flows reached its four-year low in August 1998, suggesting that the Russian crisis was characterized by both contagion and large aggregate outflows. I also found that contagion appears to be regional and that the developed countries seem to be sheltered from contagion. Without doubt, a phenomenon such as the Black Death can be identified as contagious, but we cannot make the same claim about crises in financial markets. Financial contagion is an issue of interest not only to policymakers but also to portfolio managers, for in the presence of contagion, the benefits of geographical diversification may be overstated. The waves of crises in the 1990s have prompted economists to examine the factors that trigger such crises and to propose models that issue warning signals. But identifying and measuring contagion depend on how contagion is defined.In the traditional view, contagion is a result of unexpected changes in macroeconomic fundamentals. The change may arise from aggregate shocks that affect the fundamentals of several countries simultaneously or from a shock in one country that affects the fundamentals in other countries. This definition can be challenged. As to the first cause, aggregate shocks do not constitute contagion because they are not transmitted from one country to another; they hit all countries simultaneously. As to the second cause, a shock in one country may affect others because the countries are linked by trade ties or a common economic policy and are hence part of the same real economy. Separating the amount of contagion that may be caused by common macroeconomic factors from the contagion provoked by market news or shifting investor expectations and risk preferences is a challenge.My approach is based on research that focused on the propagation of shocks between countries, wherein contagion was reflected in stock prices. I investigated whether investment flows, however, detect contagion. Capital flows may provide a way of detecting contagion better than stock prices do because flows reflect both prices and quantities. They are also linked to the preferences and beliefs of investors and are thus likely to provide valuable information.I extend previous research on the propagation of shocks between countries in several ways. First, I tested the model on a unique database of cross-border equity flows generated by international investors. Second, I constructed daily aggregate contagion indexes for the 1996–2000 period. Third, to test whether contagion is more global or more regional in nature, I built these indexes so that they could be decomposed into their regional components—the “safe” havens of the developed markets, the emerging markets of Latin America, Asia, and Europe, and the commodity-oriented countries.I found little statistical evidence of contagion. The first of the three indexes, which quantified the average likelihood of contagion across 23 countries, indicated that after reaching a high point in August 1997 (the Asian currency crisis), contagion decreased. It then increased again and culminated in the middle of April 1998, so when the Russian crisis occurred four months later, contagion was already at a historically high level.The two other indexes of contagion attempt to measure the “contagiousness” of equity flows. They take into account the magnitude and direction of net equity flows, as well as the likelihood of contagion, thus distinguishing positive from negative contagion. The Weighted Index indicates that the risk of contagion was extremely high in April 1998. The index reached its four-year low at the end of August 1998, suggesting that the Russian crisis was characterized by both contagion and large aggregate outflows. This pattern differs from the behavior of the index during the Asian crisis. The increase in the index between September 1997 and March 1998 suggests that a flow of capital out of the turbulent regions was accompanied by an inflow to safer countries.As to the regional aspect of crises, the indexes indicate that the region that suffered the least from contagion was the safe countries group, followed by Latin America. Asia experienced the highest proportion of contagious days.I found little evidence of propagation from one region to another, although some evidence indicates that turbulence in Asia may propagate to emerging European and commodity-oriented countries. The group of safe countries appears to be sheltered from contagion.Assuming that the indexes capture financial contagion to some extent, the next question is: Is contagion predictable? Analysis of the time-series properties of the indexes indicates that they possess some persistence. The results of a regime-switching model tend to support the existence of various turbulent regimes, with the turbulent regime being highly transitory.
Journal: Financial Analysts Journal
Pages: 35-49
Issue: 1
Volume: 58
Year: 2002
Month: 1
X-DOI: 10.2469/faj.v58.n1.2508
File-URL: http://hdl.handle.net/10.2469/faj.v58.n1.2508
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# input file: UFAJ_A_12047320_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Alexander W. Butler
Author-X-Name-First: Alexander W.
Author-X-Name-Last: Butler
Title: Revisiting Optimal Call Policy for Convertibles
Abstract: 
 When a company calls its convertible bonds, it typically must give the bondholders a notice period of approximately 30 days to decide whether to convert the bonds. This important institutional detail substantially affects the optimal call policy for convertible bonds. When the company calls the bonds, it fixes the price at which bondholders can redeem them, effectively giving bondholders a 30-day put option. The optimal time to call the convertibles minimizes the value of the conversion option net of the put option. This optimization problem is solved here, and a simple decision rule for the company results. This solution contains those of previous researchers as a special case. When a company calls its convertible bonds, it typically must give the bondholders a notice period of approximately 30 days to decide whether to convert the bonds. This important institutional detail substantially affects the optimal call policy for convertible bonds.By incorporating this detail, this article provides a new benchmark for the appropriate point at which to call a convertible bond issue. Academics and practitioners have long advocated a “safety cushion” for calling convertible bonds that is above the point at which the stock price equals the conversion price. I rationalize and quantify this safety cushion.Specifically, the safety cushion is rational because when a company calls a convertible bond issue, it is effectively giving a put option on the underlying stock to the bondholders. That is, by calling the convertibles, the company fixes the price at which bondholders can redeem the bonds, which gives bondholders a put option for the notice period (in practice, usually 30 days). The optimal time to call the convertibles minimizes the value of the conversion option net of the put option. I analytically solve the problem of the optimal call policy: Companies call so as to maximize the value of their existing equity; to do so, they minimize the value of the bond and warrant net of the stock and put options that must be given up by calling the convertible bonds. I derive a closed-form solution to the optimal call policy for the special case in which exercise of the warrants has no dilutive effect on the existing equity. The more general case of arbitrary dilution can be readily solved numerically.I find that companies will delay calling their convertible bonds when there is a notice period, and this delay increases monotonically as the length of the notice period increases. The instance in which the notice period is of zero length (subject of previous research) is a special case of the optimal call policy found in my approach.I document the sensitivity of the optimal call policy to changes in key parameters. The results indicate that, all else being equal, optimal call policy is most sensitive to changes in the volatility of the underlying stock. It is less sensitive to the length of the call period, the dilutive effect the convertibles will have on the existing equity, and the maturity of the bonds. Furthermore, optimal call policy is quite insensitive to interest rate environments.When several variables are allowed to change simultaneously, optimal call policy can be much higher than for the base case described in the article. For instance, with moderate potential dilution but high volatility, a long maturity, and a long call period, the optimal call policy can easily be above a 50 percent premium (that is, the company in this case should call when the stock price is more than 50 percent higher than the conversion price). Similarly, with a moderate call period but high volatility, a long maturity, and low potential dilution, the optimal call policy can easily be above a 70 percent premium.These results are important for both financial managers who wish to correctly minimize the value of their companies' liabilities and bond traders who wish to correctly anticipate strategic call behavior by those financial managers.
Journal: Financial Analysts Journal
Pages: 50-55
Issue: 1
Volume: 58
Year: 2002
Month: 1
X-DOI: 10.2469/faj.v58.n1.2509
File-URL: http://hdl.handle.net/10.2469/faj.v58.n1.2509
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# input file: UFAJ_A_12047321_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Dan Givoly
Author-X-Name-First: Dan
Author-X-Name-Last: Givoly
Author-Name: Carla Hayn
Author-X-Name-First: Carla
Author-X-Name-Last: Hayn
Title: Rising Conservatism: Implications for Financial Analysis
Abstract: 
 We provide evidence that is consistent with an increase in reporting conservatism by U.S. companies in the past few decades. Using a constant sample of almost 900 companies, we examined several measures of accounting conservatism, including the level and rate of accumulation over time of negative nonoperating accruals, the differential timeliness of incorporating good news versus bad news in reported earnings, the skewness and variability of the earnings distribution relative to the cash flows distribution, and changes in the market-to-book ratio. The increased conservatism has contributed to a persistent and prevalent decline in reported profitability, an increase in the incidence of losses, and an increase in the dispersion of earnings. Increased conservatism affects financial ratios and P/E multiples. Thus, incorporating information on the level of a company's reporting conservatism improves valuations and the yield to investment strategies that are based on these ratios. Anecdotal evidence suggests that financial reporting by U.S. companies has become more conservative in recent decades. For example, most of the new accounting pronouncements have had the effect of accelerating expense recognition and further deferring the recognition of revenues. Furthermore, U.S. capital markets have become more litigious, which induces company managers to be less aggressive in their financial reporting and auditors to be more cautious and prudent in their audits. The observation of an increase in the frequency of losses in recent years, although undoubtedly caused by a number of factors, is consistent with an increase in reporting conservatism.The fact that generally accepted accounting principles have a built-in conservative bias is widely recognized, but the recent trend toward an even greater conservatism has not been systematically documented. We examine the change in the degree of conservatism in financial reporting over the 1950–98 period and discuss its implications for financial statement analysis. Using a constant sample of almost 900 companies, we identify several measures of conservatism, including the level and rate of accumulation over time of negative nonoperating accruals (defined as the difference between net income and cash flows from operations, excluding depreciation and changes in the balance of noncash working capital accounts), the differential speed of incorporating good and bad news in reported earnings, the skewness and variability of the earnings distribution relative to the cash flows distribution, and changes in the market-to-book ratio (M/B).The results of a series of tests are consistent with an increase in reporting conservatism, particularly since about 1980. For example, reported profitability gauged by such ratios as return on assets shows a persistent decline over time without a parallel drop in operational cash flows. In fact, the gap between reported earnings and operational cash flows has widened in recent years, which reflects a systematic and material accumulation of negative nonoperating accounting accruals. This trend is consistent with a transition to a more conservative reporting regime. Other measures of conservatism, among them the speedier incorporation in the financial statements of bad news relative to good news, indicate a similar trend.The finding of increased conservatism suggests that the high M/B values and P/E multiples that peaked in the late 1990s arose, in part, because of changes in the financial reporting regime. Thus, they may indicate more than overpricing. When adjusted for conservatism, an adjustment that takes the form of removing from the income numbers the accumulation of negative nonoperating accruals, the sharp rise in M/Bs and P/Es in the 1980s and 1990s becomes much more modest.We provide at least one measure of change in reporting conservatism that is readily available to analysts as a way to improve fundamental analysis—the current accumulation of nonoperating accruals. We demonstrate that this measure can be used to characterize the reporting regime of individual companies and, therefore, to adjust the earnings and equity multiples computed for a company.
Journal: Financial Analysts Journal
Pages: 56-74
Issue: 1
Volume: 58
Year: 2002
Month: 1
X-DOI: 10.2469/faj.v58.n1.2510
File-URL: http://hdl.handle.net/10.2469/faj.v58.n1.2510
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# input file: UFAJ_A_12047322_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: James D. Peterson
Author-X-Name-First: James D.
Author-X-Name-Last: Peterson
Author-Name: Paul A. Pietranico
Author-X-Name-First: Paul A.
Author-X-Name-Last: Pietranico
Author-Name: Mark W. Riepe
Author-X-Name-First: Mark W.
Author-X-Name-Last: Riepe
Author-Name: Fran Xu
Author-X-Name-First: Fran
Author-X-Name-Last: Xu
Title: Explaining After-Tax Mutual Fund Performance
Abstract: 
 Published research on the topic of mutual fund performance focuses almost exclusively on pretax returns. For U.S. mutual fund investors holding positions in taxable accounts, however, what matters is the after-tax performance of their portfolios. We analyzed after-tax returns on a large sample of diversified U.S. equity mutual funds for the 1981–98 period. We found the variables that determined after-tax performance for this period to be past pretax performance, expenses, risk, style, past tax efficiency, and the recent occurrence of large net redemptions. U.S. equity fund investors in high tax brackets lost an average of about 2.2 percentage points annually to taxes in the 1981–98 period. But despite the important impact of taxes on investor returns, published research on the topic of mutual fund performance focuses almost exclusively on pretax returns. We identify a concise set of publicly available variables that are useful for explaining the subsequent after-tax performance of U.S. equity funds. With this information, investors and their advisors are better equipped to make fund selections for taxable accounts.The study consisted of an analysis of the returns on a large sample of diversified U.S. equity mutual funds for the 1981–98 period. The main findings from our analysis of after-tax returns are as follows: After we controlled for other factors, we found thatfunds that were historically tax efficient subsequently outperformed comparable funds on an after-tax basis,funds that recently experienced large net redemptions, particularly large-capitalization value funds, subsequently underperformed comparable funds on an after-tax basis,risk, investment style, past pretax performance, and expenses were important determinants of after-tax returns (and of pretax returns), andturnover in stock holdings was apparently not related to future after-tax returns.To isolate the tax effects associated with the characteristics studied, we also analyzed mutual fund tax efficiency in the 1981–98 period. This analysis revealed that, after other factors were controlled for, funds that did not experience recent large cash redemptions, did experience recent large cash inflows, were historically tax efficient, were classified as small cap, or had high expense ratios subsequently tended to be more tax efficient. However, although funds with large cash inflows, high expense ratios, or an emphasis on small-cap stocks tended to be more tax efficient, they also tended to have lower pretax returns. In fact, the negative influence of these traits on pretax returns was at least as great as their positive influence on tax efficiency, which implies a neutral or negative net effect of the three traits on after-tax returns. These results suggest that taxable investors and their advisors should not make investment decisions with tax efficiency as their sole consideration. The focus should be on after-tax returns. We recommend, as would be the recommendation for investors holding funds in nontaxable accounts, that taxable investors diversify among investment styles (large–small, value–growth) and focus on funds with good past pretax performance and low expenses. In addition, when selecting U.S. equity funds for taxable accounts, investors should further focus on funds with high past tax efficiency that have not recently experienced large net redemptions.
Journal: Financial Analysts Journal
Pages: 75-86
Issue: 1
Volume: 58
Year: 2002
Month: 1
X-DOI: 10.2469/faj.v58.n1.2511
File-URL: http://hdl.handle.net/10.2469/faj.v58.n1.2511
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:1:p:75-86




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# input file: UFAJ_A_12047323_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rachel Campbell
Author-X-Name-First: Rachel
Author-X-Name-Last: Campbell
Author-Name: Kees Koedijk
Author-X-Name-First: Kees
Author-X-Name-Last: Koedijk
Author-Name: Paul Kofman
Author-X-Name-First: Paul
Author-X-Name-Last: Kofman
Title: Increased Correlation in Bear Markets
Abstract: 
 A number of studies have provided evidence of increased correlations in global financial market returns during bear markets. Other studies, however, have shown that some of this evidence may be biased. We derive an alternative to previous estimators for implied correlation that is based on measures of portfolio downside risk and that does not suffer from bias. The unbiased quantile correlation estimates are directly applicable to portfolio optimization and to risk management techniques in general. This simple and practical method captures the increasing correlation in extreme market conditions while providing a pragmatic approach to understanding correlation structure in multivariate return distributions. Based on data for international equity markets, we found evidence of significant increased correlation in international equity returns in bear markets. This finding proves the importance of providing a tail-adjusted mean–variance covariance matrix. A generally accepted concept today is that, over time, returns when the markets are experiencing large negative movements are more highly correlated than returns during more normal times. If true, this phenomenon has serious implications for portfolio and risk management because it means that the benefits of diversification are curtailed precisely when investors most need them.The correlation, however, depends on how the returns are conditioned on the size of the returns. Previous studies have provided alternative correlation structures with which to compare conditional empirical correlations, but these estimates have upward or downward biases that need to be corrected. In this article, we provide a quantile correlation approach that is not biased by the size of the return distribution. The result is a simple and pragmatic approach to estimating correlations conditional on the size of the returns. Based on empirical data, we show how the correlation estimates can be used directly in portfolio and risk management.We derive a conditional correlation structure based on the quantile of the joint return distribution; that is, correlation is conditioned on the size of the return distribution. In a bivariate framework, the correlation is estimated by using those observations that fall below the portfolio return of the two assets. The approach is thus in line with current correlation measures used in Markowitz-style portfolio analysis and in current risk management techniques. The quantile correlation structure is determined by the weights of the assets in the portfolio and the quantile estimates of the distribution of returns on the two assets and of the portfolio return.When the distribution is normal, the conditional correlation structure is constant; hence, the conditional quantile correlation will equal the unconditional correlation. Therefore, because the correlation structure is constant over the distribution for normality, one can easily compare empirical estimates of conditional correlation with their theoretical values under conditions of normal distribution.We examine a variety of daily returns from international stock market indexes for the period May 1990 through December 1999 to establish, first, their unconditional correlations. For example, this procedure produced a correlation between the U.S. market (S&P 500 Index) and the U.K. market (the FTSE 100 Index) of 0.349. Assuming bivariate normality for the whole distribution, we would expect the quantile conditional correlation also to be 0.349. For quantiles up to the 95 percent level, we found that the assumption of normality cannot be rejected at the 95 percent confidence level for all the series. For higher quantiles, however—that is, large negative returns in the bivariate return distribution—the conditional correlation structure increased the correlations; in the case of the U.S. and U.K. markets, the correlation increased to 0.457. The effect on mean–variance portfolio optimization is a reduction in the recommended weight of the risky assets held in the portfolio.These results imply that the gains from diversification are not reaped in periods when diversification benefits are most crucial from a mean–variance perspective—in bear markets. Practitioners, therefore, need to know what sort of model is generating the correlations they are relying on. If the underlying model assumed normality, then the correlation estimates used in the model need to be adjusted to incorporate the bear market's higher-than-normal correlation structure.
Journal: Financial Analysts Journal
Pages: 87-94
Issue: 1
Volume: 58
Year: 2002
Month: 1
X-DOI: 10.2469/faj.v58.n1.2512
File-URL: http://hdl.handle.net/10.2469/faj.v58.n1.2512
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:1:p:87-94




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# input file: UFAJ_A_12047324_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Duen-Li Kao
Author-X-Name-First: Duen-Li
Author-X-Name-Last: Kao
Title: Battle for Alphas: Hedge Funds versus Long-Only Portfolios
Abstract: 
 The study reported here empirically examined whether the alphas of hedge funds and those of long-only portfolios present different distributions and are derived from different risk factors. Adjusted for return volatility differences, hedge funds seem to offer more consistent alphas for potential transfer to either equity or bond asset classes than do long-only portfolios—even under extreme market conditions. Potential explanations for the findings include lack of data reliability and differences between hedge funds and actively managed long-only funds in compensation, investment constraints, and structures. Factors related to market index returns do not adequately detect hedge funds' risk postures beyond a fund's exposure to the market-directional risk of standard asset classes. Risk factors derived from asset prices in financial markets do provide timely and systematic descriptions of the risks underlying trading strategies used by hedge funds. The multifactor style-risk analysis presented here can effectively monitor a hedge fund's exposure to systematic versus idiosyncratic risks and volatility-risk factors over time. The technology investing debacle, diminishing equity return expectations, and the inability of long-only portfolios to generate positive alphas have greatly contributed to institutional investors' recent interest in hedge-fund investments. The optionlike return pattern of hedge funds, however, is a challenge for investors in analyzing risk exposures. Single measures of risk and return always have the potential to be misleading, but they are especially inadequate in analyzing hedge-fund risk. Investors need to carefully examine the return patterns of a fund at times of various market conditions and consider the fund's exposure to various forms of systematic risk factors.This article addresses two questions relevant to investor analysis of hedge-fund performance: First, do alphas from hedge funds and long-only portfolios have different return attributes? And second, do the sources of alpha for the two types of investments derive from different risk factors? Because investors can transfer alpha obtained from hedge funds to their traditional asset-class portfolios, a more appropriate way to evaluate hedge funds and long-only portfolios than simply comparing their returns is to compare their returns in excess of their respective benchmarks. The empirical findings presented here indicate that hedge funds, especially equity market-neutral strategies, provide more consistent transferable alpha than do long-only portfolios for both equity and bond asset classes and in various market environments. I assess possible explanations of this performance difference from the standpoints of data reliability and differences between hedge funds and long-only funds in fees, manager incentives, investment constraints versus flexibility, and other structural factors.Risk factors derived from asset prices in financial markets are timely and useful for hedge-fund risk analysis. Most relevant to hedge funds' risk profiles are exposure to the market-directional risk of standard asset classes and various volatility risks. I show that the way in which a hedge fund manages its exposures to implied volatilities in extreme market conditions may be the key to consistent performance. The results presented in the article highlight the importance of diversifying one's hedge-fund investments among different strategies—between funds and within a fund—for achieving consistent performance.An analytical framework that incorporates multiple risk factors (rather than a single factor) gives investors a more complete picture of hedge-fund risk taking. Therefore, in the spirit of equity style analysis, which is so popular among practitioners, I evaluate common risk factors driving the performance of hedge funds and long-only portfolios. In this style-risk approach, various financial market risk indicators are categorized into (1) exposure to market risks (market-directional risk) and (2) exposure to volatility risk, which provides a concise assessment of risk exposures over time.I also review another approach to analyzing hedge-fund risk—direct replication of the hedge fund's optionlike payoff profile, trading strategies, or arbitrage opportunities. Return series derived from this “mimicking” approach are particularly useful for studying the risk factors and performance attributes of hedge-fund investing. It also provides a promising direction for future research into hedge-fund asset pricing.
Journal: Financial Analysts Journal
Pages: 16-36
Issue: 2
Volume: 58
Year: 2002
Month: 3
X-DOI: 10.2469/faj.v58.n2.2520
File-URL: http://hdl.handle.net/10.2469/faj.v58.n2.2520
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:2:p:16-36




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# input file: UFAJ_A_12047325_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Miles Livingston
Author-X-Name-First: Miles
Author-X-Name-Last: Livingston
Author-Name: Lei Zhou
Author-X-Name-First: Lei
Author-X-Name-Last: Zhou
Title: A Proposal for Quoting Money Market Rates
Abstract: 
 U.S. money market interest rates may be quoted in many different ways. Regardless of the method, however, the amount of the loan, the coupon, and the par value of the loan are the same. The only difference in the methods is how the interest rate is quoted. This multiplicity of ways of quoting interest rates is a cause of constant confusion for novices attempting to analyze money market instruments and has no value for experts. We propose a single way to quote money market interest rates regardless of the type of money market instrument. The proposed method is not only consistent for the various instruments; it is also consistent with the Truth in Lending Law. Any observer of the U.S. market for money market instruments must be struck by the great number of ways of quoting money market interest rates. At least five different ways are frequently used to quote interest rates on zero-coupon money market instruments with maturities of less than six months. And additional methods are used to quote coupon-bearing money market instruments or money market instruments with maturities of between six months and one year.Two instruments may have the same price or amount of loan, same coupon, and same par value, but the calculation of the interest rate differs. For example, suppose a 90-day noncoupon money market instrument has a par value of $100 and a price of $99. The quoted discount rate on the instrument is 4 percent, the add-on rate is 4.04 percent, the bond-equivalent yield is 4.10 percent, the semiannual yield is 4.12 percent, and the annual yield to maturity is 4.16 percent. This multiplicity of ways of quoting interest rates is a cause of constant confusion for novice analysts in the field of money market instruments and has no value for experts.The reason for the multiplicity of interest rates appears to be historical accident. Before hand-held calculators, various money markets developed separately over time, but the ability to calculate rates easily was important, so each market developed an easy calculation. With the advent of hand-held calculators, calculation of any of these interest rates is no longer a problem.Because long-term bonds in the United States are quoted in terms of semiannual yield to maturity (i.e., annualized semiannually compounded yield to maturity), the world of fixed-income analysis would be greatly simplified if all interest rates were stated this way. There would be no need to state interest rates on a particular debt instrument in different ways, and given the ease of calculating the semiannual yield to maturity, there is no reason to have any other interest rate. Therefore, we propose that the bond market use the semiannual yield for all bonds and money market instruments.
Journal: Financial Analysts Journal
Pages: 38-42
Issue: 2
Volume: 58
Year: 2002
Month: 3
X-DOI: 10.2469/faj.v58.n2.2521
File-URL: http://hdl.handle.net/10.2469/faj.v58.n2.2521
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:2:p:38-42




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# input file: UFAJ_A_12047326_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Erik Lie
Author-X-Name-First: Erik
Author-X-Name-Last: Lie
Author-Name: Heidi J. Lie
Author-X-Name-First: Heidi J.
Author-X-Name-Last: Lie
Title: Multiples Used to Estimate Corporate Value
Abstract: 
 We evaluated various multiples practitioners use to estimate company value. We found, first, that the asset multiple (market value to book value of assets) generally generates more precise and less biased estimates than do the sales and the earnings multiples. Second, although adjusting for companies' cash levels does not improve estimates of company value, using forecasted earnings rather than trailing earnings does. Third, the earnings before interest, taxes, depreciation, and amortization (EBITDA) multiple generally yields better estimates than does the EBIT multiple. Finally, the accuracy and bias of value estimates, as well as the relative performance of the multiples, vary greatly by company size, company profitability, and the extent of intangible value in the company. Despite the importance of valuation in a variety of contexts, surprisingly few studies have examined the accuracy of various valuation techniques. Only the effect of the choice of matching companies on the valuation accuracy of P/E multiples and the usefulness of discounted cash flow and various multiples in valuing rather narrow subsets of companies, such as companies that operate in bankruptcy, have been addressed. The study reported here explicitly examined the overall performance of a variety of multiples used for valuation. The purpose was to examine the biases and valuation accuracy of multiples based on earnings, sales, or book value of assets for several categories of companies.For the aggregate sample, we found that all multiples yield estimates that are somewhat negatively biased. That is, the mean valuation errors are slightly negative, whereas the median valuation errors are roughly zero. The ratio of market value to book value of assets yields the most accurate estimates. Adjusting the market and book values for the level of cash does not improve the accuracy, but using forecasted earnings in place of historical earnings improves the estimates based on the P/E multiple.We partitioned the sample into financial and nonfinancial companies and, within those two groups, formed groups based on size and profitability. We also partitioned the companies into those with high (low) levels of intangible assets and research and development activities. We found that valuations are more precise for large companies. For all company sizes, the asset multiple performs the best and the sales multiple performs the worst. Valuations based on the asset multiple appear to be most precise for companies with mediocre or low earnings; they are roughly equally as precise as valuations based on other multiples for companies with high earnings. The bias for the measures as applied to companies grouped by earnings varies: For companies with high earnings, earnings-based multiples yield a positive valuation bias, but the asset multiple yields a negative bias—and vice versa for companies with low earnings.The valuations tend to be more accurate for financial companies than for nonfinancial companies. Nevertheless, the trends regarding the performance of various multiples for groups based on size or profitability are similar for financial and nonfinancial companies.When we assessed the performance of the multiples for companies with high intangible assets (i.e., either “dot-com” companies or companies with large levels of R&D), the valuation estimates became generally worse, especially for the dot-coms. We also found the estimates to be systematically lower than the actual values, presumably because the estimates do not fully capture the growth opportunities and other intangibles associated with these companies.Our research is certainly relevant to practitioners, such as investment bankers and analysts, because they use multiples to value companies, but we believe it is also consequential to academic researchers. For instance, studies of the effect of corporate diversification on value use multiples to value individual segments of a company and then compare the estimated aggregate value to the market value to determine the “excess value” created by diversification. The results presented here may help such researchers choose multiples that minimize potential bias embedded in the value measures, especially if the companies or company segments exhibit certain irregularities.
Journal: Financial Analysts Journal
Pages: 44-54
Issue: 2
Volume: 58
Year: 2002
Month: 3
X-DOI: 10.2469/faj.v58.n2.2522
File-URL: http://hdl.handle.net/10.2469/faj.v58.n2.2522
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:2:p:44-54




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# input file: UFAJ_A_12047327_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Matthew R. Morey
Author-X-Name-First: Matthew R.
Author-X-Name-Last: Morey
Title: Mutual Fund Age and Morningstar Ratings
Abstract: 
 The study reported here identified an age bias in the Morningstar mutual fund ratings. I found that the average overall star ratings of seasoned funds are consistently—and in many cases, significantly—higher than the average overall star ratings of younger funds. This bias is not the result of a survivorship bias but of the methodology Morningstar uses to calculate the ratings. If star ratings affect fund flows, then this age bias in the Morningstar ratings is of significance to the mutual fund industry and to investors. With the tremendous growth of privately managed retirement accounts and the more than 10,000 mutual funds now available to investors, mutual fund ratings have never been more in demand. One popular, if not the most popular, provider of mutual fund ratings today is Morningstar, Inc. Started in the mid-1980s, Morningstar has grown largely as a result of the success of its five-star rating system. Similar to the rating of hotels, movies, and restaurants, Morningstar rates mutual funds on a scale of one to five stars, where one star is the worst rating and five stars is the best.The Morningstar rating system has become so popular that many people believe investment flows in and out of mutual funds are closely related to the Morningstar ratings. Moreover, the heavy use of Morningstar ratings in mutual fund advertising suggests that mutual fund firms believe investors care about Morningstar ratings.The purpose of the study reported in this article was to document a methodological bias in the Morningstar ratings. The bias results from the way Morningstar treats funds of different “ages.” Morningstar ratings are created by aggregating 3-year, 5-year, and 10-year star ratings for each fund. The ratings of young funds that do not have 5 years of return history are based solely on the 3-year ratings. The ratings for funds with 10 years or more of return history are based on a 20 percent weighting of the 3-year rating, a 30 percent weighting of the 5-year rating, and a 50 percent weighting of the 10-year rating. Therefore, the ratings of older funds are less likely to fall than those of younger funds. The result is that older funds tend to have higher ratings—not because of performance per se but because of the weighting system.After illustrating this bias, I document that the bias emerges in the actual ratings. Upon examining each of the 37 quarterly Morningstar data disks from October 1991 to October 2000, I found that the average overall star rating of the seasoned (oldest) funds was greater than that of the young funds in 36 of the 37 quarters. Moreover, in 26 of 37 cases, the seasoned funds' average rating was significantly higher. Finally, I found in robustness checks that these results are related to methodological bias, not survivorship bias.Two implications of the results are particularly important. First, if investors do care about the ratings, then these results mean that investors should be careful in interpreting the overall ratings as signals of past performance, much less future performance. Investors need to look beyond the ratings when deciding which fund(s) to invest in. And to its credit, Morningstar gives similar advice.Second, mutual fund rating services may want to use a single consistent time horizon to evaluate funds. Systems that use time horizons that depend on the age of the fund can lead to biases that make the ratings more subjective than objective. Again, to its credit, Morningstar has tried to address this issue by putting more emphasis on alternative ratings that use the same amount of information for each fund.
Journal: Financial Analysts Journal
Pages: 56-63
Issue: 2
Volume: 58
Year: 2002
Month: 3
X-DOI: 10.2469/faj.v58.n2.2523
File-URL: http://hdl.handle.net/10.2469/faj.v58.n2.2523
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:2:p:56-63




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# input file: UFAJ_A_12047328_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Author-Name: Peter L. Bernstein
Author-X-Name-First: Peter L.
Author-X-Name-Last: Bernstein
Title: What Risk Premium Is “Normal”?
Abstract: 
 The goal of this article is an estimate of the objective forward-looking U.S. equity risk premium relative to bonds through history—specifically, since 1802. For correct evaluation, such a complex topic requires several careful steps: To gauge the risk premium for stocks relative to bonds, we need an expected real stock return and an expected real bond return. To gauge the expected real bond return, we need both bond yields and an estimate of expected inflation through history. To gauge the expected real stock return, we need both stock dividend yields and an estimate of expected real dividend growth. Accordingly, we go through each of these steps. We demonstrate that the long-term forward-looking risk premium is nowhere near the level of the past; today, it may well be near zero, perhaps even negative. The investment management industry thrives on the expedient of forecasting the future by extrapolating the past. As a consequence, U.S. investors have grown accustomed to the idea that stocks “normally” produce an 8 percent real return and a 5 percent risk premium over bonds compounded annually over many decades. Why? Because long-term historical returns have been in this range with impressive consistency. Because investors see these same long-term historical numbers year after year, these expectations are now embedded in the collective psyche of the investment community.Both the 8 percent real return and the 5 percent risk premium assumptions are unrealistic in light of current market levels; more importantly, they have rarely been realistic in the past. As we demonstrate in this article, the long-term forward-looking risk premium is nowhere near the 5 percent level of the past; indeed, today, it may well be near zero, perhaps even negative.The goal of this article is to estimate the objective forward-looking equity risk premium relative to bonds through history. For correct evaluation, such a complex topic requires several careful steps: To gauge the risk premium for stocks relative to bonds, we need an expected real stock return and an expected real bond return. To gauge the expected real stock return, we need both stock dividend yields and an estimate of expected real dividend growth. To gauge the expected real bond return, we need both bond yields and an estimate of expected inflation through history. Accordingly, we go through each of these steps.We distinguish between observed historical return differences (that is, excess returns of the past) and the risk premium, which refers to expected future return differences. A critical component of our approach to the risk premium is to consider what investors could reasonably have been expecting at various points in the past. Using data from a variety of sources, we examine the history of U.S. bond returns, stock returns, return expectations, and economic, political/geopolitical, and demographic changes from 1802 to 2001.We draw the following conclusions:  The observed real stock returns and the excess return for stocks relative to bonds in the past 75 years have been extraordinary, largely as a result of important nonrecurring developments.  The investors of 75 years ago would not have had an objective basis for expecting the 8 percent real returns or 5 percent excess returns that stocks subsequently delivered.  To shape future expectations based on extrapolating these lofty historical returns is dangerous. In so doing, an investor is tacitly assuming that valuation levels that have doubled, tripled, and quadrupled, relative to underlying earnings and dividends, can be expected to do so again.  The real internal growth that companies have generated for nearly 200 years in dividends and earnings is slower than the increase in real per capita GDP. This internal growth is far less than the consensus expectations for future earnings and dividend growth.  The historical average equity risk premium, measured relative to 10-year government bonds, that investors might objectively have expected on their equity investments, is about 2.4 percent. The consensus that a normal risk premium is about 5 percent was shaped by deeply rooted naivete in the investment community, where most participants have a career span reaching no farther back than the monumental 25-year bull market of 1975-1999. This kind of mind-set is a mirror image of the attitudes of the chronically bearish veterans of the 1930s. Today, investors are loathe to recall that the real total returns on stocks were negative for most 10-year spans during the two decades from 1963 to 1983 or that the excess return of stocks relative to long bonds was negative as recently as 10 years ago. When reminded of such experiences, today's investors tend to retreat behind the mantra “things will be different this time.” No one, however, can kneel before the notion of the long run and at the same time deny that past circumstances will again occur in the decades ahead. Indeed, such crises are more probable than most of us would like to believe. Investors naive enough to expect a 5 percent risk premium and to sharply overweight equities accordingly may well be doomed to deep disappointments in the future.
Journal: Financial Analysts Journal
Pages: 64-85
Issue: 2
Volume: 58
Year: 2002
Month: 3
X-DOI: 10.2469/faj.v58.n2.2524
File-URL: http://hdl.handle.net/10.2469/faj.v58.n2.2524
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# input file: UFAJ_A_12047329_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: C. Mitchell Conover
Author-X-Name-First: C. Mitchell
Author-X-Name-Last: Conover
Author-Name: Gerald R. Jensen
Author-X-Name-First: Gerald R.
Author-X-Name-Last: Jensen
Author-Name: Robert R. Johnson
Author-X-Name-First: Robert R.
Author-X-Name-Last: Johnson
Title: Emerging Markets: When Are They Worth It?
Abstract: 
 Using 24 years of data, we show that emerging market equities are a worthy addition to a U.S. investor's portfolio of developed market equities. Specifically, portfolio returns increased by approximately 1.5 percentage points a year when emerging country equities were included in the investment set. When we considered U.S. Federal Reserve monetary policy, however, we found that the benefits of investing in emerging markets accrued almost exclusively during periods of restrictive U.S. monetary policy. During periods of expansive U.S. monetary policy, the benefits to a U.S. investor of holding emerging market equities were trivial. An implication of our findings is that evaluating monetary conditions is a necessary prerequisite to identifying an optimal allocation of assets to international equities. The study we report reexamined the benefits to U.S. investors of investing in international equities, with a focus on emerging market stocks and on differences in returns and risks between periods of expansive U.S. monetary policy and periods of restrictive U.S. monetary policy. Several past studies have shown that international equities offer diversification benefits for U.S. investors, primarily because of the relatively low correlation of non-U.S. with U.S. stock returns. Emerging market equities have been shown to have particularly low correlations with the U.S. stock market. A troubling aspect of the past correlation findings, however, is that the correlations of non-U.S. and U.S. equity markets differ substantially over time. Of even more concern is the finding that the correlations tend to increase during periods when the markets are exhibiting the worst performance. Thus, the benefits of international diversification may be lowest when diversification is most needed.Our analysis had two basic objectives: to quantify the overall benefit of investing in emerging markets and to determine whether the benefit fluctuates systematically with changes in U.S. monetary conditions. Based on recent evidence that shows stock market performance in developed countries to be systematically related to broad changes in monetary policy, we hypothesized that the benefits of international diversification may be related to changes in U.S. monetary conditions. In particular, previous findings confirm that, in the developed markets, equities perform much better (worse) than average during expansive (restrictive) monetary periods—perhaps because the monetary authorities in developed countries tend to cooperate in setting monetary policy. We argued, however, that the monetary policy decisions of developing country monetary authorities are less likely to coincide with their counterparts in developed countries. Thus, relative to the developed markets, emerging markets might provide a more effective hedge against the poor performance exhibited by U.S. equities during periods of restrictive U.S. monetary policy.The sample used in this analysis compares favorably with past research, based on both breadth and length of time period covered. We considered returns to 20 emerging markets over a 24-year study period, whereas past studies relied on approximately half as many countries and a much shorter time frame. Therefore, our findings are less influenced by extreme observations that may have occurred in a particular time period or a particular country.Our results indicate that adding emerging market equities to a portfolio that consists of developed country equities adds a net benefit of 1.5-2.0 percentage points (pps) a year to returns. This finding confirms the view that emerging market equities are an attractive diversification vehicle for U.S. investors. Furthermore, we found that emerging market equities represent a significant weight in both high-risk and low-risk efficient portfolios, which indicates that emerging market equities are beneficial even for equity investors with relatively high levels of risk aversion.A more surprising result is that the benefit associated with investing in emerging market equities accrues almost entirely during periods of restrictive U.S. monetary policy; we found the net benefit to be more than 4 pps annually. During periods of expansive U.S. monetary policy, emerging markets added only a trivial improvement to portfolio performance (approximately 0.2 pps a year). This finding indicates that a necessary prerequisite to determining the appropriate allocation to international equities is to monitor U.S. monetary conditions.
Journal: Financial Analysts Journal
Pages: 86-95
Issue: 2
Volume: 58
Year: 2002
Month: 3
X-DOI: 10.2469/faj.v58.n2.2525
File-URL: http://hdl.handle.net/10.2469/faj.v58.n2.2525
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:2:p:86-95




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# input file: UFAJ_A_12047330_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ronald van Dijk
Author-X-Name-First: Ronald
Author-X-Name-Last: van Dijk
Author-Name: Fred Huibers
Author-X-Name-First: Fred
Author-X-Name-Last: Huibers
Title: European Price Momentum and Analyst Behavior
Abstract: 
 Previous studies have found evidence that selecting stocks with positive price momentum is effective in the U.S., European, and emerging stock markets for periods up to a year. The reasons that historical price momentum forecasts the direction and magnitude of stock returns, however, are not clear. Insight into the determinants of price momentum would allow investors to judge whether and how price momentum should play a role in their investment strategies. Studying the European stock markets, we found that positive price momentum is caused by analyst underreaction to new earnings information. We found earnings surprises, expected earnings growth, and earnings revisions to be systematically related to historical price movements. Importantly, the data show that European price momentum is distinct from the widely documented value and size effects. Our findings clarify the benefits of assessing analyst behavior to predict whether momentum investing might work in the next period. Price momentum refers to a tendency of stock prices to continue on the same path from one period to the next. The existence of such return continuation for periods up to a year has been documented for the U.S., European, and emerging equity markets in studies conducted by both academics and practitioners. The cause (or causes) of price momentum, however, is subject to much controversy. Some argue that it is a manifestation of slow reaction by analysts to earnings-related news. The study reported in this article provides empirical evidence, based on European data, of the validity of this hypothesis.We used a comprehensive sample of all European stocks that had at least one earnings forecast in the I/B/E/S database spanning the period February 1987 and June 1999. We confirmed that price momentum strategies were profitable in the sample period. This finding is robust to corrections for size effects, value versus growth effects, estimated earnings-growth effects, and the effects of country-specific risk.To test the underreaction hypothesis, we examined the relationships among earnings surprises, expectations for future earnings growth, earnings revisions, and the returns from momentum investing. The primary finding of this study is that a pessimism bias exists for portfolios composed of strong-price-momentum stocks and an optimism bias exists for portfolios consisting of weak-price-momentum stocks. The optimism bias is definitely more substantial than the pessimism bias; underreaction of analysts to earnings-related news is likely. We based this conclusion on the observation that earnings surprises are positive for strong-momentum stocks and negative for weak-momentum stocks. Moreover, just after an earnings announcement by a company, the expected growth in earnings is more overestimated for weak-momentum stocks than it is for strong-momentum stocks. The revisions were generally downward but were more downward for weak-momentum stocks.Furthermore, we found that the widely documented value and size anomalies are distinct from the price momentum anomaly. An almost perfectly linear negative relationship exists between price momentum and the book-to-market ratio, whereas if the momentum and the book-to-market effects were the same phenomenon, we would expect a positive relationship. We found a relationship between market capitalization and momentum to be either absent or positive, which is inconsistent with the hypothesis that these two anomalies are the same phenomenon.When we examined how robust the results are to some changes in sample selection and the method of portfolio construction, we found that the empirical results were not driven by one particular European country and were similar for the first and second halves of the sample period. In addition, the results are robust to alternative currency assumptions for the returns and to alternative methods of portfolio construction.Based on our findings, price momentum strategies were profitable in the European markets in the period we studied, but these strategies may produce incremental returns only as long as underreaction to earnings information persists. Therefore, this study implies that to monitor the risks of using a price momentum strategy, investors should continuously observe analyst behavior and changes in behavior. Indicators for underreaction are earnings surprises within the price momentum portfolios and autocorrelations in earnings-forecast revisions. Whether price momentum strategies will continue to generate excess returns after a significant change in analyst behavior depends on the existence of other causes for price momentum—which calls for further research.
Journal: Financial Analysts Journal
Pages: 96-105
Issue: 2
Volume: 58
Year: 2002
Month: 3
X-DOI: 10.2469/faj.v58.n2.2526
File-URL: http://hdl.handle.net/10.2469/faj.v58.n2.2526
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:2:p:96-105




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# input file: UFAJ_A_12047331_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Wall Street People: True Stories of Today's Masters and Moguls (a review)
Abstract: 
 This enjoyable and instructive book is a treasure trove for students of financial history—with sketches of luminaries and rascals, anecdotes, and descriptions of the sources of various financial products. 
Journal: Financial Analysts Journal
Pages: 106-107
Issue: 2
Volume: 58
Year: 2002
Month: 3
X-DOI: 10.2469/faj.v58.n2.2527
File-URL: http://hdl.handle.net/10.2469/faj.v58.n2.2527
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:2:p:106-107




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# input file: UFAJ_A_12047332_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Complete Investment and Finance Dictionary (a review)
Abstract: 
 Designed as an investment guide as well as a lexicon, the author of this reference book defines and illustrates the use of various analytical tools and points out potential pitfalls in their applications. 
Journal: Financial Analysts Journal
Pages: 107-108
Issue: 2
Volume: 58
Year: 2002
Month: 3
X-DOI: 10.2469/faj.v58.n2.2528
File-URL: http://hdl.handle.net/10.2469/faj.v58.n2.2528
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:2:p:107-108




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# input file: UFAJ_A_12047333_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: No Bull:My Life In and Out of Markets (a review)
Abstract: 
 This memoir of a hedge-fund manager provides not only insights into his investing strategy and successes but also a description of his personal life. 
Journal: Financial Analysts Journal
Pages: 108-109
Issue: 2
Volume: 58
Year: 2002
Month: 3
X-DOI: 10.2469/faj.v58.n2.2529
File-URL: http://hdl.handle.net/10.2469/faj.v58.n2.2529
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:2:p:108-109




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# input file: UFAJ_A_12047334_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Complexity, Risk, and Financial Markets (a review)
Abstract: 
 This philosophical approach to investing (reviewed together with Latticework) focuses on the need for investors to accept and deal with uncertainty and complexity. 
Journal: Financial Analysts Journal
Pages: 110-111
Issue: 2
Volume: 58
Year: 2002
Month: 3
X-DOI: 10.2469/faj.v58.n2.2530
File-URL: http://hdl.handle.net/10.2469/faj.v58.n2.2530
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:2:p:110-111




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# input file: UFAJ_A_12047336_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert J. Shiller
Author-X-Name-First: Robert J.
Author-X-Name-Last: Shiller
Title: Bubbles, Human Judgment, and Expert Opinion
Abstract: 
 Research in psychology tells us how even the experts can get caught up in speculative bubbles. The widespread public disagreement about whether the stock market has been undergoing a speculative bubble since about 1995 reflects an underlying disagreement about how to view human judgment and intellect. The concept of a speculative bubble seems to require that some form of investor credulity or foolishness be at work. The disagreement is about whether we can in reality attribute such foibles to investors—notably, whether it is plausible to attribute such weaknesses to professional investors, the experts, who were apparently no more detached from the alleged bubble than other investors.Research in psychology has highlighted well-documented patterns of error that are widespread in human beings. These errors might explain the mistakes of the experts, as well as of everyone else. Some of the errors are individual cognitive errors. The representativeness heuristic is a failure to account for base-rate probabilities. Overconfidence is a tendency to overestimate one's unique abilities and information. Attention errors arise from an inconsistent focusing of our energies. And the wishful thinking bias is a tendency to ascribe too high a probability to a desired outcome.Other errors are social in origin. There is a tendency in people toward herd behavior. Herd behavior is not necessarily the blind following of others. Indeed, investors must take account of the opinions of others because no one person can research everything individually. A fundamental difficulty that all investors face, then, is how to judge the source of opinions that others have about the outlook for investments. We would like to pool the information that the others used to arrive at their opinions, but we cannot know where they received their information. In certain circumstances, we may assume that more information underlies their pronouncements than actually exists.This problem affects even our interpretation of stories presented in the media. The origins of many reports may lie more in a journalistic desire to tell a good “new era” story than to convey the ambiguity of the facts.Getting at the truth about the future involves dealing with true uncertainty—our fundamental lack of knowledge. We do not have quantitative probabilities of future possible events. We must, instead, judge their likelihood by reference to intuitive extrapolation of historical cases or to impressions of general societal and business trends.Business organizations, bureaucracies, and endowment, investment, and political committees—all filled with experts—are fundamentally ill equipped to make judgments about uncertain futures. When they attempt to deal with true uncertainty in a professional manner, “groupthink” can emerge. One cause of groupthink is the fear of being marginalized by expressing dissent. Groupthink can thus lead to errors in judgment and disastrous actions. When expert decisions about asset allocation are subject to groupthink, the errors may not be corrected even by the strongest doubters and may lead to flawed inferences and the amplification of a speculative bubble.Some contributors to errors in judgment are legal in origin. The “prudent person standard,” for example, which fiduciaries must honor and advisors must respect, requires that these experts temper their independent judgments and follow what a prudent person would find sensible. The problem with this standard is that the expert has no way to distinguish the sensible from the conventional, so the standard makes these people interpreters of conventional wisdom rather than investment professionals. At the time of a speculative bubble, the conventional wisdom and the very concept of prudence may be influenced by the bubble.When considered together, the evidence about sources of human error implies that experts are often caught up in speculative bubbles along with everyone else.
Journal: Financial Analysts Journal
Pages: 18-26
Issue: 3
Volume: 58
Year: 2002
Month: 5
X-DOI: 10.2469/faj.v58.n3.2535
File-URL: http://hdl.handle.net/10.2469/faj.v58.n3.2535
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:3:p:18-26




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# input file: UFAJ_A_12047337_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Viral V. Acharya
Author-X-Name-First: Viral V.
Author-X-Name-Last: Acharya
Author-Name: Sanjiv Ranjan Das
Author-X-Name-First: Sanjiv Ranjan
Author-X-Name-Last: Das
Author-Name: Rangarajan K. Sundaram
Author-X-Name-First: Rangarajan K.
Author-X-Name-Last: Sundaram
Title: Pricing Credit Derivatives with Rating Transitions
Abstract: 
 We present a model for pricing risky debt and valuing credit derivatives that is easily calibrated to existing variables. Our approach expands a classical term-structure model to allow for multiple rating classes of debt. The framework has two salient features: (1) it uses a rating-transition matrix as the driver for the default process, and (2) the entire set of rating categories is calibrated jointly, which allows arbitrage-free restrictions across rating classes as a bond migrates among them. We illustrate the approach by applying it to price credit-sensitive notes that have coupon payments linked to the rating of the underlying credit. The pricing of credit derivatives is approaching modeling maturity. In particular, reduced-form models that directly specify the default process or the credit spread have resulted in successful conjoint implementations of term-structure models with default models. We contribute to this literature by presenting a discrete-time reduced-form model for valuing risky debt based on a classical term-structure model developed in 1990.We extend this model to include risky debt by adding a “forward spread” process to the forward-rate process for default-risk-free bonds. Instead of modeling the movement of the spread itself, however, the engineering of our model focuses on the stochastic process for inter-rating spreads. Working with inter-rating spreads provides any credit spread as the sum of higher-rated inter-rating spreads.This approach offers analytical tractability. No restrictions are placed on the correlation between the forward-spread and the forward-rate stochastic processes. The probability of default at any point in time is allowed to depend on the entire history of the process to that point and is determined from rating-transition matrixes that are exogenously supplied. The model is flexible enough to incorporate any specification for the recovery process that is consistent with the default process and the spread processes.We extend an earlier pricing lattice that was developed by computing a no-arbitrage tree that embedded the riskless term structure and the term structure of credit spreads. This tree considered the modeling of only a single rating category at a time, but our model calibrates all rating classes jointly on the same pricing lattice. Embedding all rating categories in one pricing lattice requires a set of conditions that will ensure consistency across all classes of debt. The additional information comes from the introduction of the rating-transition matrix. Thus, our model can be used to price credit derivatives based on multiple classes of debt, which was not possible using simpler models.The consistency conditions across rating classes can be explained as follows: The credit rating of a corporate borrower can improve or deteriorate during the life of its issued debt. Thus, the credit spread on its debt contains valuable information about the future credit spreads on debt of all possible rating classes that the borrower could migrate to. This condition is true for a corporate borrower with any given rating at a point in time. This interdependence of spreads across rating classes immediately implies that calibration of the forward-spread process for a given rating class must be undertaken simultaneously with the calibration of the forward-spread processes for all other rating classes. Formalizing this interdependence and characterizing the joint calibration process is the primary contribution of this paper.Our model requires as inputs the government yield curve and the term structures of credit spreads for each rating class, which are available from a number of providers. The same sources deliver the required interest rate and spread volatilities. The model can be efficiently implemented and lends itself most appropriately to pricing credit derivatives, such as credit-sensitive notes, whose coupon payments are linked to the credit quality of the underlying corporate borrower. We provide a numerical example to illustrate the calibration of the model and its use to price credit-sensitive notes.
Journal: Financial Analysts Journal
Pages: 28-44
Issue: 3
Volume: 58
Year: 2002
Month: 5
X-DOI: 10.2469/faj.v58.n3.2536
File-URL: http://hdl.handle.net/10.2469/faj.v58.n3.2536
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:3:p:28-44




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# input file: UFAJ_A_12047338_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Michael J. Dempsey
Author-X-Name-First: Michael J.
Author-X-Name-Last: Dempsey
Title: The Nature of Market Growth, Risk, and Return
Abstract: 
 In the model of asset appreciation advanced here, the market economy and the market of asset claims on the economy are modeled as organic (or exponential growth) processes, similar to those commonly seen in nature and the biological sciences. In “Dempsey's organic growth model of appreciation” (DOGMA), investors have a log-wealth utility function. Within the framework, the market risk premium is derived as the premium that balances supply and demand among risky and risk-free assets. The model indicates that the premium is less than is indicated by ex post returns observed on U.S. stock markets. The model is consistent, however, with empirical observations that idiosyncratic risk and small company size are rewarded by the markets. In terms of the model, investors choose to allocate their portfolios long in both the risky market and the risk-free asset. Furthermore, their portfolios are independent of the investment time horizon. I consider the nature of the market, risk, and the manner in which returns are generated consistent with risk. For the practitioner, the article offers a number of valuable insights. In particular, I draw attention to the nature of financial investing in which investment offers, on the upside, unbounded returns with, on the downside, the possibility of losing substantially. A novel offering of the article is the consideration that the potential reward may be inherent in the risk. So, for example, if half of one's investment doubles in value ($1 becomes $2) while the other half loses half its value ($1 becomes 50 cents), the investment grows by (2.5 − 2)/2 × 100 percent = 25 percent. Such reward might by itself be sufficient to compensate the investor for bearing the implied risk.In developing the model, I model the market economy—and the market of asset claims on the economy—as an organic or exponential growth process, in which investors have a log-wealth utility function. Such a growth process is representative of growth processes in nature and is consistent with observations of stock market growth performance. A log-wealth utility function implies that investors tend to balance the possibility of, say, doubling their initial investment wealth with an equal possibility of halving their investment wealth, for which psychological propensity empirical support exists.The implications of the organic model with continuous growth differ from those of the discrete one-period model. In particular, whereas the traditional one-period model assumes that periodic growth rates of +x percent and −x percent on uncorrelated investments are equally likely and hence effectively cancel each other, the organic growth model implies that it is exponential growth rates +x percent and −x percent that are equally likely. Because the exponent of +x is unbounded but the exponent of −x is limited to zero, such exponential growth rates, in combination, generate a growth factor that is always greater than unity. This outcome is consistent with the realization that the investment outcome on the upside is unbounded but cannot be less than zero on the downside. Thus, the organic model of capital appreciation predicts that given two well-diversified portfolios with similar betas, the one whose assets have the higher idiosyncratic volatility will have the higher return. The prediction is borne out by empirical findings for the returns of U.S. stocks for the 1963–90 period. Empirical evidence also indicates that the volatility of stocks is correlated closely with the inverse of company size. My model findings thus support a satisfying theoretical explanation for the research findings that returns on stocks are correlated with the inverse of company size.Within the model's framework, the market risk premium is that which balances supply and demand among risky and risk-free assets. It turns out that the clearing price for the risk premium as it equates supply and demand depends on stock market volatility. Thus, the model predicts that an annualized stock market volatility of 15 percent, as was measured for the 1980–94 period, is consistent with a risk premium of as little as 2 percent whereas a volatility of 30 percent (it was closer to 33.6 percent in the 1926–39 Depression period) is consistent with a risk premium closer to 7 percent. When the individual or idiosyncratic volatility of individual stock returns is allowed for, an additional annualized return of as much as 4 percent may be generated in terms of the model.The model predicts further that the portfolio choices of investors will likely remain long in both the risky market and the risk-free asset and that such portfolio choices will remain effectively indifferent to the investor's time horizon.
Journal: Financial Analysts Journal
Pages: 45-59
Issue: 3
Volume: 58
Year: 2002
Month: 5
X-DOI: 10.2469/faj.v58.n3.2537
File-URL: http://hdl.handle.net/10.2469/faj.v58.n3.2537
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:3:p:45-59




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# input file: UFAJ_A_12047339_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hakan Saraoglu
Author-X-Name-First: Hakan
Author-X-Name-Last: Saraoglu
Author-Name: Miranda Lam Detzler
Author-X-Name-First: Miranda Lam
Author-X-Name-Last: Detzler
Title: A Sensible Mutual Fund Selection Model
Abstract: 
 We present a rigorous framework for asset allocation and selecting mutual funds that takes into account the unique preferences and constraints of an individual investor. The framework is based on the analytic hierarchy process (AHP), and the model generates reasonable asset-allocation recommendations and identifies the most suitable funds within an asset class. We include sample mutual fund selection for a hypothetical investor. A mutual fund selection model that uses the AHP framework is flexible, is user friendly, and ensures consistency throughout the portfolio decision process. Modern portfolio theory states that the investment decision process can be separated into two independent steps. In one, investment professionals, such as mutual fund managers, specialize in constructing risky portfolios. In a second process, individual investors choose complete portfolios by combining the optimal risky portfolio, based on their risk tolerances, and the risk-free asset. Finance research has traditionally focused on the first part of the investment process, especially on identifying some risky portfolio that would be universally optimal for all investors.In the real world, however, the investment process is more complicated; in addition to risk and return, factors such as taxes and human capital must be considered. Because different investors face different constraints in their investment decisions, a risky portfolio that is universally optimal may be impossible to find. Investors are left to their own judgments when determining a proper risk level and constructing their own complete portfolios. But many individual investors may not be competent at these tasks. We propose a model that assists investors in determining their asset allocations and selecting mutual funds for their complete portfolios.Our model divides the mutual fund selection problem into two hierarchies: The first hierarchy addresses alternatives at the asset-class level (asset allocation), and the second hierarchy addresses alternatives at the fund level (fund selection). Each hierarchy consists of three levels—the mission of the hierarchy, the selection criteria, and the available alternatives. In the first hierarchy, the mission is to obtain a suitable asset-allocation recommendation for an investor. The selection criteria are the investor's investment objectives and constraints, and the alternatives are the asset classes. In the second hierarchy, the mission is to obtain the most suitable mutual fund within each asset class. The selection criteria are based on structural and operational characteristics of the funds, and the alternatives are the funds available in each asset class.We provide an example to illustrate application of the model to the mutual fund selection problem for a hypothetical investor. We start with the investor's investment objectives and constraints as identified by choices the investor makes through pairwise comparisons. We empirically estimate the suitability of the asset classes according to each investment objective by using a sample from the Morningstar database covering the 1976–98 period. Then, we combine the relative importance of the investment objectives and the strength of the asset classes according to each objective to obtain the asset-allocation weights suitable for the investor. Once the weights of the asset classes are determined, the next step involves evaluating individual mutual funds in each asset class. We use a specific asset class to illustrate the ranking of individual mutual funds based on the selection criteria.The method we describe is an objective procedure for choosing mutual funds and thus a valuable addition to a financial advisor's toolkit. This method has the following distinct advantages.First, it incorporates the unique preferences and constraints of an individual investor into the mutual fund selection problem by allowing the importance of investment objectives and fund attributes to vary by investor.Second, it prevents the investor from making inconsistent preference assignments. Because the fund selection decision involves more than one attribute (e.g., return objective, tax efficiency, risk), enforcing consistency is essential.Finally, the framework minimizes the amount of technical input required from investors because it allows the integration of the financial advisor's recommendations, the findings of academic research, and historical mutual fund data. The result is a user-friendly yet rigorous model.
Journal: Financial Analysts Journal
Pages: 60-72
Issue: 3
Volume: 58
Year: 2002
Month: 5
X-DOI: 10.2469/faj.v58.n3.2538
File-URL: http://hdl.handle.net/10.2469/faj.v58.n3.2538
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:3:p:60-72




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# input file: UFAJ_A_12047340_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Nusret Cakici
Author-X-Name-First: Nusret
Author-X-Name-Last: Cakici
Author-Name: Anthony Tessitore
Author-X-Name-First: Anthony
Author-X-Name-Last: Tessitore
Author-Name: Nilufer Usmen
Author-X-Name-First: Nilufer
Author-X-Name-Last: Usmen
Title: Closed-End Funds and Turnover Restrictions
Abstract: 
 Past studies have found that investors can earn higher returns than a benchmark by purchasing shares of closed-end funds with discounts or selling shares with premiums. These studies either ignored the impact of transaction costs or used equally weighted portfolio strategies without controls on turnover or transaction costs. We examined whether constraining the holdings of individual funds and turnover has any bearing on the excess returns earned by closed-end equity funds over a benchmark return. We found that when transaction costs were low, portfolios with frequent rebalancing and loose turnover constraints outperformed the benchmark and other portfolios in the period we studied. We found, in contrast, that when transaction costs were moderate to high, portfolios with less-frequent rebalancing and tight turnover constraints outperformed the benchmark and other portfolios. The implication for the portfolio manager is that excess returns may be achieved in a variety of trading-cost environments with the proper mix of policy variables. A popular view is that closed-end funds should be purchased for their discounts. If a closed-end fund trades at a discount, an investor can purchase shares at a price below net asset value or, at least, purchase shares cheaply. Selling these shares less cheaply at a later date can lead to excess returns.This view is supported by empirical findings. A number of studies have shown that managed portfolios of closed-end funds can outperform a benchmark when discounts and premiums form the basis for fund selection. One recent study found that outperformance could be achieved even in an environment of high transaction costs by selling short the funds with the deepest discounts. These studies did not control turnover and holdings of funds, however, which is an important practical issue that we attempt to address in this article.We examined whether constraining the amount of turnover and holdings of funds, thereby controlling trading costs, has any bearing on the excess returns earned by a managed portfolio of closed-end funds. We used an expected-return-optimization model that selects portfolios of closed-end funds in an environment defined by transaction costs. The expected return of each fund depends on its current discount. Our methodology allowed us to control trading costs by tightening or loosening the turnover constraints together with limiting the holdings of each fund.We back tested the model for the period January 11, 1991, to September 1, 2000, for various holding periods ranging from 1 to 13 weeks and various transaction-cost environments ranging from 0 to 4 percent rates. The data consisted of U.S.- and U.K.-traded closed-end equity funds. The sample contained 128 funds at the start in 1991 and ended with 206 funds in 2000. The benchmark was a capitalization-weighted portfolio of all funds in the sample.We found that portfolios with frequent rebalancing and loose constraints on turnover outperformed the benchmark and other portfolios when transaction costs were low. Lengthening the time between rebalancing and constraining the amount of turnover evidently prevent the model from capitalizing on the opportunities available in discounts. We also found, surprisingly, that when transaction costs were moderate to high, portfolios with less-frequent rebalancing and more-stringent restrictions on turnover outperformed the benchmark and other portfolios. In this case, constraints serve to protect the model from “wrong” decisions (i.e., being too aggressive on funds with high expected returns that subsequently produce low actual returns). The penalties for these decisions are more severe when transaction costs are high.The practical implication of the second finding for portfolio managers is that in an environment of high transaction costs, excess returns on discounted funds can still be achieved but only with the proper mix of policy variables. Specifically, the best-performing strategies in an environment of moderate-to-high (3–4 percent rate) transaction costs consist of tight constraints on turnover (about once a year) and infrequent rebalancing (about a month and a half between re-optimizations). Thus, not only is restricting turnover important when transaction costs are high, so also is limiting the frequency at which the model can reach “incorrect” decisions. This finding is in sharp contrast to the best mix of policy variables used in a low-transaction-cost environment.
Journal: Financial Analysts Journal
Pages: 74-81
Issue: 3
Volume: 58
Year: 2002
Month: 5
X-DOI: 10.2469/faj.v58.n3.2539
File-URL: http://hdl.handle.net/10.2469/faj.v58.n3.2539
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:3:p:74-81




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Author-Name: Bruce G. Resnick
Author-X-Name-First: Bruce G.
Author-X-Name-Last: Resnick
Author-Name: Gary L. Shoesmith
Author-X-Name-First: Gary L.
Author-X-Name-Last: Shoesmith
Title: Using the Yield Curve to Time the Stock Market
Abstract: 
 In the study reported here, we extended the probit model for forecasting an economic recession by using the yield-curve spread as the explanatory variable to forecast a bear stock market and tested market-timing strategies based on the model. We found that the value of the yield spread between the composite 10-year+ U.S. T-bond yield and the three-month T-bill yield holds important information about the probability of a bear stock market. We discuss our out-of-sample market-timing tests at various probability screens of a forthcoming bear market in one month. At a 50 percent probability screen, our simulations show that, for the period studied, a market timer switching out of stocks (T-bills) into T-bills (stocks) one month before a bear (bull) stock market could have realized a compound annual return of 16.46 percent versus 14.17 percent from a stock-only buy-and-hold strategy. This result is economically significant. Some researchers have suggested that the stock market returns from being able to predict turning points in the business cycle would be enormous. The unanswered question has been how investors can predict economic turning points with any precision. Recently, however, a probit model has been developed to predict, based on the shape of the yield curve, four quarters in advance whether the U.S. economy will go into a recession.Combining these two areas of research, we suggest that it may indeed be possible to time the stock market. Specifically, if the yield spread is useful in forecasting turning points in the business cycle four quarters in advance and if an investor can use that knowledge to carry out a viable stock-market-timing strategy, then conducting a stock-market-timing strategy eight months after a strong signal is received, by way of the magnitude of the yield spread, might beat a stock-only buy-and-hold investment strategy.We tested this idea by conducting an out-of-sample simulation based on an eight-month lag between the yield spread and the stock market. The results were disappointing. We were successful, however, in developing a probit model for forecasting downturns in the stock market one month ahead based on the yield spread as the explanatory variable.The basic data we used are the monthly S&P 500 Index levels and the yield spread between 10-year+ T-bonds and three-month T-bills. A bear market was defined as six or more consecutive months of a generally declining stock market.To determine the profitability of using the probit market-timing strategy versus a simple stock-only buy-and-hold strategy, we performed out-of-sample simulations. We obtained total monthly returns, including dividends, for the S&P 500 for the period January 1971 through December 1999. We also obtained corresponding 30-day T-bill returns. Using the out-of-sample time series of probabilities obtained from our probit model, we simulated a market-timing strategy beginning in January 1971 of investing 100 percent in an S&P 500 mutual fund if the probability of a bear stock market one month later was less than X percent or investing 100 percent in T-bills if the probability of a bear market was greater than X percent. In each successive month through December 1999, the investment position was reassessed and changed in accord with the probability of a bear market one month later. In the simulations, we used three probability screens (or values of X)—30 percent, 40 percent, and 50 percent.Each of the probit market-timing strategies outperformed the buy-and-hold strategy. The terminal value of investing $1 over the 29-year period in a stock-only buy-and-hold strategy would have produced $46.71 and an annual compound return of 14.17 percent. When a bear market probability screen of 50 percent was used, the terminal value was $83.02 and the annual compound return was 16.46 percent. Thus, our probit market-timing strategy yielded an extra $36.31 in terminal value or, on an annual basis, an additional 2.29 percentage points in annual return.Moreover, the strategy based on our probit model produced a significant timing coefficient when we applied the model for statistically evaluating market-timing ability. Thus, the probit market-timing strategy produced a larger mean excess return than a stock-only buy-and-hold strategy at a lower level of total and systematic risk than is inherent in the market portfolio.Finally, the parsimonious nature of our model makes it particularly attractive for use by market timers.
Journal: Financial Analysts Journal
Pages: 82-90
Issue: 3
Volume: 58
Year: 2002
Month: 5
X-DOI: 10.2469/faj.v58.n3.2540
File-URL: http://hdl.handle.net/10.2469/faj.v58.n3.2540
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Author-Name: Mark Kritzman
Author-X-Name-First: Mark
Author-X-Name-Last: Kritzman
Author-Name: Don Rich
Author-X-Name-First: Don
Author-X-Name-Last: Rich
Title: The Mismeasurement of Risk
Abstract: 
 Investors typically measure risk as the probability of a given loss or the amount that can be lost with a given probability at the end of their investment horizons. This view of risk considers only the final result, but investors perceive (or should perceive) risk differently. They are affected by exposure to loss throughout the investment period, not just at its conclusion. We introduce two new ways of measuring risk—within-horizon probability of loss and continuous value at risk—that reveal that exposure to loss is substantially greater than investors normally assume. Investors typically measure risk as the probability of a given loss or the amount that can be lost with a given probability at the end of their investment horizons. This view of risk considers only the final result, however, whether the horizon is one month, one year, or one decade. It ignores what might happen along the way. We argue that investors and investment managers care, or should care, about exposure to loss throughout their investment periods.For example, an asset manager may face termination if the portfolio under management falls below a certain value at any point within a measurement period. A hedge fund will suffer withdrawals if it experiences a significant loss at any point within its investment horizon, which may threaten its solvency. A borrower may breach a covenant in a loan agreement if assets penetrate a specified threshold at any time during the term of the loan. A borrower of securities who wishes to anticipate incremental collateral requirements must focus on the distribution of the securities' market values throughout the borrowing period. Finally, institutions faced with capital requirements are monitored continually, not just at the end of a particular interval. These examples are but a few of the many circumstances in which investors should pay attention to probability distributions throughout the entire duration of their investment horizons.For this reason, we introduce two new approaches to risk measurement—within-horizon probability of loss and continuous value at risk (VAR)—which are based on the concept of “first passage.” We apply these risk measures to currency hedging and hedge-fund exposure to loss. Our examples reveal that if loss is measured at the end of a long horizon, currency hedging has little impact on the probability of loss, but if performance is monitored throughout a long horizon, hedging reduces probability of loss substantially. Moreover, VAR measured continuously throughout the investment horizon is significantly greater than conventionally measured VAR for both hedged and unhedged portfolios. Our examples also demonstrate that a hedge fund's exposure to loss is much greater than is implied by the distribution of the fund's value at the end of its investment horizon.Our analysis reveals that interim probability of loss is greater than terminal probability of loss. Moreover, unlike terminal probability of loss, which declines with time, interim probability of loss increases with the length of the investment horizon. This feature of within-horizon probability of loss presents a new challenge to the widely held view that time diversifies risk.Finally, our analysis implies that many investors are exposed to substantially greater risk than they assume and they should, at the least, be made aware of within-horizon exposure to loss. Such knowledge can eliminate the surprise of a significant loss during the investment period and prevent investors from misinterpreting it as unduly deviant. Moreover, the knowledge allows investors to consider whether a more conservative investment strategy is warranted.
Journal: Financial Analysts Journal
Pages: 91-99
Issue: 3
Volume: 58
Year: 2002
Month: 5
X-DOI: 10.2469/faj.v58.n3.2541
File-URL: http://hdl.handle.net/10.2469/faj.v58.n3.2541
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Forbes Greatest Investing Stories (a review)
Abstract: 
 This book by a veteran contributing editor to Forbes presents profiles of an array of colorful actors on the financial stage and extracts useful lessons from their exploits.
Journal: Financial Analysts Journal
Pages: 100-100
Issue: 3
Volume: 58
Year: 2002
Month: 5
X-DOI: 10.2469/faj.v58.n3.2542
File-URL: http://hdl.handle.net/10.2469/faj.v58.n3.2542
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:3:p:100-100




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# input file: UFAJ_A_12047344_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Paving Wall Street: Experimental Economics and the Quest for the Perfect Market (a review)
Abstract: 
 The evolution of the use of simulated trading environments as a special field in financial research is traced from the simple classroom exercises of the 1940s to today's sophisticated, computer-based auction markets.
Journal: Financial Analysts Journal
Pages: 101-102
Issue: 3
Volume: 58
Year: 2002
Month: 5
X-DOI: 10.2469/faj.v58.n3.2543
File-URL: http://hdl.handle.net/10.2469/faj.v58.n3.2543
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:3:p:101-102




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Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life (a review)
Abstract: 
 The author of this book pinpoints the reasons for the overconfidence of traders and other investment professionals about their trading skills and describes their inability to appreciate fully the deeper philosophical problems of probability.
Journal: Financial Analysts Journal
Pages: 102-103
Issue: 3
Volume: 58
Year: 2002
Month: 5
X-DOI: 10.2469/faj.v58.n3.2544
File-URL: http://hdl.handle.net/10.2469/faj.v58.n3.2544
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Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Author-Name: Jonathan Scheid
Author-X-Name-First: Jonathan
Author-X-Name-Last: Scheid
Title: Buffett in Foresight and Hindsight
Abstract: 
 Investors know the extraordinary performance of Warren Buffett with hindsight, but what did they know with foresight? Will Rogers said, “Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.” Investors know today with perfect hindsight that the performance of Warren Buffett's Berkshire Hathaway Inc. has been extraordinary. But did they know it with foresight? We report that investors, as a group, did not see Buffett's performance with foresight, and we use our evidence to highlight the pitfalls of hindsight in investment analysis.A share of Berkshire Hathaway stock could have been bought for $18 on May 10, 1965, the day Warren Buffett took control of the company. That share could have been sold for $71,000 on December 31, 2000. The annualized return of Berkshire Hathaway's stock during the period was 26.18 percent, more than double the 11.69 percent of the S&P 500 Index.The $18 price of Berkshire Hathaway stock in 1965 was its “value-in-foresight”; that is, that price represents the sum of investors' wisdom in 1965 about the future performance of Berkshire Hathaway stock. Looking back in hindsight, from the vantage point of 2000, we know that the value of Berkshire Hathaway stock in 1965 was $1,383; that is, investors would have had to invest $1,383 in the S&P 500 in 1965 to earn the $71,000 accumulated by investors who bought shares of Berkshire Hathaway for $18 in 1965. So, Berkshire Hathaway's “value-in-hindsight” is almost 77 times higher than its value-in-foresight.If investors had foreseen in 1965 the wonderful future performance of Berkshire Hathaway, the company's stock price would have jumped from $18 to $1,383 right then. The fact that the price of Berkshire Hathaway shares increased only gradually over the years tells us that today's investors are fooled by hindsight to believe that they have seen Buffett's performance in foresight.Buffett himself understands well the distinction between foresight and hindsight. When the DJIA declined in the spring of 1966 after its climb beyond 1,000 earlier that year, some of Buffett's partners called to warn him that the market might decline further. Such calls, Buffett said, raise two questions: “If they knew in February that the Dow was going to 865 in May, why didn't they let me in on it then; and (2) if they didn't know what was going to happen during the ensuing three months back in February, how do they know in May?”The bias of hindsight that leads us to believe that we have seen Berkshire Hathaway's extraordinary performance with foresight also fools us into believing that we can identify the next Buffett and Berkshire Hathaway. We might identify, instead, the next WebVan, the next Enron, or any of the many stocks that peaked at tens or even hundreds of dollars before they were gone. Today more than ever, through 401(k) and other saving programs, investors hold their financial futures in their own hands. They cannot entirely avoid the risks in investing, but they cannot afford to let the confidence of hindsight ruin their financial well-being.
Journal: Financial Analysts Journal
Pages: 11-18
Issue: 4
Volume: 58
Year: 2002
Month: 7
X-DOI: 10.2469/faj.v58.n4.2450
File-URL: http://hdl.handle.net/10.2469/faj.v58.n4.2450
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Author-Name: Aigbe Akhigbe
Author-X-Name-First: Aigbe
Author-X-Name-Last: Akhigbe
Author-Name: Anna D. Martin
Author-X-Name-First: Anna D.
Author-X-Name-Last: Martin
Title: Do Microsoft Acquisitions Benefit the Computer Industry?
Abstract: 
 We examined whether acquisitions by Microsoft Corporation affect the stock prices of its competitors in the computer industry. We found that Microsoft's acquisitions in the Internet/online-services segment adversely affect the stock prices of the Internet/online-services rival portfolio. These competitors appear to be threatened by Microsoft's moves—anticompetitive or otherwise—to further its industry leadership and affirm the future success of the targets' technologies. Furthermore, the results of our study do not indicate that the financial market perceives Microsoft's operating-system acquisitions to be instrumental in achieving synergies from Microsoft's dominant role in the operating-system segment to the detriment of its Internet/online-services rivals. Indeed, we found the portfolio of Internet/online-services rivals to respond favorably to Microsoft's operating-system acquisitions, perhaps because Microsoft is essentially diverting resources away from the Internet/online-services segment. Microsoft Corporation is frequently under attack for anticompetitive behavior. Some studies do not show, however, that the financial markets believe Microsoft's behavior is anticompetitive or that the antitrust actions are beneficial for Microsoft's competitors. In this article, we examine Microsoft's impact on its competitors with a focus on whether acquisitions by Microsoft affect the stock prices of its competitors.Acquisition announcements by Microsoft might cause analysts to reassess the competitive positions of companies in the computer industry for several reasons. First, an acquisition by a well-established and fiercely competitive rival might be viewed as an endorsement of the target's technology, management, or other unique skills. Second, some market participants might hold the more extreme view that Microsoft acquisitions are part of a broad strategy to actually eliminate its competitors. Thus, the expected future cash flows and stock prices of Microsoft competitors are likely to be negatively affected by announcements of Microsoft acquisitions.To test the reactions of competitors' stock prices to Microsoft acquisitions, we identified a sample of 46 acquisitions conducted by Microsoft between 1987 and 2000. Using standard event-study methodology, we assessed the stock-price reaction of Microsoft as well as the reaction of portfolios of rival companies in the computer industry.Our findings show that when Microsoft announces an acquisition meant to augment its operating-system offerings, the stock-price response of Microsoft is positive, which is consistent with Microsoft maintaining and/or increasing its dominant role in this industry segment.We found that Microsoft's acquisitions in the Internet/online-services segment adversely affect the stock price of a portfolio of its rivals in this segment. This negative response by competitors differs from previous related research. Past studies found that the stocks of rival portfolios benefit from acquisition announcements, either because the acquisition indicates favorable future industry conditions or, when industry consolidation is expected, because the rivals are viewed as potential targets. Our findings suggest that the Internet/online-services competitors are threatened by Microsoft's moves, anticompetitive or otherwise, to further its industry leadership and affirm the future success of the targets' technologies.We did not find that the financial market perceives Microsoft's acquisitions in the operating-system segment to be instrumental in achieving synergies from its dominant role in that segment to the detriment of its Internet/online-services rivals. Indeed, we found that the stock price of the portfolio of Internet/online-services rivals responded favorably to Microsoft's acquisitions in the operating-system segment, perhaps because Microsoft is thereby essentially diverting resources away from the Internet/online-services segment.
Journal: Financial Analysts Journal
Pages: 19-27
Issue: 4
Volume: 58
Year: 2002
Month: 7
X-DOI: 10.2469/faj.v58.n4.2451
File-URL: http://hdl.handle.net/10.2469/faj.v58.n4.2451
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Author-Name: Hiromichi Tamura
Author-X-Name-First: Hiromichi
Author-X-Name-Last: Tamura
Title: Individual-Analyst Characteristics and Forecast Error
Abstract: 
 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. The purpose of the study reported in this article was to investigate how an analyst's characteristics affect the analyst's forecast error. Previous literature found positive serial correlation in forecast errors that can be attributed to underreaction to new information, especially to bad news. What is not clear, because most of the papers are based solely on consensus estimates, is the relationship between an individual analyst's behavior and the analyst's personal characteristics. In contrast to previous research, this study focused on each analyst's forecast error (calculated by averaging the errors for each analyst). I investigated the analyst's relative optimism and likely other influential factors, such as previous track record and reputation with customers.First, I reexamined the issue of serial correlation of forecast errors by using each analyst's forecast error. I found that the correlation coefficient is larger for the groups of analysts who had past forecasts that were relatively optimistic and that the average distance to the consensus forecast is small. These results suggest that analysts who are negatively shocked by actual earnings or who “herd” toward the consensus forecast tend to make forecast errors that are positively correlated with previous forecast errors.Next, I investigated serial correlation in the average distance of an analyst's forecast to the consensus forecast—that is, the analyst's relative optimism. I found that the average distance to consensus itself has positive serial correlation that may be attributed to the analyst's personality (optimistic or pessimistic). Furthermore, I found stronger positive serial correlation for the average distance to consensus among the herd-to-consensus analysts. These results indicate that herd-to-consensus analysts report earnings estimates that are not only near the consensus but also are strongly affected by personal characteristics.
Journal: Financial Analysts Journal
Pages: 28-35
Issue: 4
Volume: 58
Year: 2002
Month: 7
X-DOI: 10.2469/faj.v58.n4.2452
File-URL: http://hdl.handle.net/10.2469/faj.v58.n4.2452
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Author-Name: Andrew W. Lo
Author-X-Name-First: Andrew W.
Author-X-Name-Last: Lo
Title: The Statistics of Sharpe Ratios
Abstract: 
 The building blocks of the Sharpe ratio—expected returns and volatilities—are unknown quantities that must be estimated statistically and are, therefore, subject to estimation error. This raises the natural question: How accurately are Sharpe ratios measured? To address this question, I derive explicit expressions for the statistical distribution of the Sharpe ratio using standard asymptotic theory under several sets of assumptions for the return-generating process—independently and identically distributed returns, stationary returns, and with time aggregation. I show that monthly Sharpe ratios cannot be annualized by multiplying by √12 except under very special circumstances, and I derive the correct method of conversion in the general case of stationary returns. In an illustrative empirical example of mutual funds and hedge funds, I find that the annual Sharpe ratio for a hedge fund can be overstated by as much as 65 percent because of the presence of serial correlation in monthly returns, and once this serial correlation is properly taken into account, the rankings of hedge funds based on Sharpe ratios can change dramatically. The building blocks of the Sharpe ratio—expected returns and volatilities—are unknown quantities that must be estimated statistically and are, therefore, subject to estimation error. This raises the natural question: How accurately are Sharpe ratios measured? In this article, I provide an answer by deriving the statistical distributions of the usual Sharpe ratio estimator—sample mean excess return over sample standard deviation—using standard econometric methods under several different sets of assumptions for the statistical properties of the return series on which the ratio is based. Armed with these statistical distributions, I show that confidence intervals, standard errors, and hypothesis tests for the estimated Sharpe ratio can be computed in much the same way that they are computed for regression coefficients, such as portfolio alphas and betas.The accuracy of Sharpe ratio estimators hinges on the statistical properties of returns (e.g., time-series properties, such as mean reversion, momentum, or time-varying volatilities). Although this may seem like a theoretical exercise best left for statisticians, there is often a direct connection between the investment management process of a portfolio and its statistical properties. For example, a change in the portfolio manager's style from a small-cap value orientation to a large-cap growth orientation will typically have an impact on the portfolio's volatility, degree of mean reversion, and market beta. Even for a fixed investment style, a portfolio's characteristics can change over time because of fund inflows and outflows, capacity constraints (e.g., a microcap fund that is close to its market-capitalization limit), liquidity constraints (e.g., an emerging market or private equity fund), and changes in market conditions (e.g., sudden increases or decreases in volatility, shifts in central banking policy, and extraordinary events, such as the default of Russian government bonds in August 1998).At a superficial level, it is obvious that the properties of the Sharpe ratio should depend on the investment style of the portfolio being evaluated; the performance of more volatile investment strategies is more difficult to gauge than that of less volatile strategies. Therefore, it should come as no surprise that the results derived in this article imply that Sharpe ratios are likely to be more accurately estimated for mutual funds than for hedge funds. A less intuitive implication is that the time-series properties of investment strategies (e.g., mean reversion, momentum, and other forms of serial correlation) can have a nontrivial impact on the Sharpe ratio estimator itself, especially when computing an annualized Sharpe ratio from monthly data. For example, the results derived in this article show that the common practice of annualizing Sharpe ratios by multiplying monthly estimates by √12 is correct only under very special circumstances and that the correct multiplier—which depends on the serial correlation of the portfolio's returns—can yield Sharpe ratios that are considerably smaller (in the case of positive serial correlation) or larger (in the case of negative serial correlation). Therefore, Sharpe ratio estimators must be computed and interpreted in the context of the particular investment style with which a portfolio's returns have been generated.Although the Sharpe ratio has become part of the canon of modern financial analysis, the results presented in this article suggest that a more sophisticated approach to interpreting Sharpe ratios is called for, one that incorporates information about the investment style that generated the returns and the market environment in which those returns were generated. For example, hedge funds have very different return characteristics from the characteristics of mutual funds; hence, the comparison of Sharpe ratios between these two investment vehicles cannot be performed naively. In light of the recent interest in alternative investments by institutional investors—investors that are accustomed to standardized performance attribution measures such as the annualized Sharpe ratio—there is an even greater need to develop statistics that are consistent with a portfolio's investment style. The empirical example in this article underscores the practical relevance of proper statistical inference for Sharpe ratio estimators: Ignoring the impact of serial correlation of hedge fund returns can yield annualized Sharpe ratios that are overstated by more than 65 percent, understated Sharpe ratios in the case of negatively serially correlated returns, and inconsistent rankings across hedge funds of different styles and objectives. By using the appropriate statistical distribution for quantifying the performance of each return history, the Sharpe ratio can provide a more complete understanding of the risks and rewards of a broad array of investment opportunities.
Journal: Financial Analysts Journal
Pages: 36-52
Issue: 4
Volume: 58
Year: 2002
Month: 7
X-DOI: 10.2469/faj.v58.n4.2453
File-URL: http://hdl.handle.net/10.2469/faj.v58.n4.2453
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:4:p:36-52




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# input file: UFAJ_A_12047350_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jacob Boudoukh
Author-X-Name-First: Jacob
Author-X-Name-Last: Boudoukh
Author-Name: Matthew Richardson
Author-X-Name-First: Matthew
Author-X-Name-Last: Richardson
Author-Name: Marti Subrahmanyam
Author-X-Name-First: Marti
Author-X-Name-Last: Subrahmanyam
Author-Name: Robert F. Whitelaw
Author-X-Name-First: Robert F.
Author-X-Name-Last: Whitelaw
Title: Stale Prices and Strategies for Trading Mutual Funds
Abstract: 
 We demonstrate that an institutional feature of numerous mutual funds—funds managing billions in assets—generates fund net asset values that reflect stale prices. Because investors can trade at these NAVs with limited transaction costs in many cases, obvious trading opportunities exist. These opportunities are especially prevalent in funds that buy Japanese or European equities. Simple, feasible strategies generate Sharpe ratios (excess return divided by standard deviation) that are many times greater than the Sharpe ratio of the underlying fund. We illustrate the potential of the strategy for three Vanguard Group mutual funds. A particular issue to keep in mind is that when the strategies are implemented, the gains from these strategies are matched by offsetting losses incurred by buy-and-hold investors in these funds. In the past few years, the financial press has produced numerous articles about large cash flows into and out of certain mutual funds over short time periods. Most of the funds have had one major identifying characteristic: They invest in international—that is, non-U.S.—assets. We attempted to explain this phenomenon and documented the performance of trading strategies that are consistent with these fund flows.Two key institutional features underlie the trading strategies that lead to the rapid in-and-out trading. First, with the proliferation of mutual funds, a U.S. investor can buy into and exchange out of no-load mutual funds at essentially zero cost. Moreover, the opportunities abound; approximately 700 no-load mutual funds invest in international equities, and a number of them are very large. For example, at least 25 international equity funds have assets under management exceeding $1 billion.The second institutional feature is that when U.S. investors buy/sell mutual funds during the day, they do so at the prices prevailing at the close of trading in the United States. Those prices are based on the last transaction prices of the stocks in the fund. For Japanese and other Asian equities, the last transaction could have been at the previous 1:00 a.m. (U.S. Eastern Standard Time), and for many European equities, it could have been 12:00 noon. When these markets are closed, information flow does not cease; information relevant for valuation of the securities traded in the closed markets is still being released. For example, the literature contains considerable evidence that international equity returns are correlated at all times, even when one of the markets is closed. Moreover, the magnitude of the correlations may be quite large. This phenomenon induces large correlations between observed security prices during the U.S. trading day and the next day's return on these funds.In some cases, derivatives on international markets trading in the United States provide even more informative signals (than U.S. market returns) about the unobserved movements in the prices of securities in the non-U.S. equity funds. This knowledge can be used to generate considerable excess return in the buying and selling of mutual funds. With no transaction costs and perfect liquidity, an investor can purchase funds at stale prices. In the most extreme case, one can use 1:00 a.m. prices to buy a Japan fund while one has information about the “true” price some 15 hours later at 4:00 p.m.Given these facts, it is perhaps no surprise that we document extraordinarily high excess profits and Sharpe ratios for two categories of investment funds: Pacific/Japan equity funds and international/Europe equity funds. Our sample of funds was chosen for the staleness of their underlying prices, the size of the fund, and the ease of implementing the trading strategy. We studied a strategy of switching between a money market account and the underlying fund in response to signals during U.S. market hours. We also studied the effect of the various trading costs from various types of implementation procedures.Because mutual funds do place some limits on the frequency and amount of exchanges between funds, although the limits are not always enforced, we examined strategies with particularly strong signals. We found for both types of fund that, although the strategy recommended active trading only 5–10 percent of the time, the return, on average, substantially exceeded the return to a buy-and-hold strategy during an ex post very good market for equities. More interesting is the fact that for both types of fund, we could predict the next day's movement more than 75 percent of the time. Sharpe ratios generally ranged between 5 and 10 on the days the investor was in the market. The range of Sharpe ratios depended on whether the strategy included hedging of equity price movements during non-U.S. trading hours.To illustrate in a detailed manner the mechanics and results of the trading strategy, we provide a case study using three mutual funds from the Vanguard family of funds. This analysis is of special interest to academic readers because these funds are available through the retirement plans of numerous educational institutions and can be easily traded on the Internet or over the phone.
Journal: Financial Analysts Journal
Pages: 53-71
Issue: 4
Volume: 58
Year: 2002
Month: 7
X-DOI: 10.2469/faj.v58.n4.2454
File-URL: http://hdl.handle.net/10.2469/faj.v58.n4.2454
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:4:p:53-71




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# input file: UFAJ_A_12047351_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David VanderLinden
Author-X-Name-First: David
Author-X-Name-Last: VanderLinden
Author-Name: Christine X. Jiang
Author-X-Name-First: Christine X.
Author-X-Name-Last: Jiang
Author-Name: Michael Hu
Author-X-Name-First: Michael
Author-X-Name-Last: Hu
Title: Conditional Hedging and Portfolio Performance
Abstract: 
 Simple conditional currency-hedging rules often increase risk-adjusted portfolio returns and are thus of interest to investors. Several researchers have reported successful application of a “forward hedge rule” (FHR) in which one hedges whenever the foreign currency trades at a forward premium. An alternative strategy, a “real-interest-rate hedge rule” (RIR), is based on hedging when the domestic real interest rate exceeds the foreign rate. As an extension, we propose a combination of these rules—a “real forward hedge rule” (RFHR). We evaluate the performance of the rules for various currency, stock, and bond portfolios from the developed countries. In tests of risk-adjusted returns for 1976–1997, the RFHR significantly outperformed standard benchmarks and often beat the FHR and the RIR. Moreover, results of a simple dominance test for rolling 5- and 10-year periods suggest that the RFHR consistently improves portfolio performance for a U.S. investor. Managers of international equity and bond portfolios face added complications from currency fluctuations, so currency hedging is often used to minimize risk. Simple conditional currency-hedging rules may decrease risk, but they also frequently increase risk-adjusted portfolio returns (the Sharpe ratio). We tested the efficacy of a “real forward hedge rule” applied to equally weighted portfolios of currencies, stocks, bonds, and stocks plus bonds from the G–5 countries (France, Germany, Japan, the United Kingdom, and the United States) over a 21-year period. The rule we proposed outperformed both conventional benchmarks and two other conditional hedging rules. These results suggest that U.S. managers could benefit from using this rule.Conditional hedging rules make hedging decisions on the basis of the information available to individuals at the investment decision point. Several researchers have reported successful application of a forward hedge rule (FHR), in which one hedges whenever the foreign currency trades at a forward premium. This strategy is based on an assumption that exchange rates follow roughly a random walk and that managers are rewarded by hedging whenever they can capture the forward premium. Other researchers have reported evidence supporting a real-interest-rate hedge rule (RIR) in which one hedges when the domestic real interest rate exceeds the foreign one. This rule is based on the supposition that purchasing power parity is a better predictor of the subsequent exchange rate than is the forward rate.Recognizing that the RIR might help improve results obtained from applying the FHR (because the RIR links inflation expectations to exchange rates and helps explain the reasons for differences in interest rates), we propose a combination of these rules in a real forward hedge rule (RFHR). The RFHR invokes hedging only when (1) the foreign currency is at a forward premium and (2) the domestic real interest rate exceeds the foreign rate. This combined rule hedged less often than the FHR or RIR (about 34 percent versus 50 percent of the time), but it proved to be correct more frequently (59 percent of the time versus 57–58 percent) during the period of our study.We tested the RFHR against standard unconditional benchmarks (never hedged, always half-hedged, and always fully hedged) and against the FHR and RIR for equally weighted portfolios of G–5 currencies, stocks, bonds, and stocks plus bonds. Monthly observations for 1976–1997 were drawn from Datastream, and hedging transaction costs of 5 bps a month were assumed. We adopted the viewpoint of a U.S. investor throughout.With one exception (fully hedged bonds), the RFHR led to significantly higher Sharpe ratios than did the unconditional benchmarks. Also, although the differences in Sharpe ratios between the RFHR and the FHR or RIR generally were not statistically significant, the RFHR showed clear superiority in a simple dominance test. In this test, we computed Sharpe ratios for rolling 5- and 10-year periods of monthly observations and counted the number of times each strategy had the highest Sharpe ratio. That is, for the 204 overlapping 5-year periods for equity (or bond or bond plus equity) portfolios, the dominance test counted the number of 5-year periods in which application of each of the six strategies resulted in the best Sharpe ratio. The test found that for all but the rolling 5-year bond portfolios (in which the FHR, the RFHR, and the fully hedged strategies were roughly equally successful), use of the RFHR strategy led to the highest Sharpe ratio most often. In fact, in many cases, the number of periods in which the RFHR dominated was greater than that of any three competing approaches combined. Although the dominance test is not a statistical test, it does indicate a high level of consistency in performance.One can conclude from this study that application by U.S. investors of the RFHR to international portfolios often leads to better results. The combined rule is less successful with bonds, which may not benefit from the added information from the RIR because bonds are more highly correlated with interest rates. Use of the RFHR with equity portfolios and with stock plus bond portfolios, however, has the potential to provide strong benefits.
Journal: Financial Analysts Journal
Pages: 72-82
Issue: 4
Volume: 58
Year: 2002
Month: 7
X-DOI: 10.2469/faj.v58.n4.2455
File-URL: http://hdl.handle.net/10.2469/faj.v58.n4.2455
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# input file: UFAJ_A_12047352_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Engines That Move Markets: Technology Investing from Railroads to the Internet and Beyond (a review)
Abstract: 
 Expertly encompassing history, technology, and securities analysis, this tour de force warns that technological innovation has not guaranteed profits for investors. 
Journal: Financial Analysts Journal
Pages: 83-84
Issue: 4
Volume: 58
Year: 2002
Month: 7
X-DOI: 10.2469/faj.v58.n4.2456
File-URL: http://hdl.handle.net/10.2469/faj.v58.n4.2456
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:4:p:83-84




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# input file: UFAJ_A_12047353_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Investor Relations for the Emerging Company (a review)
Abstract: 
 The authors provide practical and ethical approaches to dealing with the problems specific to microcap companies going public—lack of market depth and vulnerability to stock-price manipulation. 
Journal: Financial Analysts Journal
Pages: 84-85
Issue: 4
Volume: 58
Year: 2002
Month: 7
X-DOI: 10.2469/faj.v58.n4.2457
File-URL: http://hdl.handle.net/10.2469/faj.v58.n4.2457
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# input file: UFAJ_A_12047354_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Security Market Imperfections in World Wide Equity Markets (a review)
Abstract: 
 The editors of this volume have collected or written essays encompassing the full range of research on this controversy that has been published in scholarly journals over almost 20 years. 
Journal: Financial Analysts Journal
Pages: 85-86
Issue: 4
Volume: 58
Year: 2002
Month: 7
X-DOI: 10.2469/faj.v58.n4.2458
File-URL: http://hdl.handle.net/10.2469/faj.v58.n4.2458
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# input file: UFAJ_A_12047355_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: William Fung
Author-X-Name-First: William
Author-X-Name-Last: Fung
Author-Name: David A. Hsieh
Author-X-Name-First: David A.
Author-X-Name-Last: Hsieh
Title: Asset-Based Style Factors for Hedge Funds
Abstract: 
 Asset-based style factors link returns of hedge fund strategies to observed market prices. They provide explicit and unambiguous descriptions of hedge fund strategies that reveal the nature and quantity of risk. Asset-based style factors are key inputs for portfolio construction and for benchmarking hedge fund performance on a risk-adjusted basis. We used previously developed models to construct asset-based style factors and demonstrate that one model correctly predicted the return behavior of trend-following strategies during out-of-sample periods—in particular, during stressful market conditions like those of September 2001. Hedge fund returns differ from the returns of traditional asset classes. But investors looking for alternative return characteristics in hedge funds must be concerned about the consistency between historical and future hedge fund returns. To go beyond relying on historical hedge fund performance repeating itself, one needs to answer the key question on hedge fund performance: What is the wind behind this sail? Attempts to answer this question have to contend with unconventional hedge fund strategies and limited informational disclosure from the hedge fund managers.We propose a new method called “asset-based style factors” to provide an explicit description of hedge fund strategies. Asset-based style factors model hedge fund strategies by linking their returns to observed market prices. Through these links, the myriad of hedge fund styles may eventually be expressed as a simple, unifying model of familiar asset classes in the spirit of Sharpe's style model for mutual funds. Generally, asset-based style factors help qualify the nature of the risk a hedge fund investment is exposed to beyond a mere quantitative risk measure that conventional statistical tools provide. Constructed from market prices, asset-based style factors are directly observable and have long histories of returns. These characteristics are particularly helpful in risk management applications. Asset-based style factors are transparent and unambiguous. They provide key inputs for constructing diversified portfolios and can also be used to benchmark hedge fund performance on a risk-adjusted basis.We illustrate this approach by using a model we developed for constructing asset-based style factors for trend-following strategies, update the results we previously found for the 1983–97 period with data up to September 2001, and show that trend-following funds have continued to perform as predicted for their style factor: They returned positive profits during four periods of extreme market volatility, particularly in the fall of 1998 and September 2001.
Journal: Financial Analysts Journal
Pages: 16-27
Issue: 5
Volume: 58
Year: 2002
Month: 9
X-DOI: 10.2469/faj.v58.n5.2465
File-URL: http://hdl.handle.net/10.2469/faj.v58.n5.2465
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# input file: UFAJ_A_12047356_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ananth Madhavan
Author-X-Name-First: Ananth
Author-X-Name-Last: Madhavan
Title: Market Microstructure: A Practitioner's Guide
Abstract: 
 Knowledge of market microstructure—how investors' latent or hidden demands are ultimately translated into prices and volumes—has grown explosively in recent years. This literature is of special interest to practitioners because of the rapid transformation of the market environment by technology, regulation, and globalization. Yet, for the most part, the major theoretical insights and empirical results from academic research have not been readily accessible to practitioners. I discuss the practical implications of the literature, with a focus on price formation, market structure, transparency, and applications to other areas of finance. Market microstructure concerns the process by which investors' latent or hidden demands are translated into executed trades. Interest in market microstructure is not new, but it has increased enormously in recent years because of the rapid structural, technological, and regulatory changes affecting the securities industry. Beyond these immediate concerns, however, the study of microstructure has broader practical value. A central concept in microstructure is that asset prices need not equal full-information expectations of value because of a variety of frictions. Thus, market microstructure is closely related to the study of the fundamental values of financial assets. Microstructure is also linked to traditional corporate finance because discrepancies between prices and value affect the level and choice of corporate financing.Knowledge of microstructure has grown explosively in recent years, but many important theoretical insights and empirical results from academic research are not readily accessible to practitioners. This article provides a practitioner-oriented review of the literature with an emphasis on the modern line of thought that focuses on information. The objective is to provide the reader with a valuable conceptual framework for attacking a variety of practical problems—current and future. The focus is on four broad topics within the field: first, price formation and price discovery—including both static issues, such as the determinants of trading costs, and dynamic issues, such as the process by which prices come to impound information over time. The goal is to look inside the “black box” by which latent demands are translated into realized prices and volumes;second, market structure and design issues, including the relationship between price formation and trading protocols. The focus is on how various rules affect the black box and, hence, liquidity and market quality;third, information, especially market transparency (i.e., the ability of market participants to observe information about the trading process). This topic deals with how revelation of the workings of the black box affects the behavior of traders and their strategies;fourth, the interface of market microstructure with corporate finance, asset pricing, and international finance. Models of the black box provide fresh perspectives on such topics as the underpricing of initial public offerings, portfolio risk, and foreign exchange movements. These categories roughly correspond to the historical development of research into the informational aspects of microstructure.Several conclusions from this survey of the literature are especially relevant for practitioners. First, markets are a great deal more complex than commonly believed. One of the major achievements of the microstructure literature is illumination of the black box by which prices and quantities are determined in financial markets. The recognition that order flows can have long-lasting effects on prices has many practical implications. For example, large price impacts may drive institutional traders to lower-cost venues, creating a potential for alternative trading systems. They can also explain the anomalous return behavior associated with periodic index reconstitution.Second, microstructure matters. Under certain protocols, markets may fail and large deviations between “fundamental value” and price may occur. These issues are especially relevant for exchange officials, operators of trading systems, regulators, and traders.Third, “one size fits all” approaches to regulation and policy making should be avoided. For example, greater transparency need not always enhance liquidity.Finally, the interface of microstructure with other areas of finance is an exciting new area. A more complete understanding of the time-varying nature of liquidity and its relationship to expected returns is needed; evidence is growing that liquidity is a “factor” in explaining stock returns. Differences in liquidity over time may explain variations in the risk premium and may, therefore, influence stock-price levels.
Journal: Financial Analysts Journal
Pages: 28-42
Issue: 5
Volume: 58
Year: 2002
Month: 9
X-DOI: 10.2469/faj.v58.n5.2466
File-URL: http://hdl.handle.net/10.2469/faj.v58.n5.2466
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# input file: UFAJ_A_12047357_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Stephen R. Moehrle
Author-X-Name-First: Stephen R.
Author-X-Name-Last: Moehrle
Author-Name: Jennifer A. Reynolds-Moehrle
Author-X-Name-First: Jennifer A.
Author-X-Name-Last: Reynolds-Moehrle
Author-Name: Wilbur L. Tomlinson
Author-X-Name-First: Wilbur L.
Author-X-Name-Last: Tomlinson
Title: Is There a Gap in Your Knowledge of GAAP?
Abstract: 
 As recent accounting scandals have demonstrated, an understanding of the accounting rules underlying financial information is important before analysts or users of financial statements can rely on that information. Accounting guidance comes from numerous sources. We summarize the sources of generally accepted accounting principles, explain the hierarchy of these sources of guidance, and indicate where analysts and users of financial statements can find the electronic and printed texts of the rules. The Enron Corporation scandal and other high-profile accounting investigations have demonstrated the importance of understanding how accounting rules are applied in preparing financial statements. Thus, financial analysts and other users of financial statements need to increase the attention they pay to the rules underlying companies' financial statements. Most financial statement users are familiar with the term “generally accepted accounting principles” and are familiar with key U.S. accounting rules, but few users of financial statements know what constitutes the universe of GAAP or where such information can be found. We set forth precisely the constituents of the GAAP universe, the various sources of GAAP, the relative position of each source in the hierarchy of accounting authority, and where this information can be found.The hierarchy of GAAP consists of five categories. Category A, the most authoritative level, includes Financial Accounting Standards Board (FASB) Statements of Financial Accounting Standards (SFAS) and Interpretations, Accounting Principles Board Opinions, and Accounting Research Bulletins issued by the American Institute of Certified Public Accountants (AICPA). Category B is a lower tier of authoritative documents issuing from the FASB and AICPA. An important part of Category C is consensus positions of FASB's Emerging Issues Task Force, which provides financial reporting guidance that is more timely than SFAS can be. Category D consists of such material as AICPA Accounting Interpretations and FASB Staff Implementation Guides, as well as sundry industry practices that are widely followed (but do not have the imprimatur granted GAAP in the first tier). Category E is a catchall group that includes written sources of accounting authority ranging from FASB Statements of Financial Accounting Concepts to accounting textbooks.Also in the GAAP universe are pronouncements and rules established by the U.S. SEC under its power to establish accounting standards for publicly traded companies.Unfortunately, no single source contains all these materials. We describe several paper and online sources, however, that can be consulted. The primary electronic resource for materials promulgated by the FASB is the Financial Accounting Research System, which is available on CD-ROM. Most of the same material is also available in a printed volume, Annual Bound Editions of FASB Original Pronouncements and Current Text. Many of the AICPA materials are now available through a new service, reSOURCE, which is offered by the AICPA via CD-ROM or via a fee-based Internet service. For relevant SEC material, the most comprehensive source is Lexis-Nexis, a fee-based service that is now available on the Web. In addition, a number of specialized accounting databases are available.
Journal: Financial Analysts Journal
Pages: 43-47
Issue: 5
Volume: 58
Year: 2002
Month: 9
X-DOI: 10.2469/faj.v58.n5.2467
File-URL: http://hdl.handle.net/10.2469/faj.v58.n5.2467
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# input file: UFAJ_A_12047358_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Roger Clarke
Author-X-Name-First: Roger
Author-X-Name-Last: Clarke
Author-Name: Harindra de Silva
Author-X-Name-First: Harindra
Author-X-Name-Last: de Silva
Author-Name: Steven Thorley
Author-X-Name-First: Steven
Author-X-Name-Last: Thorley
Title: Portfolio Constraints and the Fundamental Law of Active Management
Abstract: 
 Active portfolio management is typically conducted within constraints that do not allow managers to fully exploit their ability to forecast returns. Constraints on short positions and turnover, for example, are fairly common and materially restrictive. Other constraints, such as market-capitalization and value–growth neutrality with respect to the benchmark or economic-sector constraints, can further restrict an active portfolio's composition. We derive ex ante and ex post correlation relationships that facilitate the performance analysis of constrained portfolios. The ex ante relationship is a generalized version of a previously developed “fundamental law of active management” and provides an important strategic perspective on the potential for active management to add value. The ex post correlation relationship represents a practical decomposition of performance into the success of the return-prediction process and the “noise” associated with portfolio constraints. We verify the accuracy of these relationships with a Monte Carlo simulation and illustrate their application with equity portfolio examples based on the S&P 500 Index as the benchmark. The expected value added in an actively managed portfolio depends on both the manager's forecasting skill and the manager's freedom to take appropriate positions in securities that reflect those forecasts. The “fundamental law of active management” gives the maximum expected value added for an actively managed portfolio based on the forecasting ability of the manager and the breadth of application. The fundamental law does not, however, address the impact of portfolio constraints on potential value added. Constraints such as no short sales and limits on security concentration impede the transfer of information into optimal portfolio positions and decrease the expected value added.We generalize the fundamental law of active management to include a transfer coefficient as well as an information coefficient. The information coefficient measures the strength of the return-forecasting process, or signal, and the transfer coefficient measures the degree to which the signal is transferred into active portfolio weights. The transfer coefficient turns out to be a simple scaling factor in the generalized fundamental law and is an intuitive way to measure the extent to which constraints reduce the expected value of forecasting ability. In an ideal world without any constraints, a well-constructed portfolio has a transfer coefficient of 1.0 and the original form of the fundamental law applies. In practice, managers often work under constraints that produce transfer coefficients ranging from 0.3 to 0.8. The transfer coefficient suggests why performance in practice is only a fraction (0.3 to 0.8) of what is predicted by the original form of the fundamental law.Measuring the impact of portfolio constraints on active weights through use of the transfer coefficient allows an investment manager to assess strategic trade-offs in constructing portfolios. For example, we illustrate that increasing the tracking error in a long-only portfolio typically reduces the transfer coefficient because the long-only constraint becomes binding for more securities and thus impedes the transfer of information into desirable portfolio positions. Another strategic perspective is that the long-only constraint leads to an unintended small-cap bias in actively managed portfolios, which is then a motivation for market-cap-neutrality constraints. The combination of long-only and market-cap-neutrality constraints, however, leads to active management that is concentrated in the large-cap sector. We use the framework of the generalized fundamental law and transfer coefficient to illustrate the impact on portfolios of not only the long-only constraint but also turnover constraints and multiple constraints.In addition to the transfer coefficient's ex ante role, the transfer coefficient is also a critical parameter in reconciling realized performance with the realized success of return forecasting. We derive a decomposition of ex post active management performance based on the transfer coefficient and the realized information coefficient. The ex post  performance decomposition indicates that only a fraction (the transfer coefficient squared) of the variation in realized performance, or tracking error, is attributable to variation in realized information coefficients. For example, if the portfolio has no constraints and the transfer coefficient is 1.0, variation in realized performance is wholly attributable to the success of the return-prediction process. If the transfer coefficient is 0.3, however, only 9 percent of performance variation is attributable to the success of the signal and the remaining 91 percent is attributable to constraint-induced “noise.” Managers with low transfer coefficients will experience frequent periods when the signal works but performance is poor and periods when performance is good even though the return-forecasting process failed.
Journal: Financial Analysts Journal
Pages: 48-66
Issue: 5
Volume: 58
Year: 2002
Month: 9
X-DOI: 10.2469/faj.v58.n5.2468
File-URL: http://hdl.handle.net/10.2469/faj.v58.n5.2468
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Author-Name: Ernest M. Ankrim
Author-X-Name-First: Ernest M.
Author-X-Name-Last: Ankrim
Author-Name: Zhuanxin Ding
Author-X-Name-First: Zhuanxin
Author-X-Name-Last: Ding
Title: Cross-Sectional Volatility and Return Dispersion
Abstract: 
 In the past few years, the return spread between successful and unsuccessful active managers has increased dramatically. We analyzed how levels of cross-sectional volatility correspond to active manager dispersion in the U.S. and other equity markets. We demonstrate that changes in the level of cross-sectional volatility have a significant association with the distribution of active manager returns. We further show that these observations are neither unique to U.S. equities nor merely a product of the “technology bubble”; they are observable in several equity markets. In the past few years, the return spread between successful and unsuccessful active managers has increased dramatically. Moreover, many investors have experienced manager and fund tracking errors that far exceeded expectations. These phenomena are not so much a result of managers taking larger bets or becoming more diverse in their skill levels but, rather, of the riskiness of the bets being magnified by an increase in cross-sectional volatility in the equity markets. Cross-sectional volatility, in contrast to the more common volatility measure of variability of a given return series through time, measures variations in returns across market sectors or individual stocks in a given time period.We illustrate the magnitude of the recent expansion in the gulf between the good and bad manager performances in various equity markets. In the study we report, we first used return data on the S&P 500 Index from November 1989 to December 2000 and calculated the cross-sectional volatility for each month. We then analyzed how levels of cross-sectional volatility correspond to dispersion in the returns of active managers in the U.S. large-cap market. Intuitively, the active risks in portfolios are functions of both the aggressiveness and the cross-sectional volatility of security/industry/sector returns. Our empirical study shows that the recent widening of manager dispersion appears to be linked to the increase in cross-sectional volatility in the U.S. large-cap equity market without a commensurate increase in the aggressiveness of portfolios.We extended our study to address three issues. First, we demonstrate that these observations are not unique to U.S. equities. Similar increases are occurring in the U.S. small-cap and other countries' markets. Second, we suggest that this experience is not entirely new; in fact, the highest value of cross-sectional volatility in Japan occurred in 1987, not 2000. Finally, we show that the increases are not solely a product of the technology “bubble” but are still observable when technology sectors are removed from the broad equity markets.Observations for 2001 indicate that the level of cross-sectional volatility has declined in some markets, but current levels are still well above historical norms. In the future, therefore, portfolio managers must decide whether, knowing that rewards and penalties will be amplified, they are comfortable with the current magnitude of their bets. If higher active risk is beyond their objectives (or tolerance for business risk), they will have to reduce the portfolio's aggressiveness. The corollary risk is that the cross-sectional volatility will revert to its historical levels and leave portfolio managers who lowered the aggressiveness of their bets with indexlike returns at active fees.For investors, this environment poses a different sort of risk. In an environment where active bets generate large results (good and bad), active dispersion will be higher. Therefore, some mutual funds will generate astoundingly good returns and some will report astoundingly bad returns. The effect is heightened temptation for investors to chase the most recent winners in the mutual fund market. When the difference between the best and worst mutual funds in the market expands two- or threefold, the behavior of the average investor is not difficult to predict. But plenty of research warns against such behavior. The best response for individual investors in this environment is to stick with whatever well-developed investment strategy they already have. The investors who avoid the temptation to chase after the astonishing returns should look back on this wild period with better-than-average performance.
Journal: Financial Analysts Journal
Pages: 67-73
Issue: 5
Volume: 58
Year: 2002
Month: 9
X-DOI: 10.2469/faj.v58.n5.2469
File-URL: http://hdl.handle.net/10.2469/faj.v58.n5.2469
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:5:p:67-73




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Author-Name: William F. Sharpe
Author-X-Name-First: William F.
Author-X-Name-Last: Sharpe
Title: Budgeting and Monitoring Pension Fund Risk
Abstract: 
 This article describes a set of mean–variance procedures for setting targets for the risk characteristics of components of a pension fund portfolio and for monitoring the portfolio over time to detect significant deviations from those targets. Because of the significant correlations of the returns provided by the managers of a typical defined-benefit pension fund, the risk of the portfolio cannot be characterized as simply the sum of the risks of the individual components. Expected returns, however, can be so characterized. I show that the relationship between marginal risks and implied expected excess returns provides the economic rationale for the risk budgeting and monitoring being implemented by a number of pension funds. I then show how a fund's liabilities can be taken into account to make the analysis consistent with goals assumed in asset/liability studies. I also discuss the use of factor models and aggregation and disaggregation procedures. The article concludes with a short discussion of practical issues that should be addressed when implementing a pension fund risk-budgeting and -monitoring system. 
Journal: Financial Analysts Journal
Pages: 74-86
Issue: 5
Volume: 58
Year: 2002
Month: 9
X-DOI: 10.2469/faj.v58.n5.2470
File-URL: http://hdl.handle.net/10.2469/faj.v58.n5.2470
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Author-Name: Chris Brooks
Author-X-Name-First: Chris
Author-X-Name-Last: Brooks
Author-Name: Gita Persand
Author-X-Name-First: Gita
Author-X-Name-Last: Persand
Title: Model Choice and Value-at-Risk Performance
Abstract: 
 Broad agreement exists among both the investment banking and regulatory communities that the use of internal risk management models is an efficient means for calculating capital risk requirements. The determination of model parameters laid down by the Basle Committee on Banking Supervision as necessary for estimating and evaluating the capital adequacies, however, has received little academic scrutiny. We investigate a number of issues of statistical modeling in the context of determining market-based capital risk requirements. We highlight several potentially serious pitfalls in commonly applied methodologies and conclude that simple methods for calculating value at risk often provide superior performance to complex procedures. Our results thus have important implications for risk managers and market regulators. Broad agreement exists in both the investment banking and regulatory communities that the use of internal risk management models can provide an efficient means for calculating capital risk requirements. The determination of the model parameters necessary for estimating and evaluating the capital adequacies laid down by the Basle Committee on Banking Supervision, however, has received little academic scrutiny.We extended recent research in this area by evaluating the statistical framework proposed by the Basle Committee and by comparing several alternative ways to estimate capital adequacy. The study we report also investigated a number of issues concerning statistical modeling in the context of determining market-based capital risk requirements. We highlight in this article several potentially serious pitfalls in commonly applied methodologies.Using data for 1 January 1980 through 25 March 1999, we calculated value at risk (VAR) for six assets—three for the United Kingdom and three for the United States. The U.K. series consisted of the FTSE All Share Total Return Index, the FTA British Government Bond Index (for bonds of more than 15 years), and the Reuters Commodities Price Index; the U.S. series consisted of the S&P 500 Index, the 90-day T-bill, and a U.S. government bond index (for 10-year bonds). We also constructed two equally weighted portfolios containing these three assets for the United Kingdom and the United States.We used both parametric (equally weighted, exponentially weighted, and generalized autoregressive conditional heteroscedasticity) models and nonparametric models to measure VAR, and we applied a method based on the generalized Pareto distribution, which allowed for the fat-tailed nature of the return distributions. Following the Basle Committee rules, we determined the adequacy of the VAR models by using backtests (i.e., out-of-sample tests), which counted the number of days during the past trading year that the capital charge was insufficient to cover daily trading losses.We found that, although the VAR estimates from the various models appear quite similar, the models produce substantially different results for the numbers of days on which the realized losses exceeded minimum capital risk requirements. We also found that the effect on the performance of the models of using longer runs of data (rather than the single trading year required by the Basle Committee) depends on the model and asset series under consideration. We discovered that a method based on quantile estimation performed considerably better in many instances than simple parametric approaches based on the normal distribution or a more complex parametric approach based on the generalized Pareto distribution. We show that the use of critical values from a normal distribution in conjunction with a parametric approach when the actual data are fat tailed can lead to a substantially less accurate VAR estimate (specifically, a systematic understatement of VAR) than the use of a simple nonparametric approach.Finally, the closer quantiles are to the mean of the distribution, the more accurately they can be estimated. Therefore, if a regulator has the desirable objective of ensuring that virtually all probable losses are covered, using a smaller nominal coverage probability (say, 95 percent instead of 99 percent), combined with a larger multiplier, is preferable. Our results thus have important implications for risk managers and market regulators.
Journal: Financial Analysts Journal
Pages: 87-97
Issue: 5
Volume: 58
Year: 2002
Month: 9
X-DOI: 10.2469/faj.v58.n5.2471
File-URL: http://hdl.handle.net/10.2469/faj.v58.n5.2471
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:5:p:87-97




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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Ethics in Finance (a review)
Abstract: 
 Integrating moral reasoning and financial theory, this examination of the quandaries confronting those who seek an ethical stance covers a wide range of subjects—from excessive trading of brokerage accounts to socially responsible investing. 
Journal: Financial Analysts Journal
Pages: 85-85
Issue: 5
Volume: 58
Year: 2002
Month: 9
X-DOI: 10.2469/faj.v58.n5.2472
File-URL: http://hdl.handle.net/10.2469/faj.v58.n5.2472
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Financial Crime Investigation and Control (a review)
Abstract: 
 This comprehensive guide to thwarting scams and fraud in a firm recommends vigilance and the maintenance of an ethical environment by setting standards and also setting the example. 
Journal: Financial Analysts Journal
Pages: 99-100
Issue: 5
Volume: 58
Year: 2002
Month: 9
X-DOI: 10.2469/faj.v58.n5.2473
File-URL: http://hdl.handle.net/10.2469/faj.v58.n5.2473
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# input file: UFAJ_A_12047364_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Strategic Asset Allocation: Portfolio Choice for Long-Term Investors (a review)
Abstract: 
 An up-to-date account of the state of strategic asset allocation analysis, this book takes a methodical approach of moving from the simple to the complex to show how changes in assumptions can significantly affect allocation decisions. 
Journal: Financial Analysts Journal
Pages: 100-101
Issue: 5
Volume: 58
Year: 2002
Month: 9
X-DOI: 10.2469/faj.v58.n5.2474
File-URL: http://hdl.handle.net/10.2469/faj.v58.n5.2474
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# input file: UFAJ_A_12047365_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Microstructure Approach to Exchange Rates (a review)
Abstract: 
 This thought-provoking introduction to the dynamic foreign exchange market proposes a framework for explaining currency moves by applying work on exchange rate economics, information economics, and order flow to the microstructure of markets. 
Journal: Financial Analysts Journal
Pages: 101-103
Issue: 5
Volume: 58
Year: 2002
Month: 9
X-DOI: 10.2469/faj.v58.n5.2475
File-URL: http://hdl.handle.net/10.2469/faj.v58.n5.2475
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Author-Name: Daniel Morillo
Author-X-Name-First: Daniel
Author-X-Name-Last: Morillo
Author-Name: Larry Pohlman
Author-X-Name-First: Larry
Author-X-Name-Last: Pohlman
Title: “The Statistics of Sharpe Ratios”: A Comment
Abstract: 
 This material comments on “The Statistics of Sharpe Ratios”.
Journal: Financial Analysts Journal
Pages: 18-18
Issue: 6
Volume: 58
Year: 2002
Month: 11
X-DOI: 10.2469/faj.v58.n6.2480
File-URL: http://hdl.handle.net/10.2469/faj.v58.n6.2480
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Author-Name: Ralph A. Rieves
Author-X-Name-First: Ralph A.
Author-X-Name-Last: Rieves
Author-Name: John R. Lefebvre
Author-X-Name-First: John R.
Author-X-Name-Last: Lefebvre
Title: Review of Investor Relations for the Emerging Company: A Comment
Abstract: 
 This material comments on the review of Investor Relations for the Emerging Company.
Journal: Financial Analysts Journal
Pages: 19-19
Issue: 6
Volume: 58
Year: 2002
Month: 11
X-DOI: 10.2469/faj.v58.n6.2482
File-URL: http://hdl.handle.net/10.2469/faj.v58.n6.2482
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Author-Name: Hung-Gay Fung
Author-X-Name-First: Hung-Gay
Author-X-Name-Last: Fung
Author-Name: Xiaoqing Eleanor Xu
Author-X-Name-First: Xiaoqing Eleanor
Author-X-Name-Last: Xu
Author-Name: Jot Yau
Author-X-Name-First: Jot
Author-X-Name-Last: Yau
Title: Global Hedge Funds: Risk, Return, and Market Timing
Abstract: 
 We examined the performance of 115 global equity-based hedge funds with reference to their target geographical markets in the seven-year period 1994–2000. Several results are noteworthy. First, global hedge fund managers do not show positive market-timing ability but do demonstrate superior security-selection ability; the Jensen's alphas we found, before and after controlling for market timing, are sizable and positive. Second, incentive fees and leverage both have a significant positive impact on a hedge fund's risk-adjusted return (as demonstrated by Sharpe ratios and Jensen's alphas) but not on a fund's “selectivity index” (i.e., its performance after controlling for market-timing effects). Third, incentive fees can lower the hedge fund's up-market and down-market systematic risk. Fourth, the size of a hedge fund is consistently related to its return performance. Finally, contrary to the general perception, leverage does not significantly affect the systematic risk of hedge funds. We used the monthly returns of 115 global equity-based hedge funds for 1994–2000 to investigate the impact of hedge fund characteristics on the risk, return, security-selection ability, and market-timing ability of hedge funds conditioned on their target geographical markets. The typical analysis of hedge fund performance is carried out according to fund style without reference to the appropriate market benchmark. Research conditioned on the funds' target markets enabled us to refine assessment of hedge fund performance.We evaluated only those equity-based funds that detailed their investment allocations specified in the Managed Account Reports database, which identifies target markets for five groups of global hedge funds—global emerging, global established U.S. opportunity, global established European opportunity, global international (world ex United States), and global macro (world).For our analysis of market timing, we used two models for comparison. Model 1 is the traditional capital asset pricing model, which served as the base model. Model 2 is a market-timing model designed to separate portfolio managers' broad market (or macro) forecasting ability (market-timing ability) from their micro-forecasting (security-selection) ability.The results when we used the market-timing model indicate that, in general, global hedge funds do not have market-timing ability. In fact, a high percentage of hedge funds in the sample, particularly the funds targeting U.S. and developed European markets, had negative timing ability. Global hedge funds appear to have good security-selection ability. The Jensen's alphas we found before and after controlling for market timing are sizable and positive.When we considered the determinants of performance, we found that incentive fees have significant positive effects on the Sharpe ratio and Jensen's alpha but not on our “selectivity performance index,” which measures performance after controlling for market-timing effects. The leverage ratio had effects on performance measures similar to those of incentive fees. In addition, we found incentive fees to be associated with a reduction in overall systematic risk, up-market risk, and down-market risk.The size of a hedge fund was consistently related to its return performance on a before- and after-market-risk-adjustment basis. Our results imply that large funds benefit from economies of scale or that better managed hedge funds attract more investments. Fund age was significant only for market-timing performance; we found that younger hedge funds were able to time the market better than older funds.
Journal: Financial Analysts Journal
Pages: 19-30
Issue: 6
Volume: 58
Year: 2002
Month: 11
X-DOI: 10.2469/faj.v58.n6.2483
File-URL: http://hdl.handle.net/10.2469/faj.v58.n6.2483
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Author-Name: Richard A. Ippolito
Author-X-Name-First: Richard A.
Author-X-Name-Last: Ippolito
Title: Replicating Default Risk in a Defined-Benefit Plan
Abstract: 
 A stock-bonus plan with a provision to permit diversification can come close to replicating the classic default risks in defined-benefit pension plans. The diversification formula is a function of a worker's service in the company and the particular features of the defined-benefit (DB) plan that are being reproduced. The diversifiable stock-bonus (DSB) plan still gives workers a stake in the financial performance of the company, but the diversification formula eliminates the extreme downside of a traditional stock-bonus plan, namely, the possibility that workers could lose up to all of their retirement accounts after long years of service. Because the DSB plan imposes about the same default risks on workers as a DB plan, workers' compensation levels with a DSB plan need not be any higher than in a traditional pension plan. Traditional U.S. defined-benefit (DB) pension plans expose workers to default risk. If a company encounters serious financial difficulty, the company may exercise its option to terminate the pension. This risk imposes a well-known hill-like pattern of pension capital losses on workers. Since the enactment in the United States of reversion taxes, which were imposed in steps over the 1986–90 period, using a DB plan to award pension benefits that are contingent on the company's performance has become expensive. As a result, funding in private DB plans has fallen dramatically in the United States and U.S. companies have shifted their focus toward defined-contribution (DC) plans and cash-balance plans.Can some DC plan arrangement be used to recreate the classic default risks in DB plans? I show that a stock-bonus plan with a provision to permit diversification out of company stock can come close to replicating this exposure. Because it imposes about the same default risks on workers as a DB plan, workers' compensation levels should not need to be adjusted in any other way to accommodate the new pension.The diversifiable stock-bonus plans (DSBs) that I describe are entirely flexible, in the sense that the diversification formula can be altered to replicate the default risk in any DB plan. In a manner similar to a DB plan, a DSB plan can also incorporate an incentive for workers to join the company and retire at relatively early ages. Moreover, a DSB plan has some distinct advantages over a DB plan. First, default losses in DB plans depend importantly on the nominal interest rate, a variable that is outside the company's control. DSB plan losses depend solely on the company's financial performance. Second, workers may discount the value of DB plans because the company can unilaterally terminate the plan, which exposes them to contract risk (the possibility that the company managers will terminate the pension even if the company is financially healthy). DSB plans have no contract risk. Workers incur losses strictly in proportion to those incurred by all equity investors in the company. Third, the DSB plan does not entail an all-or-nothing termination event. If the company experiences financial difficulties, under the DSB contract, workers incur losses only in proportion to changes in the price of the company's stock, which is zero only in the event of bankruptcy.The DSB plan lets workers share in the upside performance of the company over much of their careers without tying them to a contract that exposes all their pension retirement savings to the performance of a single stock late in their careers. Once they attain some diversification vesting date, workers can begin to lock in some of the gains they have enjoyed by owning company stock.In addition, the diversification allowed in the DSB plan could be permissible, not mandatory. Thus, workers would not have to diversify up to the maximum allowed by the plan; they could retain the exposure that optimizes the value of the DSB plan within the context of their overall portfolios.Alternatively, companies could mandate diversification. The company might decide that large losses incurred by some future older workers could impose a kind of externality on the company in the form of adverse publicity. Another reason is that if the company's financial performance deteriorates (but short of bankruptcy) and if older workers remain undiversified, their pensions will fall in value, making them less likely to retire at the very time the company needs to shed workers.In summary, in an environment in which workers may be rethinking their exposure to their company's financial performance, the value that they attach to the pension plan could importantly depend on the diversification features of the plan. In this sense, the DSB plan provides an ideal hybrid between a classic stock-bonus plan and traditional DB format.
Journal: Financial Analysts Journal
Pages: 31-40
Issue: 6
Volume: 58
Year: 2002
Month: 11
X-DOI: 10.2469/faj.v58.n6.2484
File-URL: http://hdl.handle.net/10.2469/faj.v58.n6.2484
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Author-Name: Manuel Ammann
Author-X-Name-First: Manuel
Author-X-Name-Last: Ammann
Author-Name: Silvan Herriger
Author-X-Name-First: Silvan
Author-X-Name-Last: Herriger
Title: Relative Implied-Volatility Arbitrage with Index Options
Abstract: 
 In the study reported here, we investigated the efficiency of markets as to the relative pricing of similar risk by using implied volatilities of options on highly correlated indexes and a statistical arbitrage strategy to profit from potential mispricings. We first analyzed the interrelationships over time of the three most highly correlated and liquid pairs of U.S. stock indexes. Based on this analysis, we derived a relative relationship between implied volatilities for each pair. If this relationship was violated (i.e., if we detected a relative implied-volatility deviation), we suspected a relative mispricing. We used a simple no-arbitrage barrier to identify significant deviations and implemented a statistical arbitrage trade each time such a deviation was recorded. We found that, although many deviations can be observed, only some of them are large enough to be exploited profitably in the presence of bid–ask spreads and transaction costs. The question of market efficiency is of great interest to practitioners and academics. For derivatives markets, many tests of market efficiency have examined arbitrage relationships; none, however, has attempted to test the efficiency of options markets regarding relative implied volatilities of highly correlated underlying assets—or, in other words, the relative pricing of similar risk. This aspect of option market efficiency cannot be tested in a conventional way through the use of exact arbitrage relationships. Rather, a statistical arbitrage rule has to be applied. In the study reported here, we followed this approach to investigate the relative pricing of U.S. stock index options.First, from end-of-month March 1995–December 1999 data, we ranked all pairs of U.S. stock indexes for which exchange-listed options are available. Of 11 indexes, we found that the S&P 500 Index (SPX), S&P 100 Index (OEX), and NYSE Composite Index (NYA) exhibited the highest correlations and the best liquidity. We thus selected these three for the analysis.Second, we analyzed the interrelationship over time of the SPX–OEX, SPX–NYA, and OEX–NYA pairs by using rolling ordinary least-squares regressions of index returns and a robust minimum–maximum approach to determine high and low boundaries for regression coefficients. Based on this analysis, we show that relative implied-volatility relationships can be derived for options with matching maturities. That is, given an observed implied volatility, we obtained low and high boundaries for the implied volatility of the option on the other index. If such a relationship was violated (i.e., if relative implied volatility of the one option was higher than the high boundary or lower than the low boundary of the other option), we considered that we had observed a deviation and we suspected relative mispricing.We measured implied volatility deviations from 3 January 1995 through 10 February 2000 and found that, although many deviations were observable, only a few of them were large enough to be used profitably in the presence of bid–ask spreads and transaction costs. Therefore, to test an arbitrage trading strategy, we used an additional margin as a no-arbitrage barrier to account for spreads and trading costs. The deviations that remained after we imposed this barrier we considered significant enough to allow the implementation of a potentially profitable statistical arbitrage trade.We implemented a statistical arbitrage trade for the period January 1995 through February 2000 every time such a deviation was newly recorded. Such situations occurred on 10 days for the SPX–OEX pair, on 37 days for the SPX–NYA pair, and on 28 days for the OEX–NYA pair. The average holding time before relative volatilities were back within the no-arbitrage boundaries and the position was closed out was 2.9 days for the SPX–OEX pair, 9.6 days for the SPX–NYA pair, and 3.6 days for the OEX–NYA pair.On average, the trades were profitable for all index pairs after deduction of transaction costs. One losing trade occurred for the SPX–OEX pair, and six losing trades occurred for each of the other pairs. For all pairs, the average profit was larger than the average loss. With respect to profitability, however, because we used daily closing prices and assumed that trading would be possible at the signal price, not the tick following the signal price, we could not conclude with certainty that such a trading strategy would have generated exactly the same results in practice.Overall, although the arbitrage strategy was profitable, we found too few potential arbitrage transactions to conclude that option markets are inefficient.
Journal: Financial Analysts Journal
Pages: 42-55
Issue: 6
Volume: 58
Year: 2002
Month: 11
X-DOI: 10.2469/faj.v58.n6.2485
File-URL: http://hdl.handle.net/10.2469/faj.v58.n6.2485
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Author-Name: Cyrus A. Ramezani
Author-X-Name-First: Cyrus A.
Author-X-Name-Last: Ramezani
Author-Name: Luc Soenen
Author-X-Name-First: Luc
Author-X-Name-Last: Soenen
Author-Name: Alan Jung
Author-X-Name-First: Alan
Author-X-Name-Last: Jung
Title: Growth, Corporate Profitability, and Value Creation
Abstract: 
 Associating corporate performance and shareholder value creation with growth in earnings (or sales) has been the modus operandi in the investment industry. It has greatly influenced managerial compensation schemes and portfolio decisions. We shed light on the relationship between growth and performance by addressing two broad questions. First, what is the relationship between corporate profitability metrics, such as economic value added, and the company's earnings or sales growth rate? Second, does maximizing corporate profitability necessarily enhance shareholder value (as measured by Jensen's alpha)? Using multivariate analysis, we show that, although the corporate profitability measures generally rise with earnings and sales growth, an optimal point exists beyond which further growth destroys shareholder value and adversely affects profitability. Associating corporate performance and shareholder value creation with growth in earnings or sales has been the modus operandi of the investment industry. It has greatly influenced managerial compensation schemes and portfolio decisions. Yet, the financial press is replete with examples of once rapidly growing companies that have “gone south” (Enron Corporation is only one recent example). Indeed, growth without profitability cannot be sustained.We shed light on the relationship between growth and performance by addressing two broad questions. First, what is the relationship between corporate profitability metrics, such as economic value added (EVA) or return on investment, and the company's earnings (sales) growth rate? Second, does maximizing corporate profitability necessarily enhance shareholder value (as measured by Jensen's alpha)?First, to investigate the link between growth and performance, we examined the unconditional distribution of several performance metrics across quartiles of sales growth and earnings growth rates. We used annual Compustat files on U.S. companies for the period 1990 through 2000. Next, with a common set of data as conditioning variables, we estimated a multivariate regression model for each growth measure. We then explored how management's use of EVA, for compensation and resource allocation, relates to shareholder value creation. For this analysis, we estimated a regression model augmented to control for growth, company size, and idiosyncratic risk.Our analysis shows that, although these measures of corporate profitability and shareholder value generally rise with earnings and sales growth, an optimal point exists beyond which further growth destroys shareholder value and adversely affects profitability. Moreover, companies with moderate growth in earnings (sales) exhibit the highest rates of return and value creation for their owners.Our empirical results indicate that corporate managers need to abandon the habit of blindly increasing company size and investment managers need to carefully consider the drawbacks of diseconomies of scale. Company managers need to make a fundamental shift in their strategic orientation from “growth now, profitability later” to “profitable growth now.” That is, growth should not be the input to strategic planning but the outcome of a sound investment strategy that is geared to accepting value-creating projects. Investors and portfolio managers should be aware of the dangers of conforming to market pressures for growth for growth's sake.
Journal: Financial Analysts Journal
Pages: 56-67
Issue: 6
Volume: 58
Year: 2002
Month: 11
X-DOI: 10.2469/faj.v58.n6.2486
File-URL: http://hdl.handle.net/10.2469/faj.v58.n6.2486
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# input file: UFAJ_A_12047373_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Title: The Levered P/E Ratio
Abstract: 
 A vast literature examines the role of debt in corporate valuation, but most of these works proceed from the vantage point of corporate finance (i.e., ascertaining the effects of adding debt to a previously unlevered company). The investment analyst, however, confronts an already-levered company with already-levered return parameters. The analyst's challenge is to estimate the stock's theoretical value by inferring the company's underlying structure of returns. This shift in vantage point leads to results about the effect of leverage that are surprisingly different from the results of studies from the corporate finance angle. Whereas corporate finance studies find only a moderate effect of leverage, when viewed from the analyst's perspective, a company's value has such a high degree of sensitivity to the leverage ratio that it can significantly alter the theoretical P/E valuation. Moreover, from the analyst's vantage point, leverage always moves the P/E toward a lower value than that obtained from the standard formula. Since the original Modigliani–Miller study in the 1950s, a vast literature has accumulated on the role of debt in corporate valuation. Many of the studies focus on incorporating the effects of taxes, bankruptcy costs, credit spreads, and inflation in the basic M&M framework. Virtually all of the academic works proceed from the vantage point of corporate finance by ascertaining how various debt levels affect a company's value—that is, the effects of adding debt to a previously unlevered company. To an investment analyst, however, the company (in medical terminology) “presents” itself as already having certain observable growth characteristics, with the required funding supplied by a combination of equity and debt. That is, the issue is an already-levered company with already-levered return parameters. The analyst's challenge is to estimate the stock's theoretical value by inferring the company's underlying structure of returns.This fundamental shift in vantage point leads to surprisingly different results. The corporate finance studies reveal that increasing debt loads leads to only moderate valuation shifts and that such shifts can be, depending on the circumstances, either upward or downward. In contrast, when the focus is on the parameters the company presents to the marketplace, sensitivity to the leverage ratio is so high that leverage can significantly alter the company's theoretical P/E valuation. Moreover, from this vantage point, the P/E is always lower than the value obtained by use of the standard Gordon growth formula.This sensitivity can be illustrated by considering three companies, each of which retains 40 percent of earnings and is achieving 8 percent growth. The only difference among them is that the first company is debt free, the second has a debt ratio of 40 percent, and the third has a debt ratio of 50 percent. Suppose that the market discount rate for the unlevered company is 10 percent and the interest rate is 6 percent. Using the basic Gordon model with these assumed values, one finds that the theoretical P/E for the debt-free company is 30; the 40 percent debt load of the second company drives its theoretical P/E down to 23; and the third company, with the slightly higher 50 percent debt ratio, finds its theoretical P/E cut to 20. The comparison between the second and third companies may be a more realistic gauge of the effect of varying debt levels within a given market sector than a comparison between a debt-free company and a leveraged company.In practice, many other considerations, such as taxes, act as confounding factors on these effects. Nevertheless, the widespread and increasing role of debt in corporate life suggests that leverage factors should play a larger role in the analytical process. This concern is particularly relevant today because once the debt ratio rises beyond the 50 percent level—which has become quite common in today's financial marketplace—the incremental impact of additional debt grows at a rapidly accelerating pace.
Journal: Financial Analysts Journal
Pages: 68-77
Issue: 6
Volume: 58
Year: 2002
Month: 11
X-DOI: 10.2469/faj.v58.n6.2487
File-URL: http://hdl.handle.net/10.2469/faj.v58.n6.2487
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Handle: RePEc:taf:ufajxx:v:58:y:2002:i:6:p:68-77




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Author-Name: Stefano Cavaglia
Author-X-Name-First: Stefano
Author-X-Name-Last: Cavaglia
Author-Name: Vadim Moroz
Author-X-Name-First: Vadim
Author-X-Name-Last: Moroz
Title: Cross-Industry, Cross-Country Allocation
Abstract: 
 Recent empirical evidence has demonstrated that both global industry factors and country factors are important determinants of equity prices. In light of this evidence, we describe a cross-industry, cross-country allocation framework for making active global equity investment decisions. We present a forecasting approach to predicting the relative performance of industries in each of 22 developed country equity markets and demonstrate that a blend of style signals provides an effective way to predict the return performance of these assets. The out-of-sample portfolio performance of investment strategies based on these forecasts for the 1991–2001 period would have provided annual gross returns in excess of the world benchmark return of 400 bps a year with one-way turnover of 50 percent. Conventional global risk models cannot explain this outperformance. Thus, explaining this “anomaly” is a challenge for the investment and academic communities. The increasing globalization of business presents new challenges and new opportunities for asset managers. Traditionally, active international equity allocations were made in a two-step process that overlaid security selection within countries on top-down country selection. The effectiveness of this paradigm has been lessened, however, by the market recognizing that companies operate and compete on a global basis and pricing securities accordingly. Today, the risk–reward trade-offs of country factors and global industry factors need to be balanced in constructing global equity portfolios. In this article, we suggest that a cross-industry, cross-country allocation (CICCA) matrix provides the means to simultaneously account for industry and country factors in active equity allocation decisions. In this approach, managers make allocations among a grid of industries and countries.The CICCA approach is designed to balance the risk–reward trade-offs of investing in “local” industries (e.g., Italian media stocks); thus, it recognizes the interaction of country and industry factors in determining security prices. CICCA provides asset managers with an operational “middle ground” between traditional top-down equity allocation and pure bottom-up stock selection. In this framework, country allocations and global industry allocations result from local industry selection. Similarly, global style tilts result from local style tilts. The result is an alternative to emphasizing “global value” or “global growth” as the overriding top-down decision. The risks of the CICCA tilts can be monitored at the aggregate level and can be altered via local industry allocations. To obtain final security holdings, the manager can overlay security selection decisions on the local industry selection. Stock selection may thus override or reinforce CICCA decisions.CICCA can be used to construct local industry allocations aimed at outperforming global benchmarks. We present a forecasting framework to predict the relative performance of local industries in the global investment universe. A blend of style signals that includes measures of profitability, value, and price momentum provides an effective means of predicting asset price performance. The out-of-sample performance of risk-controlled investment strategies that used these forecasts over the 1990–2001 period suggests that CICCA could have been used to outperform global equity benchmarks by as much as 400 bps a year.We also examine alternative models—one that emphasizes country factors as the principal determinants of the relative attractiveness of a local industry and one that emphasizes global industry factors as the principal determinants. The predictions based on the relative attractiveness of securities within and across global industries dominate those based on the relative attractiveness of securities within and across countries. Our strategy backtests suggest that an industry-relative CICCA strategy could have been used to outperform the world index by 490 bps a year in the period studied.In addition, we studied the historical performance of CICCA strategies on a risk-adjusted basis. We used a four-factor model that included value, size, and momentum risks in addition to the market risk. Even after accounting for the risks of style tilts, CICCA strategies delivered an economically and statistically significant outperformance of market returns.The “anomaly” we document could be explained by a variety of factors. Possibly, because of home-biased investment decisions, large mispricings exist in the global investment universe that can be exploited by a fully integrated global investment approach. Alternatively, the CICCA approach may actually be carrying out style rotations within and across industries and thus providing returns that reflect risks that are not captured by conventional risk models or conventional definitions of style factors. This possibility suggests that analysis of risk factors in the new global equity landscape needs to be extended.
Journal: Financial Analysts Journal
Pages: 78-97
Issue: 6
Volume: 58
Year: 2002
Month: 11
X-DOI: 10.2469/faj.v58.n6.2488
File-URL: http://hdl.handle.net/10.2469/faj.v58.n6.2488
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Author-Name: Bernd Scherer
Author-X-Name-First: Bernd
Author-X-Name-Last: Scherer
Title: Portfolio Resampling: Review and Critique
Abstract: 
 A well-understood fact of asset allocation is that the traditional portfolio
                    optimization algorithm is too powerful for the quality of the inputs. Recently,
                    a new concept called “resampled efficiency” has been introduced into
                    the asset management world to deal with estimation error. The objective of this
                    article is to describe this new technology, put it into the context of
                    established procedures, and point to some peculiarities of the approach. Even
                    though portfolio resampling is a thoughtful heuristic, some features make it
                    difficult to interpret by the inexperienced. 
                    "Portfolio Resampling: Review and Critique": A
                        Comment
                A long-established problem of portfolio optimization is that it suffers from
                    error maximization. The acceptability of quantitative methods in portfolio
                    construction has suffered from this fact; eventually, these methods gave rise to
                    risk budgeting to enforce diversification. At the heart of the problem lies the
                    portfolio optimization algorithm, which is too powerful for the quality of the
                    inputs. Because portfolio construction calls for decisions between marginal
                    risks and returns of competing assets and because the inputs are measured with
                    error, the efficient allocation of risk among investment opportunities requires
                    a practical solution to the problem of estimation error.Recently, a method known as resampled efficiency has found increasing interest
                    among practitioners as a way to deal with this important problem. In this
                    article, I review the concept of portfolio resampling and resampled efficiency.
                    One of the beauties of portfolio resampling is that it allows the user to
                    visualize the impact of estimation errors on optimized portfolio weights, which
                    otherwise would be virtually impossible because of the complex interactions
                    among assets. Because resampling provides the distribution of portfolio weights,
                    it can be used to test whether the inclusion of assets is statistically
                    significant or whether additional information is sufficient to justify portfolio
                    rebalancing (i.e., whether two portfolios are statistically different).
                    Resampled efficiency allows the construction of efficient frontiers (geometric
                    location of future investment opportunities) based on efficient sets that in
                    most circumstances would be regarded as more diversified than traditional
                    mean–variance-optimized portfolios. Changes in inputs or return
                    requirements trigger only small changes in suggested allocations, so the
                    algorithm compares favorably in the eyes of most practitioners with traditional
                    mean–variance-based portfolio construction.As I review the portfolio-resampling method, however, I inevitably detect some
                    weak spots. Although the lack of a decision theoretic foundation for the method
                    might not be perceived as troublesome by many practitioners, other features are
                    troubling in practice and deserve careful attention. First, the concept of
                    resampled efficiency may force highly volatile and otherwise dominated assets
                    into the solution. Samples from a highly volatile asset sometimes also exhibit
                    very attractive mean returns, making that asset dominate all other assets at the
                    aggressive end of the efficient frontier. Equally likely
                        negative mean returns, however, will not yield large
                    negative weights because the long-only constraint (which is so typical of
                    institutional investors) does not allow negative allocations. The higher the
                    volatility of the asset, the more pronounced this effect. Aggressive allocations
                    derived via resampling should thus be treated with care.In addition, one of the basic properties of efficient-portfolio mathematics is
                    that the efficient frontier does not contain upward-bending parts. Such a
                    phenomenon would imply that one can construct portfolios superior to the
                    frontier by linearly combining two neighboring frontier portfolios. Portfolio
                    resampling, however, does allow upward-bending parts.A final criticism results from the special importance portfolio resampling gives
                    to the original set of inputs. Because all resamplings are derived from the same
                    vector and covariance matrix and the true distribution is unknown, all the
                    resampled portfolios will suffer from deviation of the parameters from the true
                    distribution in much the same way. Hence, it is fair to say that all portfolios
                    inherit the same estimation error.Resampled efficiency is an interesting heuristic to deal with an important
                    problem—error maximization. We do not have a theoretical basis for why it
                    should be optimal, however, and it does have some characteristics that should
                    make practitioners cautious when using it.
Journal: Financial Analysts Journal
Pages: 98-109
Issue: 6
Volume: 58
Year: 2002
Month: 11
X-DOI: 10.2469/faj.v58.n6.2489
File-URL: http://hdl.handle.net/10.2469/faj.v58.n6.2489
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Alan Shrugged: Alan Greenspan, the World's Most Powerful Banker (a review)
Abstract: 
 Although rife with factual errors, this book offers interesting biographical tidbits about Federal Reserve Chairman Alan Greenspan. 
Journal: Financial Analysts Journal
Pages: 110-111
Issue: 6
Volume: 58
Year: 2002
Month: 11
X-DOI: 10.2469/faj.v58.n6.2490
File-URL: http://hdl.handle.net/10.2469/faj.v58.n6.2490
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Author-Name: Jeffrey S. Molitor
Author-X-Name-First: Jeffrey S.
Author-X-Name-Last: Molitor
Title: To the AIMR Board of Governors
Abstract: 
 This material comments on “To the AIMR Board of Governors”.
Journal: Financial Analysts Journal
Pages: 17-17
Issue: 6
Volume: 58
Year: 2002
Month: 11
X-DOI: 10.2469/faj.v58.n6.2491
File-URL: http://hdl.handle.net/10.2469/faj.v58.n6.2491
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Dividends and Dividend Taxation
Abstract: 
 Rather than making dividend distributions tax free, why not simply allow companies to deduct dividends as they do bond coupon payments? 
Journal: Financial Analysts Journal
Pages: 4-4
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2495
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2495
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Author-Name: Jacob Boudoukh
Author-X-Name-First: Jacob
Author-X-Name-Last: Boudoukh
Author-Name: Marti Subrahmanyam
Author-X-Name-First: Marti
Author-X-Name-Last: Subrahmanyam
Author-Name: Matthew Richardson
Author-X-Name-First: Matthew
Author-X-Name-Last: Richardson
Author-Name: Robert Whitelaw
Author-X-Name-First: Robert
Author-X-Name-Last: Whitelaw
Title: “Stale Prices and Strategies for Trading Mutual Funds”: Authors' Response
Abstract: 
 This material comments on “Stale Prices and Strategies for Trading Mutual Funds”.
Journal: Financial Analysts Journal
Pages: 15-15
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2496
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2496
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Author-Name: Richard O. Michaud
Author-X-Name-First: Richard O.
Author-X-Name-Last: Michaud
Title: “An Examination of Resampled Portfolio Efficiency”: A Comment
Abstract: 
 This material comments on “An Examination of Resampled Portfolio Efficiency”.
Journal: Financial Analysts Journal
Pages: 15-16
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2497
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Author-Name: Jonathan Fletcher
Author-X-Name-First: Jonathan
Author-X-Name-Last: Fletcher
Author-Name: Joe Hillier
Author-X-Name-First: Joe
Author-X-Name-Last: Hillier
Title: “An Examination of Resampled Portfolio Efficiency”: Authors' Response
Abstract: 
 This material comments on “An Examination of Resampled Portfolio Efficiency”.
Journal: Financial Analysts Journal
Pages: 16-16
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2498
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Author-Name: Robert C. Merton
Author-X-Name-First: Robert C.
Author-X-Name-Last: Merton
Title: Thoughts on the Future: Theory and Practice in Investment Management
Abstract: 
 Existing finance theory can be put into practice in ways that will greatly benefit clients—from individuals to pension funds to endowments. Existing finance theory can be put into investment management practice in ways that will greatly benefit clients—from individuals to endowments. Our profession has developed the tools, but too often, advisors rely on static one-period analyses when considering how best to handle the returns and risks of clients. These decisions are inextricably connected to horizons—the long run, the decision horizon, the planning horizon, and the planning subhorizons. These horizons vary for different client groups, as does the production of wealth and risk to wealth. Moreover, the trends, needs, and situations of client groups vary. My discussion focuses on households, then turns briefly to pension funds and to endowments.In the realm of households, one of the biggest trends of the past 20–25 years is that householders are being called upon to make complex and important financial decisions. The profession has developed models and made them available through advisory engines on the Internet and in books and pamphlets. But this disaggregated approach to saving and retirement planning simply hands out all the parts of the task to householders. They must make all the decisions and assemble the product parts.The time has come to extend the models by trying to capture the myriad of risk dimensions in a real-world lifetime financial plan. Analysis of risk must take into account human capital, the volatility and flexibility of human capital at various ages, and its correlation with other assets. In addition, our risk models for individuals and households should incorporate uncertainty about future reinvestment rates and uncertainty about the risk–reward opportunities captured by, for example, the Sharpe ratio. Different measures are needed for the risk to household wealth in the long run and in the short run. Instead of using dollars to measure the risk–reward frontier, an advisor would do well to use annuity units.Another element advisors should include as part of an integrated plan for households is the notion of targeted expenditures—such as college tuition. The financing of such expenditures can be taken off the table, and indeed, financial services firms can finance the amounts. A similar approach can be taken with core retirement funds (life annuities).In the future, I see investment services for households developing in the direction of services to deal with lifetime household risks, hedging and insurance for financial assets, and the offering of comparatively seamless products to implement those plans. Examples of services include integrated financial planning for retirement (such as wedding long-term care and life annuities), providing condo value insurance, and offering customized or special-purpose vehicles or derivatives that provide the payoff equivalent of a dynamic trading strategy without the household doing the actual trading.Those providing these services must consider a much wider set of asset classes and risks than are considered in today's analyses. To the traditional analysis of risk–return trade-offs for tangible wealth, we need to add explicit analyses of human capital, hedging of reinvestment rates, mortality and traditional insurance risk, and income and estate taxes.For the dwindling group of pension plans, if the pension fund sponsor chooses to keep the pension fund and its associated liabilities on its balance sheet, the sponsoring company absolutely must look at the risks chosen for the pension fund from the perspective of the whole company. Risk management should involve all parts of the company—operations, hedging of targeted risk exposures, and capital structure.Endowment funds, particularly those supporting universities, also need to consider all their asset and liability risks. Assets include both tangible ones, such as buildings, and intangible ones, such as future tuition receipts. On the liability side of universities, some aspects that are important for surplus management in pension plans apply to endowments. The endowment needs to consider the cost of operations and other liabilities of the university when considering what risks to take. For example, a substantial liability for many universities is salaries for tenured faculty.Investment managers and advisors have a much richer set of tools than they traditionally use. Thus, the issue in implementing my suggestions is more a question of engineering than new science. We know how to approach the problem in principle; the challenge is actually doing the modeling.
Journal: Financial Analysts Journal
Pages: 17-23
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2499
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2499
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Author-Name: Zvi Bodie
Author-X-Name-First: Zvi
Author-X-Name-Last: Bodie
Title: Thoughts on the Future: Life-Cycle Investing in Theory and Practice
Abstract: 
 Advances in financial science have made possible an improved menu of life-cycle investment products. Global population aging and deregulation have created opportunities for innovative investment firms to create new products and services that address the needs of people saving for retirement and other life-cycle goals. It will be a challenge to frame risk–reward trade-offs and cast financial decision making in a format that ordinary people can understand and implement. Fortunately, advances in financial science have made possible a new generation of user-friendly investment products.Among the important insights of modern financial science are the following:A person's welfare depends not only on her end-of-period wealth but also on the consumption of goods and leisure over her entire lifetime.Multiperiod hedging (rather than “time diversification”) is the way to manage market risk over time.Portfolio managers can and should make greater use of the information about interest rates and implied volatilities embedded in the prices of derivatives, such as swaps and options.The value, riskiness, and flexibility of a person's labor earnings are of first-order importance in optimal portfolio selection at each stage of the life cycle.Habit formation can give rise to a demand for guarantees against a decline in investment income.Because of transaction costs, agency problems, and limited knowledge on the part of consumers, dynamic asset allocation will and should become an activity performed by financial intermediaries, rather than by their retail customers.The tendency in the last several years has been to offer participants in self-directed retirement plans more and more investment alternatives. But when people do not have the knowledge to make choices in their own best interests, increasing the number of alternative investments does not necessarily make them better off. In fact, it may make them more vulnerable to exploitation by opportunistic salespeople or by well-intentioned but unqualified professionals.The modern theory of contingent-claims analysis provides the framework for the production and pricing of new and improved life-cycle contracts that combine features of insurance and investment. For example, consider an escalating life annuity with a minimum benefit linked to the cost of living. Payments would increase with inflation and with the performance of a market index, and increases would be locked in for life. It could be dynamically hedged and priced by using default-free inflation-protected bonds and index futures or options. This product would be very different from a mutual-funds-based variable annuity contract, which passes the investment risks directly through to the consumer.Longer life expectancies have coincided with increased health care costs near the end of peoples' lives, which raises the specter that many elderly people may need several years of expensive long-term care. A “bundled” insurance/investment contract could help to deal with this problem by combining an escalating life annuity with long-term care insurance. Combining the coverage would mitigate the adverse selection that can occur in the demand for each of the two products on a stand-alone basis.
Journal: Financial Analysts Journal
Pages: 24-29
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2500
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2500
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Author-Name: Stephen Kealhofer
Author-X-Name-First: Stephen
Author-X-Name-Last: Kealhofer
Title: Quantifying Credit Risk I: Default Prediction
Abstract: 
 Until the 1990s, corporate credit analysis was viewed as an art rather than a science because analysts lacked a way to adequately quantify absolute levels of default risk. In the past decade, however, a revolution in credit-risk measurement has taken place. The evidence from this research presents a compelling case that the conceptual approach pioneered by Fischer Black, Robert Merton, and Myron Scholes provides a powerful practical basis for measuring credit risk. “Quantifying Credit Risk II: Debt Valuation” shows that their approach provides superior explanations of secondary-market debt prices. Until the 1990s, corporate credit analysis was viewed as an art rather than a science because of analysts' inability to adequately quantify absolute levels of default risk. More than 30 years ago, however, Fischer Black and Myron Scholes proposed that one could view the equity of a company as a call option. As subsequently elaborated by John Cox, Robert Merton, and others, this approach has come to be called “the Merton model.” In the 1990s, an empirical implementation of this approach developed by Oldrich Vasicek and the author (the KMV model) has enjoyed considerable success with practitioners. This article, the first of a two-part series, focuses on empirical tests of this approach for predicting default.The article begins with a description of how the KMV model differs from the canonical Merton model in the academic literature. The main distinctions of the KMV model are its focus on the probability of default of the company as a whole, rather than valuation of the debt, and its use of an empirically determined default frequency distribution. It retains the main virtues of the Merton approach, however, in that it is a cause-and-effect model of default that transforms equity market prices into information on the credit quality of companies.The article then turns to a description of the tests of the power of the KMV model versus agency debt ratings. Two kinds of tests and their results are described. First, power curve analysis shows that the outputs of the KMV model (“EDFs” or expected default frequencies) consistently outperform agency debt ratings in correctly predicting default—for any level of incorrect predictions.Power curve analysis does not rule out, however, that in some cases, the agency debt ratings may do a better job of predicting default than the KMV analysis. Therefore, a second test, called “intracohort analysis,” is performed to evaluate the marginal information content of ratings relative to the KMV approach and vice versa. The intracohort analysis reveals that there is essentially no information in ratings that is not already captured in the EDFs but considerable information in EDFs that is not captured in ratings. “Noise” in equity prices does not cause overprediction of default risk.The theoretical approach of statistical methods of default prediction as it relates to the performance of the KMV model is also discussed. Because correlation does not equal causation, statistical methods should be expected to add little power to the default–prediction power of the KMV model.The findings discussed suggest that the Black–Scholes–Merton approach, appropriately executed, provides the long-sought quantification of credit risk. As an objective, cause-and-effect model, this approach also gives analytical insights into corporate behavior, thus creating the basis for a continuing rich research program into default risk. For instance, the link between default probability and equity values provides an understanding of the correlations within corporate debt portfolios as well as correlations between equity and corporate debt portfolios. Part II of “Quantifying Credit Risk” will examine application of the model to the valuation of corporate debt.
Journal: Financial Analysts Journal
Pages: 30-44
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2501
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2501
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Author-Name: Eurico J. Ferreira
Author-X-Name-First: Eurico J.
Author-X-Name-Last: Ferreira
Author-Name: Stanley D. Smith
Author-X-Name-First: Stanley D.
Author-X-Name-Last: Smith
Title: “Wall $treet Week”: Information or Entertainment?
Abstract: 
 The purpose of the study we report was to determine the information content of the recommendations made by panelists during 1997 on “Wall $treet Week with Louis Rukeyser.” Using event-study methodology for the short term, we found a statistically significant positive abnormal return of 0.65 percent for the recommendations on the first trading day after the show on Friday. To determine the abnormal long-term (one- and two-year) average holding-period returns, we used two matching processes. Using industry and size matching, we found not only that the portfolio of recommended stocks improved in value during the following eight quarters but that its increase in value was higher than for the matched sample in all eight quarters and statistically significantly higher in half of the eight quarters. Using industry, size, and book-to-market matching, we found similar results. Overall, this study's results suggest that the panelist recommendations have significant information content. The purpose of the study reported in this article was to determine the information content of the recommendations made by panelists on “Wall $treet Week with Louis Rukeyser” (WSW) during 1997. Could investors have profited by using the recommendations on the show? If they could not, then the show might be viewed as primarily—or solely—entertainment, not informative in the sense of allowing investors to achieve positive excess returns.In the past, three articles have focused on the performance of the analysts on WSW. Generally, these studies found an information effect on the first trading day after the show. We found similar results for the first trading day after the show. When the same three studies examined the results for longer periods, the results were mixed.We extended these studies by using a more recent sample, examining a longer performance time frame (i.e., quarterly results up to two years), and using a more appropriate methodology. The earlier studies used cumulative abnormal returns based on event studies in which a market model, such as an equally weighted index, was used as a benchmark. We used a different methodology because previous research has documented that cumulative abnormal returns are biased predictors of buy-and-hold abnormal returns and that significant biases arise in t-statistics when long-run abnormal returns are calculated with the use of a reference market index. The methodology found to be effective in long-run event studies, and the methodology we used, is to match sample companies to control companies of similar size and similar ratios of book value to market value. This approach yields well-specified t-statistics in virtually all sampling situations that have been considered.To examine the long-term value of the recommendations, we followed two matching processes. We set out to determine the average holding-period abnormal returns each quarter up to eight quarters. The results of the method when we matched by industry and size indicate that the portfolio of stocks recommended by WSW panelists not only improved in value during the eight quarters after the announcement but that the increase in value was higher than the matched sample in all eight quarters and statistically significantly higher in four quarters. We found similar results when we used the method of industry, size, and book-to-market (ISBM) matching. Generally, the average holding-period abnormal returns after the first day of trading after the show were about 9 percent for one year and about 16 percent for two years.We also analyzed the value of individual panelists' recommendations by using both matching methods. When we used the ISBM method, we found that 5 of the 41 special guest panelists on the show in 1997 made positive recommendations that produced two-year postrecommendation abnormal holding-period returns of more than 100 percent.These results suggest that the recommendations made on the show for the sample period were more than entertainment and had significant information content. Moreover, although we did not specifically investigate the issue of potential bias in analysts' recommendations created by conflicts of interest, these results indicate that the analysts' recommendations in our sample were followed by strong long-run positive price reactions and would have had value for those who followed them.
Journal: Financial Analysts Journal
Pages: 45-53
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2502
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2502
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Author-Name: Rajnish Mehra
Author-X-Name-First: Rajnish
Author-X-Name-Last: Mehra
Title: The Equity Premium: Why Is It a Puzzle? (corrected)
Abstract: 
 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. This article provides a critical review of the literature on the equity premium puzzle. As originally articulated more than 15 years ago, this puzzle, underscored the inability of the standard paradigm of economics and finance to explain the magnitude of the risk premium—the return earned by a risky asset in excess of the return to a relatively riskless asset.I summarize the historical experience of the United States and other industrialized countries and detail the intuition behind the discrepancy between model prediction and empirical data. The discussion addresses various research approaches that have been proposed to enhance the model's realism. One set of solutions to the equity premium puzzle advises that researchers consider alternative preference structures to the classic structure. Within this set, some researchers have called for modifying the conventional time-and-state-separable utility function, and a second group approaches the problem by adding the concept of habit formation. Yet other approaches link the puzzle to the presence of idiosyncratic and uninsurable income risk that investors face or to investors' perceiving a small probability of disaster. Another attempt to resolve the puzzle posits that the realized returns reflect the premium in the United States on a stock market that has successfully weathered the vicissitudes of fluctuating financial fortunes. Some models incorporate borrowing constraints on young people, who would be the most likely to accept risky assets at less of a premium than is observed; other models view the premium as a transaction-facilitating service “fee.” Finally, a group of models relates the premium to changes in tax rates.While reviewing these major directions in theoretical financial research, I point out the ways in which the majority of the proposed resolutions fail along crucial dimensions. I also note that how one views the equity premium depends on whether one is talking about the observed, realized premium (which has remained fairly consistent over long horizons) or the expected short-term premium (which can vary considerably).
Journal: Financial Analysts Journal
Pages: 54-69
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2503
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2503
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Author-Name: Clifford S. Asness
Author-X-Name-First: Clifford S.
Author-X-Name-Last: Asness
Title: Surprise! Higher Dividends = Higher Earnings Growth
Abstract: 
 We investigate whether dividend policy, as observed in the payout ratio of the U.S. equity market portfolio, forecasts future aggregate earnings growth. The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low. This relationship is not subsumed by other factors, such as simple mean reversion in earnings. Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is consistent with anecdotal tales about managers signaling their earnings expectations through dividends or engaging, at times, in inefficient empire building. Our findings offer a challenge to market observers who see the low dividend payouts of recent times as a sign of strong future earnings to come. Since 1995, and until a very recent uptick caused by plunging earnings, marketwide dividend-payout ratios in the United States have been in the lowest historical decile, reaching unprecedented low levels from late-1999 to mid-2001. Alternatively stated, earnings-retention rates have recently been at or near all-time highs. Meanwhile, price-to-earnings ratios and price-to-dividend ratios have been very high by historical standards, even after the sharp fall in stock prices since early 2000. With recent valuation ratios at such high levels and dividend payouts so low, the only way that future long-term equity returns are likely to rival historical norms is if future earnings growth is considerably faster than normal. Some market observers, including some leading Wall Street strategists, do indeed forecast exceptional long-term growth; they point to the recent policy of low dividend-payout ratios, among other things, as a cause for optimism.Assuming dividend policy does not affect the expected return on the market portfolio, a low payout (dividends/earnings) must be offset either by a high earnings-to price-ratio (low P/E) or by high expected growth. We show that during the past 130 years, market P/Es have not offset variation in payout ratios; for instance, recent P/Es are very high, not low as they would have to be to offset today's low payout. Thus, the task of sustaining return is left to growth.Some interpret this forecasted marketwide inverse relationship of current dividend-payout policy to future growth as an intertemporal extension of the dividend irrelevance theorem. Implicit in this view is a world of perfect capital markets. For instance, the preceding reasoning assumes that (1) investment policy is unaltered by the amount of dividends paid, (2) information is equal and shared (meaning the dividend does not convey managers' private information), (3) tax treatment is the same for retained or distributed earnings, (4) corporate managers act in the best interests of the shareholders, and (5) markets are priced efficiently. When the assumption of perfection is relaxed, a host of behavioral or information-based hypotheses arise as potential explanations for how the market's payout ratio might relate to expected future earnings growth. Thus, in our study, we turn to the historical data to answer the question of how marketwide payout ratios relate to future earnings growth.We find that low payout ratios precede low earnings growth and high payout ratios precede high earnings growth. In other words, empirically, real life acts in precisely an opposite manner to what many would forecast. Rather than future growth rising to offset a low payout policy, future growth falls when more earnings are retained.This finding is consistent with, although other reasons may exist, a world in which managers have private information that they signal through dividend policy; that is, they pay out more when they know that future growth is bright and less when it is dim. The finding also fits a world where managers retain excess cash when they are engaging in inefficient empire building that will hurt future earnings growth. In other words, times of low payout/high retention may be times of wasteful profligacy, and times of high payout/low retention may be times of relative efficiency or frugality. Any explanation of this phenomenon must be considered conjecture, however, at this point.Applying our results to today's markets, we find little historical support for the contention that future earnings growth will be exceptionally high. Rather, historical evidence on the link between payout ratios and subsequent earnings growth bolsters the view that future earnings growth is likely to be below the long-term average. This outlook is certainly worrisome, particularly because valuation multiples remain well above historical norms.
Journal: Financial Analysts Journal
Pages: 70-87
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2504
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2504
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Author-Name: Roger G. Ibbotson
Author-X-Name-First: Roger G.
Author-X-Name-Last: Ibbotson
Author-Name: Peng Chen
Author-X-Name-First: Peng
Author-X-Name-Last: Chen
Title: Long-Run Stock Returns: Participating in the Real Economy
Abstract: 
 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. Until 2001, investors had not seen consecutive negative annual stock market returns since the 1970s. To the contrary, during the 1980s and 1990s, the market produced its best 20-year performance ever. But neither the past two years nor the past two decades are good predictors of the long run.We establish a new method for forecasting the future return of stocks over bonds by building on the relationship between the stock market, earnings, and the overall economy. We analyze historical equity returns by decomposing the 1926–2000 returns into supply factors commonly used to describe the aggregate equity market and overall economic productivity—inflation, earnings, dividends, the P/E, the dividend-payout ratio, book value, return on equity, and GDP per capita. We examine each factor and its relationship to the long-term supply-side framework.We discuss several key findings. First, the growth in corporate productivity, as 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 (1.25 percentage points of the total 10.70 percent). The bulk of the return is attributable to dividend payments and growth in nominal earnings (including inflation and real earnings growth). Third, the increase in share of equity relative to the overall economy 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.We used historical information in the supply-side models to forecast the equity risk premium. Contrary to several recent studies on the premium that declared the forward-looking equity risk premium to be close to zero or negative, we found the long-term supply of the equity risk premium to be only slightly lower than the straight historical estimate. We estimated the expected premium to be 3.97 percentage points in geometric terms and 5.90 percentage points on an arithmetic basis. This estimate is about 1.25 percentage points lower than the straight historical estimate.The differences between our estimates and those provided in several other recent studies arise principally from the inappropriate assumptions those authors used, assumptions that violate the Miller and Modigliani theorem. Also, our models interpret the current high market P/E as the market forecasting high future growth, rather than a low discount rate or overvaluation. Our estimate is in line with both the historical supply measures of public corporations (i.e., earnings) and overall economic productivity (GDP per capita).Our estimate of the equity risk premium is far closer to the historical premium than it is to zero or a negative number. The implication is that stocks are expected to outperform bonds over the long run. For long-term investors, such as pension funds and individuals saving for retirement, stocks should continue to be a favored asset class in a diversified portfolio. Because our estimate of the equity risk premium is lower than historical performance of the premium, however, some investors should lower their equity allocations and/or increase their savings rate to meet future liabilities.
Journal: Financial Analysts Journal
Pages: 88-98
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2505
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2505
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Author-Name: Sue Visscher
Author-X-Name-First: Sue
Author-X-Name-Last: Visscher
Author-Name: Greg Filbeck
Author-X-Name-First: Greg
Author-X-Name-Last: Filbeck
Title: Dividend-Yield Strategies in the Canadian Stock Market
Abstract: 
 The “Dogs of the Dow” strategy has become an increasingly popular investment strategy for unit investment trusts, resulting in superior performance for U.S.-based investors. To examine its effectiveness for Canadian investors, we applied this high-dividend-yield strategy to the Toronto 35 Index for the first 10 years of the index's existence. The 10 top-performing portfolios' higher compound returns were sufficient to compensate for taxes and transaction costs. Perhaps more important, both the Sharpe ratio, which measures excess return to total risk, and the Treynor index, which measures excess return to market risk, indicate that the strategy produced higher risk-adjusted returns than the Toronto 35. The Dogs strategy also performed well against the broader, but similar, Toronto Stock Exchange 300 Index. The “Dogs of the Dow,” a popular dividend-yield strategy, involves purchasing the 10 highest-dividend- yielding stocks on the DJIA on 31 December and rebalancing on an annual basis. This strategy is one of many value-based investment strategies being used in the U.S. market that have been explored in the financial press and the academic literature in recent years. The success of value-based strategies has also been investigated in international markets, with the Canadian market showing mixed results. In the study reported here, we investigated whether the Dow Dogs dividend-yield strategy is effective in the Canadian stock market.We compared the performance of the 10 highest-dividend-yield stocks in the Toronto 35 Index with the performances of both the Toronto 35 and the Toronto Stock Exchange (TSE) 300 Index for the 1987–97 period. We obtained data on the constituent companies, as well as returns for both indexes, from the TSE Review. We collected dividend yields on all of the Toronto 35 companies for the last trading day of July 1987 through 1997 from Research Insight. The 10 companies with the highest dividend yields composed the equally weighted Top 10 portfolio each year. The monthly returns for each stock include the price change and dividends, divided by the beginning price. We calculated the Top 10 portfolio return by investing C$10,000 in each stock on 1 August. Each C$10,000 investment was increased by each individual stock's August return. We added the end-of-August stock values to determine the portfolio value. We used the percentage change in portfolio value during the month for the monthly portfolio return. We multiplied the Canadian dollar value of each stock investment at the end of August by each stock's September return, summed the 10 stock values, and calculated the September portfolio ending value and return. We repeated this process for each of the 12 months. Then, we repeated the process for the following year by investing C$10,000 in each of 10 potentially new stocks on 1 August.The Top 10 portfolios' compound returns were between 1.2 percentage points and 20.4 percentage points greater than those of the index in eight years and were lower than the index by relatively small amounts (2.8 pps and 3.6 pps) in the other two years. The Top 10 portfolios also beat the Toronto 35 in the six consecutive 5-year periods and over the entire 10-year period. The strategy was successful even after taxes and transaction costs were taken into account.We also examined the returns on a risk-adjusted basis. The Sharpe ratio (excess return per unit of total risk) is the appropriate measure of risk-adjusted return when the investor is not well diversified and is exposed to some level of company-specific risk. When we calculated Sharpe ratios, the results were similar to the compound return results: The Top 10 portfolios outperformed the Toronto 35 in eight single-year periods and all the multiyear periods. If the Canadian Dogs strategy is part of a larger, well-diversified portfolio, the investor is exposed only to systematic risk and the Treynor index is the appropriate measure of risk. Calculating this measure, we found, again, that the Top 10 portfolios outperformed the Toronto 35 in the same eight single years and all multiyear periods.In addition, the strategy performed well against the broader, but similar, TSE 300 Index.
Journal: Financial Analysts Journal
Pages: 99-106
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2506
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2506
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:1:p:99-106




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Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The A.R.T. of Risk Management: Alternative Risk Transfer, Capital Structure, and the Convergence of Insurance and Capital Markets (a review)
Abstract: 
 Combining capital structure theory, information economics, and option analysis, this book offers both a necessary reference work and a fresh perspective by presenting a unified risk management framework. 
Journal: Financial Analysts Journal
Pages: 107-108
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2507
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2507
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:1:p:107-108




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# input file: UFAJ_A_12047392_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Daren E. Miller
Author-X-Name-First: Daren E.
Author-X-Name-Last: Miller
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Fundamentals of Risk Measurement (a review)
Abstract: 
 This do-it-yourself guide to building and launching risk measurement models will serve as both an introduction for the novice “quant” and a handy desk reference for the veteran risk professional. 
Journal: Financial Analysts Journal
Pages: 108-109
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2508
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2508
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:1:p:108-109




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Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Man Who Beats the S&P: Investing with Bill Miller (a review)
Abstract: 
 This book outlines the distinctive strategic and analytical processes that have led to Bill Miller's success as manager of the Legg Mason Value Trust, which outperformed the S&P 500 Index 11 years in a row. 
Journal: Financial Analysts Journal
Pages: 109-110
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2509
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2509
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:1:p:109-110




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# input file: UFAJ_A_12047394_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: From the Editor
Abstract: 
  Dear Readers, It is a great honor for me to be chosen as editor of the Financial Analysts Journal. From its genesis in 1945, the FAJ has established a proud and strong tradition as one of the leading investment practitioner journals in the world. Not many journals can boast that they have published 14 articles by Benjamin Graham, 19 articles by Fischer Black, 13 articles by Bill Sharpe, and 11 articles by Peter Bernstein. If one considers the many other authors and articles represented in the journal's 57-year history, the accumulated wisdom in the FAJ is staggering. The FAJ is, at its core, a journal for you, the community of investment practitioners. AIMR and I are unswerving in our commitment that the FAJ will continue to play a key role in our industry as a link between innovative researchers and thinkers and the broad practitioner community. The FAJ's purpose is spelled out in its mission and standards: FAJ Mission and Editorial Standards The goal of the Financial Analysts Journal is to advance the knowledge and understanding of the practice of investment management through the publication of high-quality, practitioner-relevant research. The Financial Analysts Journal should serve asa bridge between academic research and practice by publishing academically rigorous articles that have direct relevance to practitioners, a forum for presenting practitioner research, and a forum for the perspectives of leading practitioners, academics, and regulators about our industry.   Striving to meet these high expectations, the FAJ operates according to written quality, relevance, and readability standards. As an example, articles submitted to the FAJ are subject to an anonymous peer review process that provides an independent assessment of quality and relevance. Additionally, we work with authors to produce readable articles written in a style that is appropriate for a practitioner (rather than an academic) audience. We will, of course, continue to seek papers of the highest academic standards; we will be particularly alert to such opportunities when they are targeted to the practitioner community. I urge you to visit the FAJ Website at aimrpubs.org for details about our editorial standards. Without departing from the double-blind process, in which authors of articles do not know who their referees are and referees are not told the identities of the authors, we intend to increase the transparency of the review process. We will inform authors how their papers were judged by the referees and how the final decisions on their papers were reached. Naturally, it takes several issues for a journal to fully reflect the goals and priorities of any new editor. In this case, the situation is complicated by the fact that I and various co-authors had several articles that were submitted before the start of my tenure as editor. I will play no role whatsoever in the final editorial process for these papers; I will leave those decisions to the capable people at AIMR. I will not be submitting any new articles to the FAJ, but I may contribute some short perspectives pieces, which will be subject to independent review without my involvement in any way. In addition, I will not vote on the Graham and Dodd awards for 2002 or 2003. All of us working on the FAJ recognize that the reputation of the journal depends, in part, on its commitment to high standards of ethics and professional conduct. To help us maintain these standards in the selection and publication of articles, all authors, advisors, and reviewers, as well as the editor and editorial staff, will continue to abide by the FAJ's conflict-of-interest policies and ethical standards. These policies and standards are available on the FAJ Website. I am delighted to introduce to you a new group of people who will help the FAJ maintain its standards—the FAJ Advisory Council. They are listed on this issue's masthead and on FAJ's Website. The Advisory Council consists of luminaries who have made a substantial contribution to our industry; their key role is to advise the editor and AIMR on the proper direction of the FAJ. The masthead also lists our hard-working Editorial Board, which serves as our main source of reviewers. Some Advisory Council and Editorial Board members have previously served on the board; some names are new. All are leaders in their fields, and I thank both groups for their willingness to serve. In addition to their other duties, we are encouraging Advisory Council and Editorial Board members to submit perspectives pieces based on their decades of experience in the field, to submit cutting-edge, relevant research articles, and to help us identify outstanding practitioner-oriented papers and innovative ideas for future publication. I am looking forward to serving you. 
Journal: Financial Analysts Journal
Pages: 3-3
Issue: 1
Volume: 59
Year: 2003
Month: 1
X-DOI: 10.2469/faj.v59.n1.2521
File-URL: http://hdl.handle.net/10.2469/faj.v59.n1.2521
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:1:p:3-3




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# input file: UFAJ_A_12047395_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Dividends and the Three Dwarfs
Abstract: 
 Historically, in providing wealth to investors, dividends have dwarfed not only inflation, growth, and changing valuation levels individually but have dwarfed these three factors combined. Yet real per-share dividend and earnings growth on the S&P 500 Index since 1965 has been—zero. 
Journal: Financial Analysts Journal
Pages: 4-6
Issue: 2
Volume: 59
Year: 2003
Month: 3
X-DOI: 10.2469/faj.v59.n2.2510
File-URL: http://hdl.handle.net/10.2469/faj.v59.n2.2510
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:2:p:4-6




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# input file: UFAJ_A_12047396_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Author-Name: Anne Casscells
Author-X-Name-First: Anne
Author-X-Name-Last: Casscells
Title: Demographics and Capital Market Returns
Abstract: 
 Demographic patterns presage unprecedented pressure on U.S. asset values, Social Security policies, and intergenerational amity. By 2010, longevity in the United States will have increased by nearly 15 years since 1940 but the retirement age for full Social Security and Medicare benefits will have increased by only a single year. As those in the Baby Boom approach “normal” retirement age (65), the population will contain nearly twice as many people over 65 relative to “normal” working-age people (age 20–65) as society has ever seen. The simple fact is that moving from the current level of just under 3 workers per retiree to just over 1.5 workers per retiree is a likely formula for interclass and intergenerational rebellion; therefore, something will have to give.We start by analyzing the demographic patterns of the past 60 years. The first element of the problem is the increasing population over 65. The second element is the falling number of workers who provide the goods and services for the retirees (and for their own families). Because of both the Baby Boom of 1946–1958 and the Baby Bust of 1965–1990, the proportion of the population over 65 will soar from 12 percent today to 20 percent in 2030. The result will be deterioration in the dependency ratio—the ratio of those who produce no goods or services (and are thus dependent on others) to those who provide the goods and services for all.This problem has implications for the financial markets: Demographics played a key role in creating the stock market boom of 1975–1999 and will put a lid on asset returns for the coming quarter century. More retirees selling assets to a proportionately smaller roster of potential buyers (workers and their pension plans) equals pressure on asset values. Buyers will want total return, including income and growth; sellers will favor fixed income and fixed purchasing power. One consequence will be an increase in risk premiums required by the next generation and delivered to them by the outsized boomer generation. Goods and services that retirees want—notably, in the health care, leisure, and service industries—probably will experience material inflation. And the higher costs should be reflected in higher wages. Thus, the outcome could be a surge in real wages in the service sector and a continuing surge in medical costs.We discuss the various “solutions” to this problem that have been proposed. Financial and macroeconomic solutions will not work, because the problem is at heart a demographic one. Three demographic solutions could, however, help restore the dependency ratio: vastly increased immigration by young people, increased emigration by retirees, and a substantial rise in the retirement age. A common denominator in all of these solutions is (1) more workers and (2) fewer retirees. Although immigration of workers and emigration of retirees might slightly improve the dependency ratio, however, only a rising retirement age will make a large difference in the problem.How high the retirement age would have to go can be calculated in various ways. For example, if the recent and current retiree burden is comfortable for society, as would appear to be the case, the dependency ratio would need to match its 1980–2000 average. Then, to keep support ratios from rising from current levels, the retirement age would have to rise from 65 to 72–73 between 2005 and 2035.Whatever policy decisions are made, indications are that the laws of supply and demand are already bringing about just such a “solution.” The capital markets (i.e., investors at large) are already beginning to price the impact of future retirees' plans into asset valuations. And the media are full of accounts that retirees and near retirees are even now reassessing their ability to retire in light of stock market losses and reduced return expectations.
Journal: Financial Analysts Journal
Pages: 20-29
Issue: 2
Volume: 59
Year: 2003
Month: 3
X-DOI: 10.2469/faj.v59.n2.2511
File-URL: http://hdl.handle.net/10.2469/faj.v59.n2.2511
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:2:p:20-29




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Author-Name: Harry M. Markowitz
Author-X-Name-First: Harry M.
Author-X-Name-Last: Markowitz
Author-Name: Erik L. van Dijk
Author-X-Name-First: Erik L.
Author-X-Name-Last: van Dijk
Title: Single-Period Mean–Variance Analysis in a Changing World (corrected)
Abstract: 
 Ideally, financial analysts would like to be able to optimize a consumption–investment game with many securities, many time periods, transaction costs, and changing probability distributions. We cannot. For a small optimizable version of such a game, we consider in this article how much would be lost by following one or another heuristic that could be easily scaled to handle large games. For the games considered, a particular mean–variance heuristic does almost as well as the optimum strategy. Ideally, financial analysts would like to solve investment problems involving large universes of securities, many time periods, asset illiquidities (such as transaction costs and unrealized taxable capital gains), and changing probability distributions (with perhaps some predictability). Currently, such problems are well beyond state-of-the-art optimization. We consider in this article how much we would lose if we used one or another heuristic (rule of thumb) to solve investment problems.We cannot determine the loss that would come from use of a heuristic rather than an optimum solution for large-scale problems because we cannot compute optimum solutions. For sufficiently small problems, however, we can compute the expected payoffs to an optimum strategy and to various heuristics. In this article, we compare the expected payoffs of the optimum solution and various heuristics for a simple dynamic model for which the optimum solution can be solved. The heuristics considered can be scaled to much larger problems.The simplified model we analyze consists of two assets (stock and cash) and discrete time periods (months). In the case we consider, an investor seeks to maximize total utility, which is defined as the sum of the present values of one-period utilities. The investor has a market prediction model that may predict a very optimistic, optimistic, neutral, pessimistic, or very pessimistic state. We analyze the model for two levels of transaction costs.One of the heuristics tried is a “mean–variance surrogate for the ‘derived’ utility function” (“MV surrogate heuristic” for short). We know from dynamic programming that the expected value of total utility for the game as a whole can be maximized by maximizing the expected values of a sequence of single-period utility functions, using a so-called derived utility function. For complex games, the derived utility function cannot be computed. The MV surrogate heuristic replaces this incomputable function with a simple function of portfolio mean and variance.In addition to the MV surrogate heuristic, we test other heuristics: all stock, all cash, a 60/40 stock/cash mix, a “very active” heuristic that always moves to what would be optimum if there were no transaction costs, and an “inactive” heuristic that does nothing.For the models considered, the MV surrogate heuristic did better than the other heuristics and almost as well as the optimum strategy. We offer suggestions as to how the MV surrogate heuristic could be applied to more complex models (such as the model we tested but with more securities) and to models with other kinds of prediction rules or illiquidities (such as unrealized taxable capital gains).
Journal: Financial Analysts Journal
Pages: 30-44
Issue: 2
Volume: 59
Year: 2003
Month: 3
X-DOI: 10.2469/faj.v59.n2.2512
File-URL: http://hdl.handle.net/10.2469/faj.v59.n2.2512
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:2:p:30-44




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Author-Name: James Scott
Author-X-Name-First: James
Author-X-Name-Last: Scott
Author-Name: Margaret Stumpp
Author-X-Name-First: Margaret
Author-X-Name-Last: Stumpp
Author-Name: Peter Xu
Author-X-Name-First: Peter
Author-X-Name-Last: Xu
Title: News, Not Trading Volume, Builds Momentum
Abstract: 
 Recent research has found that price momentum and trading volume appear to predict subsequent stock returns in the U.S. market and that they seem to do so in a nonlinear fashion. Specifically, the effect of momentum appears more pronounced among high-volume stocks than among low-volume stocks. This effect would suggest the existence of an exploitable deviation from market efficiency. We argue that this phenomenon is a result of the underreaction of investors to earnings news—an effect that is most pronounced for high-growth companies. We show that, after earnings-related news and a stock's growth rate have been controlled for, the interaction between momentum and volume largely disappears. Both empirical research and stock market lore suggest that momentum and trading volume in the U.S. equity market predict subsequent returns and that they do so in a nonlinear fashion. Specifically, the effect of momentum appears to be more pronounced among high-volume stocks than among low-volume stocks (this is the “momentum–volume effect”). This effect would suggest the existence of a predictable deviation from market efficiency that is exploitable through technical trading rules.One of the possible explanations for this phenomenon is the “momentum life cycle.” This explanation suggests that stocks cycle sequentially through intervals of glamour and neglect, exhibiting high trading volume during periods of glamour and low trading volume during times of neglect. For example, high-volume stocks with low momentum would be considered to be in an early stage of a move from glamour to neglect and would be expected to exhibit lower subsequent returns relative to low-volume, low-momentum stocks, which would be near the trough of an interval of neglect.We examined volume and return data for a sample of 1,500 companies between 1981 and 1998 and also found a relationship between momentum and volume. We propose a different explanation from the momentum life cycle, however—an explanation based on investor reaction to news about company fundamentals.We argue that news about a company's prospects often creates trading volume and a change in stock price. That is, momentum occurs because news precipitates a change in expectations, which generates trading and a change in stock price. Furthermore, news creates greater volume and greater momentum for high-growth stocks, which are more sensitive to information about future earnings than are low-growth stocks. We argue that some of the reaction to news is delayed while overconfident investors slowly adjust their beliefs. Just as the initial reaction is greater for growth stocks, the delayed reaction is also greater for growth stocks. This nonlinear reaction to earnings news about stocks with different growth rates creates the nonlinearities in the momentum–volume interaction. In short, we believe that the momentum life cycle is explainable as a delayed reaction to news about company fundamentals that is strongest for high-growth stocks and that there is nothing special about volume per se.To reach this conclusion, we show that (1) trading volume is positively correlated with both the amount of fundamental news and a company's growth rate and (2) a delayed reaction to earnings-related news is greater for rapidly growing stocks. Our proxy for news is the net number of upward changes in earnings forecasts made by security analysts following a stock. Once we controlled for news and growth, we found that the apparent interaction between momentum and trading volume disappeared.Furthermore, the impact of news on subsequent performance appears to be more robust than the impact of momentum. Very bad news always resulted in significantly negative subsequent performance, whereas very low momentum did not. Additionally, regardless of momentum, stocks with very good news had subsequent returns that were consistent with the direction of the news (typically, significantly positive or zero) but such was not the case for momentum, where subsequent returns were occasionally of the opposite sign. These observations suggest that a substantial portion of the momentum effect can be explained as investors' delayed reaction to news.Our measure of news does not, however, explain all of the momentum effect. For example, the average excess return in the subsequent quarter for stocks with no news increased monotonically from the lowest- to the highest-momentum quintile. We believe that this apparently independent momentum effect is likely to be underreaction to news not captured in our forecast-revision measure.We conclude that, although momentum may be correlated with subsequent performance, momentum by itself does not contain information about future performance. Viewed in a framework that is consistent with valuation theory and the arrival of information, the momentum–volume effect, we find, is a manifestation of a richer phenomenon driven by investors' lagged responses to news. Although this finding does not preclude successful technical trading strategies, a more fruitful approach would focus directly on the apparent lagged response to news.
Journal: Financial Analysts Journal
Pages: 45-54
Issue: 2
Volume: 59
Year: 2003
Month: 3
X-DOI: 10.2469/faj.v59.n2.2513
File-URL: http://hdl.handle.net/10.2469/faj.v59.n2.2513
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# input file: UFAJ_A_12047399_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Cornelia Paape
Author-X-Name-First: Cornelia
Author-X-Name-Last: Paape
Title: Currency Overlay in Performance Evaluation
Abstract: 
 The aim of performance evaluation is to make judgments about the success of portfolio managers in asset allocation and security selection for investment portfolios. This article presents a method of performance measurement that uses the interdependence of market management and currency management in terms of allocation processes but allows their separation in terms of selection processes. As a consequence, performance evaluation is more reasonable than in previous approaches and produces the same results whether the investment process starts with market management followed by currency management or vice versa. Currency overlay is an investment management hedging strategy designed to separate, as far as possible, the currency management component from the management of the nondomestic assets in an international portfolio. In conventional performance evaluation for global portfolios that use local-currency and exchange rate returns, the interrelationship of market management and currency management is ignored, which leads to inaccurate results when performance attribution is carried out. I describe a method of performance evaluation that uses the interdependency of these management stages in terms of the allocation processes (to markets and to currencies) but allows their separation in terms of the selection processes (security selection and currency selection). As a consequence, performance evaluation of a portfolio is the same whether the investment process starts with market management followed by currency management or vice versa.The aim of performance evaluation is to make judgments about the success of managers in allocating investment funds to assets and in selecting investment securities and strategies. In the past 20–30 years, many approaches have been developed for directly comparing actively managed portfolios with passively managed, benchmark portfolios. During the late 1980s, the main goal was to find and define attribution variables (allocation and selection variables). Beginning in the 1990s, the theoretical focus shifted to global investment portfolios and adding currency management to the decision variables. By focusing on local-currency and exchange rate returns, however, and ignoring interest rate differentials, these conventional performance evaluation systems continued the separation of market and currency management.This article improves upon earlier methodology in two ways. First, within performance measurement, I provide a mathematically correct method of evaluating return variables. Second, I derive appropriate formulas for the attribution variables for the return premiums developed in that method. In this way, a new portfolio evaluation system is provided that consists of an established method of portfolio decomposition, a new method of performance measurement, and also a new method of attribution analysis. All the definitions, mathematics, and interpretations are clarified with numerical examples.The first part of the article deals with performance measurement. The aim is to find mathematically correct formulas for return and weight variables that are compatible with practical demands. Thus, all returns are initially calculated in simple, instead of continuously compounded, terms. Overall performance is defined by multiplying market and currency returns rather than adding them. Furthermore, for arbitrage reasons, forward currency returns are expressed as the difference between two Eurodeposit returns divided by a discount factor. This kind of performance measurement allows a breakdown of overall performance that suggests definitions of return variables as return “premiums”—that is, excess returns. By focusing on market and currency premiums, this article provides portfolio managers a more reasonable interpretation of performance attribution variables in global investment portfolios. Moreover, it reveals that these two management tasks are interdependent in terms of allocation but separable in terms of selection processes.The second part of the article considers attribution analysis. Here, the aim is to identify the individual contribution of each market and currency decision to the overall excess return of the portfolio (excess return over a benchmark portfolio). For this purpose, a passive benchmark portfolio is created and the success of active management in allocating and selecting is measured against it. Once return and currency premiums have been calculated, the derivation of attribution formulas is straightforward. Each attribution measure is composed of the return difference of the created active and passive portfolios. The returns differ in the weight or return only of the variable for the allocation or selection decision to be evaluated. Even though the derivation of attribution variables is thereby still influenced by the order of market and currency management within the investment process, interpretation of the variables leads to the same performance evaluation judgments regardless of when the management phases were carried out.
Journal: Financial Analysts Journal
Pages: 55-68
Issue: 2
Volume: 59
Year: 2003
Month: 3
X-DOI: 10.2469/faj.v59.n2.2514
File-URL: http://hdl.handle.net/10.2469/faj.v59.n2.2514
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Author-Name: Chansog (Francis) Kim
Author-X-Name-First: Chansog (Francis)
Author-X-Name-Last: Kim
Author-Name: Christos Pantzalis
Author-X-Name-First: Christos
Author-X-Name-Last: Pantzalis
Title: Global/Industrial Diversification and Analyst Herding
Abstract: 
 The study we report examined herding behavior among security analysts in the 1980–98 period. Using panel data, we analyzed the impact of industrial and geographical diversification on herding among analysts. We compared the propensity toward herding of analysts covering domestic companies that are industrially focused and analysts focusing on companies that are diversified geographically and/or industrially. We provide evidence that herding is more pronounced among analysts concentrating on diversified companies. This result is consistent with the notion that herding behavior increases with task difficulty. Our results also show that herding among analysts reduces the market value of companies they cover, which indicates that the market penalizes herding behavior among security analysts. This effect was more pronounced for companies that are industrially and/or geographically diversified. Given the recent market uneasiness about the quality of security analysts' services in the United States, an important issue is whether a relationship exists between the quality of analyst coverage and characteristics of the companies analysts choose to cover. The ability of security analysts to disseminate information and provide monitoring of corporate managements depends on a company's degree of organizational complexity and potential for agency conflicts. These characteristics, which are more common among diversified companies, could lead to large forecast errors coupled with unusually high levels of consensus in analyst forecasts. This phenomenon is referred to as “herding.” Because such behavior is synonymous with ineffective analyst coverage, herding could account for differences in valuations in a cross-section of companies with different degrees of diversification.We used security analysts' summary earnings forecast data for a large panel of companies in the 1980–98 period to detect whether security analysts' herding behavior is related to characteristics of the companies they follow. We operationalized herding among analysts as cases of clustering of analyst earnings forecasts coupled with large forecast errors. We maintain that, given the different nature of diversified and nondiversified companies, the extent and quality of analyst coverage of domestic companies that are industrially focused is different from the extent and quality of analyst coverage of diversified companies. Consequently, we expected analysts' propensity toward herding to be different when they were covering domestic/industrially focused companies from when they were covering geographically and/or industrially diversified companies.Diversification should exacerbate analysts' tendency toward herding because it increases the complexity and difficulty of the analyst's task. Diversified companies are generally larger, have more-complex organizational structures, and have less-transparent operations. In addition, they are more likely to exhibit agency conflicts and problems of informational asymmetry. Therefore, we argue that analysts following companies that are focused in a single line of business and that operate exclusively in the domestic U.S. market should display less herding than analysts covering companies that are industrially diversified, geographically diversified (multinationals), or both. If herding behavior serves as a proxy for analyst ineffectiveness (i.e., subpar monitoring and information dissemination), the differential valuations of diversified versus nondiversified companies is partly driven by differences in analyst propensity toward herding behavior.We used measures of forecast dispersion and forecast error to devise two measures of analyst propensity toward herding (herding indexes) for each company. We then used panel-data regressions to test the following hypotheses: (H1) Herding behavior is more pronounced among analysts following diversified companies than among those following domestic, industrially focused companies.(H2) Herding increases with the degree of both geographical and industrial diversification.(H3) Market value declines with analyst propensity toward herding.(H4) The impact of herding on market value is stronger for diversified companies.Our empirical results support all four hypotheses. Our findings indicate that analyst forecasts for geographically or industrially diversified companies display more herding, on average, than forecasts for domestic/focused companies. The results also provide strong support for the notion that herding increases with the degree of both industrial and geographical diversification. In addition, when we estimated two-stage least-squares regressions, we found that herding results in lower market valuations, which implies that the market penalizes security analysts' propensity toward herding. We found this effect to be stronger in the case of diversified companies.
Journal: Financial Analysts Journal
Pages: 69-79
Issue: 2
Volume: 59
Year: 2003
Month: 3
X-DOI: 10.2469/faj.v59.n2.2515
File-URL: http://hdl.handle.net/10.2469/faj.v59.n2.2515
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:2:p:69-79




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# input file: UFAJ_A_12047401_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Xavier Adserà
Author-X-Name-First: Xavier
Author-X-Name-Last: Adserà
Author-Name: Pere Viñolas
Author-X-Name-First: Pere
Author-X-Name-Last: Viñolas
Title: FEVA: A Financial and Economic Approach to Valuation
Abstract: 
 Traditional valuation methods (economic value added, discounted cash flow, and Modigliani and Miller models) are mathematically equivalent and thus should provide the same result when the same inputs are used. They do not. Because these methods focus on different value drivers, we suggest an alternative valuation method that provides the adjustment necessary to produce consistent results. We also propose a new corporate valuation method (“financial and economic value added,” or FEVA) that integrates the EVA, DCF, and MM approaches and allows a detailed analysis of financial and economic corporate value drivers. Financial analysts face a fundamental problem: When different valuation models are applied to the same company, they yield significantly different results. Why does this happen? Shouldn't similar methods from the same family lead to the same result? We explain why, if properly applied, all traditional methods do yield the same result, and we offer a new method that reconciles differences among the traditional methods.In addition to traditional discounted cash flow (DCF) methods, one family of valuation models, economic value added (EVA) and other franchise factor approaches, has become a favorite methodology for corporate valuation. In EVA approaches, the key value driver is the spread between the return on the existing investments and their average cost of capital. Therefore, this approach focuses on the left-hand side of the balance sheet—investment analysis. Another family of corporate valuation methodologies is grounded in the work of Modigliani and Miller; it was developed in the economics literature and has not been so widely followed by practitioners as the EVA approach, although it is consistent with the EVA approach. MM models provide a framework for the analysis of the optimal financial structure. This approach aims to identify the links between financial decisions and corporate value and, therefore, how the right-hand side of the balance sheet—the financial structure—affects corporate value.Given these three approaches, several questions arise. First, from the practitioner point of view, are these methodologies equivalent? Do they yield exactly the same result? The emphasis on exactness is important. The principle of one value states that because these approaches share the same underlying assumptions, if the approaches are properly used and the same inputs are used in each, their results should not differ. All these methods should yield exactly the same result. We show that EVA, MM, and DCF methodologies are mathematically equivalent and that, therefore, the principle applies to the last decimal. We also show the adjustments required to produce consistent valuation results, especially for the MM valuation methods, in which tax shields and bankruptcy costs play such an important role. We provide a numerical example to illustrate the adjustments.The important aspect of this issue is not its technical interest or which of the different “values” of a company is correct but, rather, what the value drivers are that each method identifies. This issue leads directly to the second question: If these approaches are mathematically equivalent, can we not develop a formula or method that integrates all the value drivers identified for each methodology? Our answer is a “financial and economic value added” (FEVA) model.The FEVA model divides corporate valuation into eight value drivers—three economic drivers taken from the EVA approach and five financial structure drivers based on the MM approach—and differentiates the contribution of each driver. This model maintains the principle of one value because the FEVA formula is mathematically consistent with the standard methodologies.
Journal: Financial Analysts Journal
Pages: 80-87
Issue: 2
Volume: 59
Year: 2003
Month: 3
X-DOI: 10.2469/faj.v59.n2.2516
File-URL: http://hdl.handle.net/10.2469/faj.v59.n2.2516
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:2:p:80-87




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# input file: UFAJ_A_12047402_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Brad Barber
Author-X-Name-First: Brad
Author-X-Name-Last: Barber
Author-Name: Reuven Lehavy
Author-X-Name-First: Reuven
Author-X-Name-Last: Lehavy
Author-Name: Maureen McNichols
Author-X-Name-First: Maureen
Author-X-Name-Last: McNichols
Author-Name: Brett Trueman
Author-X-Name-First: Brett
Author-X-Name-Last: Trueman
Title: Reassessing the Returns to Analysts' Stock Recommendations
Abstract: 
 After a string of years in which security analysts' top stock picks significantly outperformed their pans, the years 2000 and 2001 were disasters. During those two years, the stocks least favored by analysts earned an average annualized market-adjusted return of 13.44 percent whereas the stocks most highly recommended underperformed the market by 7.06 percent, a return difference of more than 20 percentage points. This pattern prevailed during most months of 2000 and 2001 and was observed for both technology and nontechnology stocks. Additional analysis suggests that these poor results were driven, at least in part, by analysts' tendency to recommend small-capitalization growth stocks during those years, despite the fall of those stocks from favor. Whether or not this preference was motivated by a desire to attract and retain the most lucrative investment banking clients, our findings should add to the debate over the usefulness of analyst stock recommendations. They should also serve to alert researchers to the possibility that excluding 2000 and 2001 from their sample periods could have a significant impact on any conclusions they draw about analyst stock recommendations. Investors have been growing increasingly suspicious of the value of sell-side analysts' stock recommendations in recent years. With investment banking business booming during the late 1990s and early 2000, the belief spread that analysts were focused on attracting and retaining investment banking clients rather than on writing research reports that accurately reflected their opinions of the companies they followed. “Sell” recommendations became scarcer, and “buy” recommendations became less meaningful to investors. The goal of the study we report was to analyze the returns to analysts' recommendations during the 1996–2001 period to discern the extent to which the recommendations continue to have value.The research followed the approach of a similar analysis we conducted for the 1986–96 period, a time during which the impact of investment banking on analysts' research reports was, arguably, of less concern. For this period, we found sell-side analysts' stock recommendations to have significant value: The stocks with more favorable consensus (average) recommendations outperformed the less favored recommendations. A portfolio of the most highly recommended stocks generated an average annual market-adjusted return of 3.97 percent, whereas a portfolio of the least favored stocks yielded an average annual market-adjusted return of –9.06 percent.For the years 1996–1999 covered in the study reported here, we found market-adjusted returns that are similar to those for the earlier period. The returns for the years 2000–2001, however, are strikingly different. The market-adjusted return on the most favorably rated stocks in 2000 and again in 2001 was about –7 percent, whereas the market-adjusted return on the least favored stocks in 2000 was a quite large 17.6 percent and in 2001, 9.3 percent.The difference between the returns to the most highly rated and least favored stocks, almost –25 percentage points in 2000 and about –16 percentage points in 2001, reflects years of very poor performance of analyst recommendations. In additional analyses, we found that these poor results were in evidence for most months of 2000 and 2001 and that they were more pronounced for technology companies (the strongest segment of the market leading into 2000) than for nontechnology companies. Perhaps most surprising was the finding that the least favored tech stocks actually rose in 2000–2001, at a time when the sector as a whole was suffering sharp declines.Key to understanding these results is the additional finding that during both the 1996–99 and 2000–01 periods, the most highly recommended stocks were generally small-capitalization stocks with low book-to-market ratios (so-called growth stocks), while the least favored stocks, although also small-caps, had high book-to-market ratios (so-called value stocks). This fact is noteworthy because in the 1996–99 period, small-cap growth stocks vastly outperformed small-cap value stocks, but during 2000–2001, value stocks trounced growth stocks. Analysts' continued tendency to recommend the (now out-of-favor) small-cap growth segment in 2000 and 2001 apparently led to their picks underperforming their pans in this period.Even with the very poor analyst performance in 2000–2001, the most highly recommended stocks during the 16-year period from 1986 through 2001 period still generated significantly greater average annual market-adjusted returns than did the least favored stocks. This result reflects favorably on the long-term value of analyst recommendations, as long as the 2000–01 results are an extreme aberration that is unlikely to be repeated. If this recent performance reflects an inability or reluctance on the part of analysts to adapt to changing market conditions (such as might be the case if analysts continued to favor small growth firms over small value firms because of their potentially greater investment banking business), however, then analyst performance for the whole period will not be a reliable predictor of future returns to analyst picks. At any rate, our results should alert researchers to the possibility that excluding the years 2000–2001 from their sample periods could have a significant impact on any conclusions they draw regarding analyst stock recommendations.
Journal: Financial Analysts Journal
Pages: 88-96
Issue: 2
Volume: 59
Year: 2003
Month: 3
X-DOI: 10.2469/faj.v59.n2.2517
File-URL: http://hdl.handle.net/10.2469/faj.v59.n2.2517
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:2:p:88-96




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# input file: UFAJ_A_12047403_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Moshe Levy
Author-X-Name-First: Moshe
Author-X-Name-Last: Levy
Author-Name: Haim Levy
Author-X-Name-First: Haim
Author-X-Name-Last: Levy
Author-Name: Avi Edry
Author-X-Name-First: Avi
Author-X-Name-Last: Edry
Title: A Negative Equilibrium Interest Rate
Abstract: 
 The average after-tax real interest rate on U.S. T-bills and the average rate of return on long-term government bonds (LTGB) have been negative over the past 75 years. Is this negative rate an equilibrium phenomenon or simply an empirical fluke? We show that a negative equilibrium interest rate is possible and that the wealthier the nation is, the more negative the equilibrium interest rate can be. This phenomenon results from a positive inflation rate and taxation of nominal profits, and it cannot hold in a period of zero inflation or in a period of deflation. A positive demand for T-bills and for LTGB exists also in a portfolio framework, even when these two assets are characterized by a negative expected rate of return and other risky assets are yielding positive expected returns. Most practitioners and academics would agree that a dollar received today is worth more than a dollar received tomorrow. This idea is reflected in the notion of “the time value of money” and in the positive interest rate that is assumed in most economic models. We find, however, that the empirical after-tax real interest rate is negative. An analysis of the 1926–2000 period reveals that the average after-tax real interest rate on U.S. T-bills was –1.34 percent and the average after-tax real return on long-term government bonds was −0.24 percent. These negative average returns are the result of inflation and the fact that it is nominal profit that is taxed. Is this finding a statistical fluke, or can such a negative interest rate be an equilibrium result?In the absence of inflation, no one would invest in T-bills yielding a negative rate of return when one could, instead, keep the money as cash and obtain a rate of return of zero. In periods of positive inflation, however, holding cash is costly and investment in T-bills may be preferable to holding cash even if T-bills yield a negative after-tax real return. Of course, one could refrain from investing altogether in such conditions and simply spend the dollar today. But could investing in such a situation be optimal? We show that the standard utility functions imply that the optimal saving may be positive even at a negative rate of return. Thus, a negative interest rate can be perfectly compatible with rational equilibrium.We further show that the higher current wealth is, the higher the saving will generally be at a given interest level. Thus, the wealthier the nation is, the more negative the equilibrium interest rate could be. The opposite holds for poor nations with rapid growth.The interest rate can be negative in equilibrium even in a portfolio context when other assets in the market are yielding positive expected rates of return. To produce this result, we used 1926–2000 data on the U.S. market to estimate the means and the variance–covariance matrix for T-bills, long-term government bonds, common stocks, and small-capitalization stocks. We analyzed the mean–variance-efficient frontier to derive the optimal portfolio composition with these four assets. We found that, although equity was characterized in this 75-year period by a positive average after-tax real rate of return (for investors who paid the marginal tax that prevailed in each year) and although T-bills and long-term government bonds had negative average after-tax real rates of return, the portfolio demand for T-bills and long-term government bonds was still positive. The portfolio demand for these two assets stems from their relatively low correlation with equity.The notion of a negative equilibrium interest rate may have far-reaching implications for many of our economic intuitions and models, most of which assume a positive interest rate. Specifically, in light of these findings, we believe that such commonly taught concepts as “the time value of money” should be reconsidered.
Journal: Financial Analysts Journal
Pages: 97-109
Issue: 2
Volume: 59
Year: 2003
Month: 3
X-DOI: 10.2469/faj.v59.n2.2518
File-URL: http://hdl.handle.net/10.2469/faj.v59.n2.2518
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Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Compensation Committee Handbook (a review)
Abstract: 
 In a single volume, this reference work provides useful and enlightening descriptions of how companies are being run by addressing essential information about compensation, legal issues, and the recruitment and training of directors. 
Journal: Financial Analysts Journal
Pages: 110-111
Issue: 2
Volume: 59
Year: 2003
Month: 3
X-DOI: 10.2469/faj.v59.n2.2519
File-URL: http://hdl.handle.net/10.2469/faj.v59.n2.2519
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# input file: UFAJ_A_12047405_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “The Equity Premium: Why Is It a Puzzle?” by Rajnish Mehra, published in the January/February 2003 issue.
Journal: Financial Analysts Journal
Pages: 7-7
Issue: 2
Volume: 59
Year: 2003
Month: 3
X-DOI: 10.2469/faj.v59.n2.2520
File-URL: http://hdl.handle.net/10.2469/faj.v59.n2.2520
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# input file: UFAJ_A_12047406_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: What Risk Matters? A Call for Papers!
Abstract: 
 Academics say that the most important risk in an investment portfolio is some variation of standard deviation; moreover, much of the finance literature is devoted to arguing for or against individual metrics of risk. But multiple metrics of risk are necessary. In addition, while academics are focusing on quantitative measures of risk, practitioners "know" that the greatest peril they face is a qualitative measure, "maverick risk"-the risk of being wrong and alone. Both the topic of using multiple metrics of risk and the topic of maverick risk are clearly in need of greater exploration in the literature. 
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 3
Volume: 59
Year: 2003
Month: 5
X-DOI: 10.2469/faj.v59.n3.2525
File-URL: http://hdl.handle.net/10.2469/faj.v59.n3.2525
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# input file: UFAJ_A_12047407_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard Michaud
Author-X-Name-First: Richard
Author-X-Name-Last: Michaud
Author-Name: Robert Michaud
Author-X-Name-First: Robert
Author-X-Name-Last: Michaud
Title: “Portfolio Resampling: Review and Critique”: A Comment
Abstract: 
 This material comments on “Portfolio Resampling: Review and Critique”.
Journal: Financial Analysts Journal
Pages: 17-17
Issue: 3
Volume: 59
Year: 2003
Month: 5
X-DOI: 10.2469/faj.v59.n3.2526
File-URL: http://hdl.handle.net/10.2469/faj.v59.n3.2526
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Author-Name: Lawrence N. Bader
Author-X-Name-First: Lawrence N.
Author-X-Name-Last: Bader
Title: Treatment of Pension Plans in a Corporate Valuation
Abstract: 
 Failure to adjust corporate valuations for pension assets and liabilities that are separable from the business operations can lead to dramatically misvalued companies. During the 1990s, equity and credit analysts generally relied on the pension costs as reported under Statement of Financial Accounting Standards No. 87. Analysts applauded the rewards of pension plans and ignored the risks. Many were unprepared to see pension income replaced by expense, surpluses by deficits, and contribution holidays by cash demands.I explore the impact of a defined-benefit pension plan on the value of its corporate sponsor. I begin by separating the pension plan from the operating business. In fact, reported pension costs are largely irrelevant to valuing the plan sponsor, and the standard pension liability measurement is incorrect. To understand the value and risk that pension plans bring to their sponsors, analysts must separate the plans from the operating business, ignore the annual cost figures, and focus on the pension assets and liabilities.The overall valuation approach I describe may sound straightforward, but of course, the application involves some devilish details. Complicating factors in determining the pension plan's effect on corporate valuation include the tax-exempt status of the plan, excessive surpluses or deficits, and the risk in the mismatch between plan assets and liabilities. The most important devilish details, however, relate to valuing pension liabilities—in particular, choosing the discount rate and using the accumulated benefit obligation (ABO) instead of the projected benefit obligation (PBO). Liabilities and service costs (included in compensation expense) should be based on the ABO, not the PBO.Earnings valuation models must adjust for debt and for financial assets that are separable from the business operations. A pension plan is simply a combination of debtlike liabilities and nonoperating financial assets. Therefore, when valuing the operating business, analysts must remove the pension plan data—except for the service cost, which is a current compensation expense. The effect of the pension plan is captured simply by adding the pension assets to and subtracting the pension liabilities from the value of the operating business. Failure to separate the pension plan can dramatically overvalue companies when pension assets are outgrowing liabilities and undervalue them when the reverse is true.
Journal: Financial Analysts Journal
Pages: 19-24
Issue: 3
Volume: 59
Year: 2003
Month: 5
X-DOI: 10.2469/faj.v59.n3.2527
File-URL: http://hdl.handle.net/10.2469/faj.v59.n3.2527
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:3:p:19-24




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Author-Name: Leslie Boni
Author-X-Name-First: Leslie
Author-X-Name-Last: Boni
Author-Name: Kent L. Womack
Author-X-Name-First: Kent L.
Author-X-Name-Last: Womack
Title: Wall Street Research: Will New Rules Change Its Usefulness?
Abstract: 
 Differences in how retail and institutional investors use analyst research cloud the future usefulness of recent reforms. Virtually anyone with an opinion on the controversies surrounding Wall Street analysts has chimed in with criticisms, complaints, and anecdotes about analyst conflicts and misjudgments. And not without cause. Clearly, two decades of ebullient bull markets leading up to the year 2000 highs created “opportunities” for sell-side analysts and their firms to engage in questionable and objectionable behavior.The clamor about analyst lack of objectivity has resulted in a number of changes. The U.S. Congress held hearings in the summer of 2001, Merrill Lynch and Company agreed in a $100 million settlement with the state of New York to make changes in the monitoring and compensation of its analysts, and by the summer of 2002, the U.S. SEC had approved new NASD and NYSE rules for sell-side analysts. These rules mandate the separation of research and investment banking; prohibit the compensation of analysts from specific investment banking deals; prohibit the managers of a company covered in an analyst's report from reviewing, approving, or changing the sell-side analyst's final judgments; prohibit banks from offering favorable research to companies in exchange for investment banking business; and require increased disclosures in such areas as analysts' personal trading positions. In addition, a $1.4 billion “global research settlement” has been reached between the SEC, the New York attorney general, and the largest U.S. investment firms to resolve issues of conflict of interest, produce reform in the industry, and shore up the integrity of equity research.Many of the new requirements are clear attempts to disclose and potentially remove biases associated with the capital-raising pressures on analysts. Other changes are intended to educate retail investors. Will the recent efforts to “fix” sell-side research make investors better off in the long run? What value does Wall Street research have for investors—retail and institutional—and how will that value change in the future?Retail investors and institutional investors use analyst reports differently. Retail investors are prone to rely on the level of a recommendation, whereas institutional investors are likely to focus on the direction of change relative to the analyst's previous recommendation.We discuss how, in light of the differences in these perspectives, the rule changes and negotiated settlements will affect sell-side research in the future. We conclude as follows:The cost of research is likely to rise. A bundled service, such as investment research, which is usually paid for through trading commissions, is not really a free good. If the cost of research is unbundled, the price must be paid in the form of either increased trading or higher fees.The scope of research is likely to narrow. Brokerage firms have already been announcing cuts in their research departments, reductions in the number of staff analysts, and discontinuations of coverage of some companies and industries.Bias may not decrease. One source of strong pressure for “optimism bias” in analyst recommendations is the need to keep access to the managers of the companies they cover. Whether this pressure will be reduced by the rule changes is unclear. In addition, if allowed, brokerage firms could choose to fund the most positively biased independent research firms.The cost of issuing IPOs could rise on average while the quality of IPOs declines. The elimination of sell-side analysts from the IPO process could result in more unprofitable deals reaching the market and greater uncertainty in expected returns from IPOs in general, creating a classic “lemons” problem.The quality of analyst research may not improve, on average, because of reduction in the funding of research.In summary, institutional investors will continue to be in a better position than retail investors to observe and understand the subtleties of sell-side research. Although partly designed to improve the lot of retail investors, the new rules and settlements are not likely to render them better able to compete against institutional investors when attempting to use Wall Street research.
Journal: Financial Analysts Journal
Pages: 25-29
Issue: 3
Volume: 59
Year: 2003
Month: 5
X-DOI: 10.2469/faj.v59.n3.2528
File-URL: http://hdl.handle.net/10.2469/faj.v59.n3.2528
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Author-Name: Robert Ferguson
Author-X-Name-First: Robert
Author-X-Name-Last: Ferguson
Author-Name: Dean Leistikow
Author-X-Name-First: Dean
Author-X-Name-Last: Leistikow
Author-Name: John R. Powers
Author-X-Name-First: John R.
Author-X-Name-Last: Powers
Title: Is the Insurance Business Viable?
Abstract: 
 The insurance business is fraught with problems for which, in many insurance lines, a solution that is acceptable to consumers and leaves the insurance business viable is not likely. We analyze the factors that create this situation. Consumers often view economically viable premiums as too high. In these cases, the tendency of private insurers is to abandon those lines to avoid failure. Pressure then mounts for government to provide insurance at “affordable” premiums or for government to force the insurance companies to do so. The results of the availability of such affordable insurance are not in consumers' interests. The insurance business is subject to problems that have no obvious solutions. Much criticism of the business focuses on unscrupulous insurance companies or unscrupulous consumers, but although these problems are serious, they are not the fundamental problem. All that is needed for the viability or acceptability of an insurance line to be problematic is that insurance companies and consumers act honestly in their own apparent self-interests. Similar to the “problem of the commons,” individuals doing what seems right for them can destroy the benefit to all.The problem is the system itself, but several factors are important contributors to this conclusion. They include inadequate information about probability densities, asymmetrical information about risk, political pressure, political campaign strategies, and downward-sloping demand curves.We analyze the factors that affect the viability of many insurance lines and illustrate the principles with numerical examples that are meant to be realistic. These examples reinforce the theoretical concerns. We also describe how the principles apply to what is going on in windstorm insurance and medical malpractice insurance.The insurance business is not likely to be viable in a realistic world of heterogeneous risks and preferences. Such a world requires creating and pricing by risk classes, which can lead to charges of unfairness, profiling, and discrimination. Indeed, pricing by risk classes is profiling—profiling by claim history, credit history, geographical location, neighborhood, income level, wealth, and so on. When risk classes are created, many lower-income people and minorities find themselves in classes with above-average risk and, therefore, above-average insurance premiums in relation to coverage. When insurance premiums are unacceptably high for a group, outcry can arise from the media, activists, regulators, and politicians proclaiming that the profiling is unfair. This possibility prevents the delineation of many useful risk classes and the establishment of sufficiently high premiums in high-risk classes to make the insurance business economically viable.For example, windstorm (hurricane) premiums that make the insurance business economically viable in this line are likely to be so high that a substantial proportion of homeowners in each risk class choose not to buy the insurance. These homeowners say that they “want to buy insurance, but it is too expensive.” Homeowners, activists, the media, and politicians tend to conclude that the insurance companies are unscrupulous. Insurance companies may then be forced to reduce premiums. This process significantly increases the probability that, eventually, the insurance companies will fail or need to be bailed out.Insurance companies try to protect themselves by writing policies that exclude events that either are not insurable (such as acts of war) or cannot provide a profit (such as expensive experimental health care). The enormous personal tragedies associated with these events, however, create well-intentioned pressure by consumers, activists, regulators, and politicians to force insurance companies to cover the events. Two possibilities result. Either the insurance premium is raised to cover losses from these events or it is not. If it is raised, less-risk-averse homeowners will drop their coverage and some relatively risk-averse homeowners will be forced to buy coverage that they would not otherwise buy. If the premium is not raised, homeowners will receive an apparent free lunch but the insurance companies will fail, will need to be bailed out, or will abandon the market.Forcing coverage can benefit politicians. Most voters do not understand many of the issues. They do not understand that, barring bailouts, if insurance companies neither fail nor abandon the market, policyholders must end up with higher premiums. Because of this lack of understanding, many voters, nonpolicyholders as well as policyholders, believe that politicians did them a favor by forcing coverage. If the insurance companies do fail or abandon the market, the politicians can (and may be forced by the electorate to) step in and provide coverage through the government. This action is also viewed favorably by many voters.But none of these alternatives is socially optimal.
Journal: Financial Analysts Journal
Pages: 30-41
Issue: 3
Volume: 59
Year: 2003
Month: 5
X-DOI: 10.2469/faj.v59.n3.2529
File-URL: http://hdl.handle.net/10.2469/faj.v59.n3.2529
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:3:p:30-41




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# input file: UFAJ_A_12047411_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Darrell Duffie
Author-X-Name-First: Darrell
Author-X-Name-Last: Duffie
Author-Name: Alexandre Ziegler
Author-X-Name-First: Alexandre
Author-X-Name-Last: Ziegler
Title: Liquidation Risk
Abstract: 
 Turmoil in financial markets is often accompanied by a significant decrease in market liquidity. Here, we investigate how such key risk measures as likelihood of insolvency, value at risk, and expected tail loss respond to bid–ask spreads that are likely to widen just when positions must be liquidated to maintain capital ratios. Our results show that this sort of illiquidity causes significant increases in risk measures, especially with fat-tailed returns. A potential strategy that a financial institution may adopt to address this problem is to sell illiquid assets first while keeping a “cushion” of cash and liquid assets for a “rainy day.” Our analysis demonstrates that, although such a strategy increases expected transaction costs, it may significantly decrease tail losses and the probability of insolvency. In light of our results, we recommend that financial institutions carefully examine their strategies for liquidation during periods of severe stress. Turmoil in financial markets is often accompanied by significant decreases in market liquidity. Financial institutions that need to liquidate positions under such stress to meet capital requirements may, therefore, face unexpectedly high bid–ask spreads, thus triggering additional losses in the form of transactions costs. The result could be a vicious circle of sales causing illiquidity losses, which necessitate further sales, and so on. Although the negative correlation between bid–ask spreads and asset prices clearly has adverse effects on financial institutions, especially those with significant leverage, the magnitude and practical relevance of this phenomenon for risk management have not been assessed.We investigate the impact on key risk measures—such as the likelihood of insolvency, value at risk (VAR), and expected tail loss—of spreads that are likely to widen just when positions must be liquidated to maintain capital ratios. We consider a simple model of a leveraged financial institution that holds cash, liquid assets, and illiquid assets and that is subject to minimum capital requirements. Using a Monte Carlo analysis of 10-day trading periods, we show that negative correlation between asset prices and bid–ask spreads may cause significant increases in all of these risk measures. The relevance of this link for risk management is especially strong in the presence of fat-tailed returns, which are prevalent in many markets.We also show that high volatility in asset returns need not increase the impact of illiquidity on risk measures. Intuitively, one would expect increasing volatility to lead to more frequent asset sales and, therefore, to larger spread-induced losses. Although increasing volatility does indeed increase the relative impact of bid–ask spreads on the probability of insolvency, we find that high volatility may actually reduce the relative effect of spreads on VAR and expected tail loss.Our analysis of the effect of spread volatility shows that the relative increases in VAR and expected tail loss that are induced by correlation between spreads and asset prices are moderate. Interestingly, however, when both price and spread volatility are increased, the probability of insolvency can become dramatic, even for the short time horizons that we consider.A potential strategy to address the dangers associated with a negative correlation between market liquidity and asset prices is for a financial institution to sell illiquid assets first and keep a “cushion” of cash and liquid assets for a rainy day. According to the simple model we present, such a strategy, while increasing expected transaction costs, may significantly decrease tail losses and, especially, the probability of insolvency. This “cash-last” liquidation strategy does not, however, bring the risk of insolvency to negligible levels when asset returns and bid–ask spreads have fat tails.Our results suggest an important trade-off between the goal of minimizing expected transaction costs associated with stressed asset “fire sales” and the goal of reducing the probability of insolvency. In light of this trade-off, financial institutions would be wise to carefully examine their strategies for liquidation during periods of severe stress.
Journal: Financial Analysts Journal
Pages: 42-51
Issue: 3
Volume: 59
Year: 2003
Month: 5
X-DOI: 10.2469/faj.v59.n3.2530
File-URL: http://hdl.handle.net/10.2469/faj.v59.n3.2530
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:3:p:42-51




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# input file: UFAJ_A_12047412_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: A Century of Investors
Abstract: 
 Today's investors are more rapidly informed than their predecessors a century ago, but they are neither better informed nor better behaved. In this article, a picture of individual investors during 1906–1918 drawn from investor questions to World's Work magazine is compared with a picture of investors of the 21st century as reflected in today's media. The investors of a century ago, like today's investors, wanted to be secure while they aspired to be rich, wanted to save while they were tempted to spend, wanted to feel the joy of pride and avoid the pain of regret. Today's investors are more rapidly informed than their predecessors a century ago, but they are neither better informed nor better behaved. This article presents a picture of investors in the 1906–18 period from questions to World's Work magazine and compares investors then with today's investors.The financial markets were as turbulent during the early 20th century as they are today. The period included substantial stock market declines and increases. Investors in the early 20th century hoped to make their fortunes from mines, automobiles, and wireless telegraphs; they could hardly imagine today's Internet. Yet, investment warnings then are similar to warnings today, and lessons that should have been learned then need to be repeated today.Viewed from the distance of time, the debate about stocks in the early decades of the 20th century appears as a shouting match between people promoting all stocks and people completely opposed to stocks. In fact, however, attitudes toward stocks a century ago were nuanced, very much like attitudes today. The World's Work distinguished between stocks of established companies and stocks of new companies and between “business men,” who understood the risks of business, and “inexperienced people,” who did not. The magazine did not oppose investment in new industrial companies by the experienced investor or investment in established businesses by the small, inexperienced investor but was unalterably opposed to the investment of savings by inexperienced people in new, poorly backed, or wildly financed enterprises.Mining enterprises constituted a large portion of the “poorly backed and wildly financed” enterprises of a century ago. Recently, a large portion of such enterprises was the dot-com companies.Investors want income as well as growth; they want safety as well as riches. That was true a century ago, and it is true today. The World's Work was emphatic in warning investors against unrealistic aspirations. The magazine noted that bond dealers receive numerous requests for investments that are sure to pay the returns at all times—without regard to market or price movements. The lack of wisdom by bond buyers is demonstrated, the magazine noted, when trustees come to settle up estates and nearly always encounter bonds for which no quotation is even obtainable.Some investors want more than income and safety; they want riches. An investor wrote to the World's Work in 1910 asking for securities that would turn her thousand dollars into a million dollars. Such desires can lead to speculation. In this case, the World's Work was emphatic that speculation based on tips from strangers—whether stock market operators, financial editors, or pundits of any sort—is almost certain to bring the investor to grief.The investors of a century ago, like today's investors, wanted to be secure while they aspired to be rich, wanted to save while they were tempted to spend, wanted to feel the joy of pride and avoid the pain of regret. As the World's Work concluded, “Human nature is human nature.”
Journal: Financial Analysts Journal
Pages: 52-59
Issue: 3
Volume: 59
Year: 2003
Month: 5
X-DOI: 10.2469/faj.v59.n3.2531
File-URL: http://hdl.handle.net/10.2469/faj.v59.n3.2531
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:3:p:52-59




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# input file: UFAJ_A_12047413_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martha L. Carter
Author-X-Name-First: Martha L.
Author-X-Name-Last: Carter
Author-Name: Sattar A. Mansi
Author-X-Name-First: Sattar A.
Author-X-Name-Last: Mansi
Author-Name: David M. Reeb
Author-X-Name-First: David M.
Author-X-Name-Last: Reeb
Title: Quasi-Private Information and Insider Trading
Abstract: 
 We investigated the informational content of corporate insider buying activity and concluded that the market impact of insider transactions varies with the length of interval between insider buy transactions and the disclosure of information to the public. Analysis of a sample obtained from the Washington Services Insider Trade database indicates that (1) the informational content of insider transactions leaks out prior to the U.S. SEC announcement, (2) information leakage is positively associated with the length of the interval between the insider buying activity and the SEC announcement, (3) information leakage for CEOs and other officers differs only marginally, and (4) those insiders with the longest delay in reporting have the greatest total impact on stock prices. Our findings suggest that insiders are able to use their disclosure timing to manipulate the stock price impact of their buying activity. Although prior studies on insider trading have documented a positive correlation between insider trades and stock price changes, most of these studies focused on either the abnormal returns after insider trading transactions or the speed with which private information is absorbed in stock prices. In this study, we address an alternative view—the impact of the timing of insider trading announcements on stock prices. Specifically, we examined the length of the reporting interval between the insider buying activity and the disclosure of the information to the public. That is, we explored whether the reporting interval is related to the timing and the size of stock price impact. We posited that the longer the time interval between the insider trade and the disclosure of the trade, the greater the potential for pre-announcement stock price run-ups. We also examined whether two types of corporate insiders (CEOs and “others”) differ in their dissemination of information (leakage) and their disclosure timing.Our analysis suggests that insider buying activity has an effect on stock prices that is positively related to the length of the reporting period. The insider transactions with the longest reporting intervals have the greatest information leakage and the greatest total impact on stock prices. We found that about 15 percent of insiders' buying transactions are reported beyond the maximum SEC allowable time window (a maximum of 41 calendar days for the disclosure of the insider trade to the public). Overall, the results indicate that insiders are able to use their disclosure timing to manipulate the impact of their buying activity on stock prices. Traders with access to predisclosure insider buying information are also able to earn excess return from this disclosure delay.Our empirical analysis provides important insights concerning the effects of insider buying activity and, in general, supports the information leakage hypothesis. We provide evidence on the disclosure of insider buying activity and its impact on stock returns. We found that the decision of the insider to delay reporting of trading activity increases the time to incorporate quasi-private information into market prices but that a substantial portion of this information leaks out prior to the public announcement. We also found evidence consistent with the hypothesis that the amount of leakage is a function of the length of the reporting interval. Although our analysis suggests that information leakage is a concern for both CEOs and other officers, because we found similar reporting patterns for both groups, the results indicate that the reporting-interval impact is greater for CEOs than for the other officers.
Journal: Financial Analysts Journal
Pages: 60-68
Issue: 3
Volume: 59
Year: 2003
Month: 5
X-DOI: 10.2469/faj.v59.n3.2532
File-URL: http://hdl.handle.net/10.2469/faj.v59.n3.2532
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:3:p:60-68




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# input file: UFAJ_A_12047414_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David C. Hyland
Author-X-Name-First: David C.
Author-X-Name-Last: Hyland
Author-Name: Salil K. Sarkar
Author-X-Name-First: Salil K.
Author-X-Name-Last: Sarkar
Author-Name: Niranjan Tripathy
Author-X-Name-First: Niranjan
Author-X-Name-Last: Tripathy
Title: Insider Trading When an Underlying Option Is Present
Abstract: 
 We argue that increased leverage, lower litigation risk, and reduced trading costs in the options market result in lower incentives for informed market participants to trade in stocks that have options listed than in stocks without traded options. We also hypothesize that the underlying market for optioned stocks is informationally more efficient than that for nonoptioned stocks. Our cross-sectional tests of U.S. market data show that the level of insider trading is significantly lower, as a percentage of total trading volume, for optioned stocks than for nonoptioned stocks during months when insider trading is intense. When we compare the magnitude of stock price adjustments to insider trades, our results indicate that the price reaction to insider trading events is less pronounced for optioned stocks. Both pieces of evidence are consistent with the view that informed trading is less likely to occur and its price effect is better anticipated in the underlying market for optioned stocks than for nonoptioned stocks. Previous research has shown that in the U.S. markets, the market for a particular stock benefits in several ways when options on that stock are listed on the exchange. These benefits in the market for the underlying stock include significant price appreciation, increased trading volume, and reduced price volatility. The effects of insider trading in the underlying stock because of options listing, however, have not been examined. We analyze cross-sectional differences in insider trading patterns and stock price reactions to insider trades in optioned and nonoptioned stocks.Options markets provide several practical advantages to informed traders. First, options investment allows higher leverage than trading in the underlying stock. Second, option traders enjoy the borrowing and lending rates implied in option prices, which are comparable to rates available only to institutional traders. Third, short-sale restrictions can be circumvented in the options market. Fourth, informed traders may incur lower legal risks because of the lack of explicit disclosure laws in the options market. Furthermore, existing insider trading laws are not as strictly enforced in the options market as they are in the stock market. All these reasons suggest that, given a choice, an insider would rather trade in the options market than in the market for the underlying stock. Because insiders in nonoptioned stocks do not have the same choices, we tested whether insider trading in this market is higher than in the market for optioned stocks.We used insider trading data on optioned and nonoptioned stocks from the U.S. SEC's Ownership Reporting System summary files. To ensure that the trades were driven by material nonpublic information, we used months we defined as “intensive insider trading months” (months in which three or more insider trades occurred in the same direction and none occurred in the opposite direction) in both samples. Our results indicate that, as a percentage of total trading volume, the average level of insider trading is lower in optioned stocks than in nonoptioned stocks. These results persisted even after differences in size and trading volume between the two samples had been accounted for.We propose that the incentive to gather information is greater for optioned companies because returns in the options market can be considerably higher than returns in the stock market. Arbitrage opportunities arise if the underlying stock market does not reflect that information. Such opportunities should translate into improved price discovery in the market for the underlying stock. Previous research shows that earnings announcements, which are public information, are more rapidly reflected in optioned-stock prices than in nonoptioned-stock prices. We tested the extent to which optioned stock prices reflect private information.We examined insider trading because it is not public until after the fact. Compared with a public event, such as an earnings release, the information content of an insider trade is difficult to anticipate for several reasons. First, knowledge about most insider trades is not available to the public until after the trade has been reported to the SEC. Second, information-based insider transactions are not predictable. Third, the securities analysis industry has invested considerable physical and human capital in collecting, processing, and interpreting earnings-related data. Therefore, when we tested whether the information underlying an insider trade is better anticipated in the market for optioned stocks, we were actually subjecting the information hypothesis to a stronger test than testing the information effect of a public event.We estimated and compared for optioned and nonoptioned stocks the excess returns in and after months with intensive insider trading. Our results show that, whereas insiders investing in nonoptioned companies earn significantly positive excess returns over a one- to six-month interval following their stock transactions, insiders in optioned companies receive zero excess returns over the corresponding periods. The excess returns for nonoptioned stocks are significantly higher, even after control for market capitalization and the level of insider trading.These results thus imply that the insider trades in nonoptioned stocks have higher information content than those in optioned stocks. From a practical standpoint, caution should be used in tracking insider trading data. Insider trades may be information or liquidity motivated. Insider trades in optioned stocks may be primarily liquidity motivated, whereas those in nonoptioned stocks may be liquidity as well as information motivated. Options, if available, may be a better vehicle for informed trading.
Journal: Financial Analysts Journal
Pages: 69-77
Issue: 3
Volume: 59
Year: 2003
Month: 5
X-DOI: 10.2469/faj.v59.n3.2533
File-URL: http://hdl.handle.net/10.2469/faj.v59.n3.2533
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:3:p:69-77




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# input file: UFAJ_A_12047415_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Stephen Kealhofer
Author-X-Name-First: Stephen
Author-X-Name-Last: Kealhofer
Title: Quantifying Credit Risk II: Debt Valuation
Abstract: 
 “Quantifying Credit Risk I” (in the January/February 2003 Financial Analysts Journal) presented evidence on the effectiveness of using the information in market equity prices to predict corporate default. This Part II links those results to the valuation of corporate debt and shows that, contrary to previous negative results, the approach pioneered by Fischer Black, Myron Scholes, and Robert Merton provides superior explanations of secondary-market debt prices. Prior research using the Merton approach to value corporate liabilities has yielded negative results. This article reports on new research indicating that the Merton approach, in fact, yields quite accurate estimates of the secondary-market prices of corporate bonds. The primary difference between this research and earlier work is the substitution of empirically based default probabilities for the lognormality assumption of the conventional Merton method.This article is the second in a two-part series on quantifying credit risk. Part I, which was published in the January/February 2003 issue of the Financial Analysts Journal, presented results of research on the model's default-predictive power. The ultimate aim of default prediction is to determine the appropriate market value of default risk. Part II explores the connection between default prediction and valuation. First, it shows that the levels of predicted individual and aggregate probabilities of default from the KMV model display considerable variation through time and that these predictions correspond to the actual, subsequently realized levels of default. Second, contrary to past understanding, most of the variation in the spreads on corporate bonds can be attributed to variation in expected default probability, not to the risk premium on corporate bonds, which is relatively stable through time. Third, Part II shows that the term structure of bond spreads corresponds empirically to the term structure of default risk.Finally, the default probabilities from the KMV model are used in an option theoretic framework to explain individual corporate debt spreads. In sharp contrast to previous academic work, the tests I explore found that the generalized Merton approach provides significantly better explanations of debt prices than those provided by alternative models. These tests used significantly more data and more powerful alternative models than previous studies.The findings suggest that the Black–Scholes–Merton approach, when appropriately executed, provides the long-sought quantification of credit risk. As an objective cause-and-effect model, the KMV model also provides analytical insights into corporate behavior, thus creating the basis for a continuing rich research program into default risk, capital structure, and debt valuation. For portfolio managers, the link from debt values to equity values featured in the KMV model provides a way to understand the correlations between individual credit risks and the correlation between the performance of equity and corporate debt portfolios. For managers of debt portfolios, the results suggest significant new approaches to decomposing and evaluating portfolio performance.
Journal: Financial Analysts Journal
Pages: 78-92
Issue: 3
Volume: 59
Year: 2003
Month: 5
X-DOI: 10.2469/faj.v59.n3.2534
File-URL: http://hdl.handle.net/10.2469/faj.v59.n3.2534
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:3:p:78-92




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# input file: UFAJ_A_12047416_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: James H. Dignan
Author-X-Name-First: James H.
Author-X-Name-Last: Dignan
Title: Nondefault Components of Investment-Grade Bond Spreads
Abstract: 
 Traditionally, attempts at decomposing the spread between risk-free debt and corporate debt has focused exclusively on default risk. This focus continues despite the fact that the data indicate that the required spreads for higher-rated corporate bonds are normally far smaller than the spreads available in the market. This article challenges the traditional notion of an “excess spread” and, instead, attributes the additional spread to non-default-related factors, such as liquidity and spread volatility. The costs associated with both liquidity and spread volatility are examined, and a framework is provided for the investor to calculate adequate compensation for such costs. In theory, the difference in yield between a risk-free U.S. Treasury security and a non-risk-free bond should reflect the compensation required to equate the cash flows of the two securities (i.e., the yield premium, or spread, should simply reflect the risky security's expected loss relative to that of the risk-free security). In practice, however, the available market spreads for investment-grade securities are habitually greater than those required by even the most plausible loss scenarios. That the spread in the marketplace is greater than the “required” spread for expected losses raises the question of whether the corporate debt market is subject to systematic mispricing or whether this “excess spread” is, in fact, compensation for non-default-related costs.I propose that excess spread does not exist, because the spread takes into account certain non-default-related costs—namely, the costs of illiquidity and spread-volatility risk—that require as much consideration from certain investors, such as total-rate-of-return portfolio managers, as does default risk. This article provides a framework for investors who do not hold fixed-income securities to maturity to calculate adequate compensation for such costs. I do not use “liquidity” as a catchall phrase to mean “everything we can't explain.” On the contrary, I clearly define liquidity as a security's bid–ask spread and consider that liquidity involves the very real cost of buying and selling securities. “Spread volatility” is defined as the basis risk between a risky bond and a duration-equivalent Treasury security and involves the price risk between a risky bond and a risk-free bond.Illiquidity and spread volatility affect the investor who has a time horizon that is shorter than the security's maturity, and these risks must be examined as a component of that security's relative value. At its core, illiquidity involves the inherent price loss associated with crossing the market's bid–ask spread; spread volatility involves the price risk of the risky security versus the risk-free security. If the investor has a time horizon shorter than the bond's maturity, the investor risks that the terminal price of the security will underperform to the degree that its total return (i.e., incremental yield plus price change) is less than that of the risk-free security.The risks of illiquidity and spread volatility are every bit as real as default risk for investors who do not hold debt securities to maturity. Unlike default risk, however, which affects all investors equally, the costs of these two risks have a more subjective component: The required compensation varies with the constraints of the marginal investor. For this reason, a backtest of these costs with any type of realistic historical analysis is impossible. Rather, I outline how one might calculate these costs given a certain set of constraints.This framework involves a Monte Carlo technique to simulate bid–ask spreads and terminal spreads for calculating the holding-period returns that normalize the relationship between bonds with different characteristics. Additionally, I propose a risk-adjustment technique that allows the investor to customize return profiles to match a particular risk preference. This simulation, or option-based approach, gives the investor the ability to replicate the distribution around an expected outcome and to price the increased variability in a rigorous fashion to identify the most preferable return profile for the specific investor. This approach's advantage is that it allows the investor to customize a return profile and, hence, optimize return per unit of risk.
Journal: Financial Analysts Journal
Pages: 93-102
Issue: 3
Volume: 59
Year: 2003
Month: 5
X-DOI: 10.2469/faj.v59.n3.2535
File-URL: http://hdl.handle.net/10.2469/faj.v59.n3.2535
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:3:p:93-102




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# input file: UFAJ_A_12047417_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Financial Instruments and Institutions: Accounting and Disclosure Rules (a review)
Abstract: 
 Through real-life cases and the latest academic research, this exhaustive text provides details of the highly specialized reporting practices (and related controversies) of thrift institutions, mortgage and commercial banks, lessors, property/casualty insurers, and life insurers. 
Journal: Financial Analysts Journal
Pages: 103-103
Issue: 3
Volume: 59
Year: 2003
Month: 5
X-DOI: 10.2469/faj.v59.n3.2536
File-URL: http://hdl.handle.net/10.2469/faj.v59.n3.2536
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# input file: UFAJ_A_12047418_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “Single-Period Mean–Variance Analysis in a Changing World” by Harry M. Markowitz and Erik L. van Dijk, which was published in the March/April 2003 issue. 
Journal: Financial Analysts Journal
Pages: 18-18
Issue: 3
Volume: 59
Year: 2003
Month: 5
X-DOI: 10.2469/faj.v59.n3.2537
File-URL: http://hdl.handle.net/10.2469/faj.v59.n3.2537
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# input file: UFAJ_A_12047419_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Managing Investments for the Long Term
Abstract: 
 Today's investment world is tyrannized by our own benchmarks, leading to countless costly investment management decisions, but we should not discard the concept of benchmarking even if we throw out the current fixation on tracking error. Successful investing over the long term requires a recognition that there is more than one measure of risk and that benchmarks should be relevant to investors' diverse long-term concerns. For that purpose, benchmarks should typically meet three objectives: finance the fund's obligations, deliver positive real returns while avoiding material losses, and deliver performance above peer medians. The sad fact is that the best benchmarks and strategies for the long term are usually discarded by sponsors because of a short-term fixation on benchmarks that meet only the peer-group objective. 
Journal: Financial Analysts Journal
Pages: 4-8
Issue: 4
Volume: 59
Year: 2003
Month: 7
X-DOI: 10.2469/faj.v59.n4.2540
File-URL: http://hdl.handle.net/10.2469/faj.v59.n4.2540
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:4:p:4-8




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Author-Name: Peter L. Bernstein
Author-X-Name-First: Peter L.
Author-X-Name-Last: Bernstein
Title: Points of Inflection: Investment Management Tomorrow
Abstract: 
 In the future, the way investment professionals earn a living is going to be so different as to be almost unrecognizable. The world of investment management has passed through a point of inflection, which means the same forces that worked in a particular way for a long time have begun to operate in different and unfamiliar directions. The way we earn our living is going to be so changed as to be almost unrecognizable, especially in research, indexing, benchmarking, and long-only investing.Ever since May Day in 1975, brokerage revenue has been too low to finance investment research without the additional revenues of investment banking. But even though the old habit of paying for research with soft dollars made life easy for both managers and clients, those days are gone forever. As so often happens, this process ultimately ran to an extreme. Truly independent research—aka hard dollar research—will be the name of the game. Hard dollars come directly out of managers' pockets, but the net cost to clients should be no greater than before, and the quality of research should be higher. There is no such thing as a free lunch.Indexed investing faces serious problems with more frequent and costly turnover. In addition, the indexes no longer qualify as “diversified portfolios.” Finally, if expected returns are in single digits rather than double digits, reliance on market returns may fail to cover required returns, making alphas and active management increasingly important.Benchmarking locks skilled managers into style boxes or into slavishly following some passive portfolio. But maximizing returns means giving managers with skill the greatest possible breadth in security selection. Liberating skilled managers from constraints is the only hope for containing the exodus of the brightest people to the world of hedge fund investing.The critical question, however, is: Benchmarking to what? The true benchmark is the return required by the structure and timing of the investor's liabilities. The critical ingredient of performance measurement, then, is a manager's contribution to the fund's required rate of return relative to the risk the manager takes. Conventional applications of benchmarking miss this essential point, but the bursting of the bubble has begun to refocus performance measurement in the more appropriate direction of required returns and risk budgeting.As hedge funds demonstrate the utility of the short-selling function, long-only investing is becoming obsolete. There is no reason short selling should be the privileged sanctuary of those managers who call themselves hedge funds. Why should conventional managers continue to operate with one hand behind their backs? Conference agendas today demonstrate that short selling is rapidly moving into the mainstream.Investment management has passed through a point of inflection. The supply chain of investment research will never again concentrate under the roof of investment banking. When returns are not as easy to come by, the constraints on manager activity imposed by benchmarking are archaic. Indexing has become more costly and more risky. And tomorrow, new techniques—as well as old techniques such as selling short—that widen a manager's range of choices will make sense in comparison with the old ways of doing things.
Journal: Financial Analysts Journal
Pages: 18-23
Issue: 4
Volume: 59
Year: 2003
Month: 7
X-DOI: 10.2469/faj.v59.n4.2541
File-URL: http://hdl.handle.net/10.2469/faj.v59.n4.2541
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# input file: UFAJ_A_12047421_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jack Treynor
Author-X-Name-First: Jack
Author-X-Name-Last: Treynor
Title: How to Regulate a Monopoly
Abstract: 
 A better method for regulating monopolies than rate regulation is to require that monopolists' costs in marginal plant equal their selling prices. The traditional approach to protecting the monopolist's customer has been rate regulation—fixing the monopolist's price to achieve a certain desired return on investment. But ROI measures focus on average, rather than marginal, cost. So, in the model for traditional rate regulation, output expands until average cost equals price. If average cost trails marginal cost as output rises, the output level at which average cost equals price is even higher than the output level at which marginal cost equals price. Thus, conventional regulation of a monopolist's price results in an even higher level of output than would perfect competition.The better approach to regulating a monopolist is to measure the monopoly's variable unit cost—raw materials (including energy) and direct labor—and require the monopolist to increase output until the cost in the monopoly's marginal plant just equals what its customers show they are willing to pay. If regulators required a competitive level of output, letting customers set the corresponding price, then (1) regulation would be simpler and less controversial because variable cost is easier to estimate than average cost and because only current data would be required for estimating costs and (2) the risks of plant decisions would be borne by investors rather than by customers.
Journal: Financial Analysts Journal
Pages: 24-25
Issue: 4
Volume: 59
Year: 2003
Month: 7
X-DOI: 10.2469/faj.v59.n4.2542
File-URL: http://hdl.handle.net/10.2469/faj.v59.n4.2542
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:4:p:24-25




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# input file: UFAJ_A_12047422_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: J. Benson Durham
Author-X-Name-First: J. Benson
Author-X-Name-Last: Durham
Title: Monetary Policy and Stock Price Returns
Abstract: 
 Some studies have argued that monetary policy affects stock market performance over monthly or quarterly horizons, which has important implications for both investors and central bankers. Previous findings, however, are not robust to the sensitivity analysis reported here. For example, division of the sample period into subperiods and use of rolling regressions for the time-series data indicate that for the vast majority of countries (including the United States), the relationship largely vanished in more recent periods. Also, panel regressions that incorporate cross-sectional variance among the 16 countries suggest that the relationship between monetary policy and stock returns is weak or nonexistent. Analysis of excess stock price return, as opposed to raw return, also indicates no relationship. Finally, alternative measures of monetary policy indicate no correlation between easing/tightening cycles and stock returns. Stock market participants justifiably watch monetary policy quite closely. Some studies have suggested that changes in central bank policy correlate with stock market performance. Specifically, easing (tightening) cycles are associated with higher (lower) stock prices. Significant results of tests for this relationship imply that profitable trading strategies are feasible and that central bankers can effectively target stock prices. Most researchers have focused on short-run data from the United States; only a few studies have examined long-run performance or cross-country data.This study reexamined the monthly and quarterly data for 16 countries, including the United States, for the 1956–2000 period in four ways. First, previous studies covered a rather lengthy period, but numerous changes during this 45-year span in the targets of monetary policy and in central bank transparency raise the question of whether the relationship still holds. Therefore, I divided the sample period into subperiod time series and also used rolling estimations. The findings suggest that in recent periods, the relationship between stock returns and monetary policy has weakened in most countries (including the United States).Second, the existing literature has not used cross-sectional variance to influence estimations of the relationship, but whether or not this empirical relationship holds across countries at a given point in time is critical for international equity portfolio managers who must make allocation decisions. Therefore, I conducted panel regressions (using data for the same 16 countries) and largely found no consistently significant correlation between monetary policy and stock returns.Third, previous studies used raw stock price return, not excess return, a distinction that has considerable implications for asset allocation decisions. If changes in the domestic risk-free rate solely drive stock price movements, and if monetary policy has no impact on excess return, then the rationale for portfolio managers to shift into (out of) equity markets and out of (into) other asset classes during periods of easing (tightening) monetary policy is less compelling. I indeed found that the results are highly sensitive to whether raw or excess price return was used.Fourth, because the use of the nominal discount rate in studies of the relationship between stock returns and monetary policy is problematic, this study also used an alternative measure of monetary policy, the inflation-adjusted stance, which also indicated a weak relationship between monetary policy and stock market performance.My findings have implications for investors, portfolio managers, and central bankers. The relationship between monetary policy changes and stock performance in earlier periods may have been an anomaly that investors have since arbitraged away. For example, monetary authorities may have more clearly signaled policy changes, or market participants may have more accurately anticipated policy movements over time. For central bankers, the findings imply that using monetary policy to target stock prices is a complicated (in addition to being a highly controversial) objective. This conclusion is somewhat ironic in light of the increased proportion of equity to total household wealth across some parts of the globe. Apart perhaps from monetary policy surprises, which this study did not directly measure, monetary policy transmission mechanisms that work through the stock market have become less potent even as their potential for real effects has increased.
Journal: Financial Analysts Journal
Pages: 26-35
Issue: 4
Volume: 59
Year: 2003
Month: 7
X-DOI: 10.2469/faj.v59.n4.2543
File-URL: http://hdl.handle.net/10.2469/faj.v59.n4.2543
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# input file: UFAJ_A_12047423_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Lars Oxelheim
Author-X-Name-First: Lars
Author-X-Name-Last: Oxelheim
Title: Macroeconomic Variables and Corporate Performance
Abstract: 
 Increased economic and financial integration and substantial macroeconomic fluctuations require that corporate managers and investment analysts pay more attention than in the past to the link between the “noise” that these fluctuations represent and the company's performance—past and future. For many reasons, company managers must weed out the effects of the noise to obtain a clear picture of the company's intrinsic competitiveness and long-term sustainable profits. The question is: To what extent can outside shareholders and investment analysts adopt this approach to corporate performance? Current reporting practice does not provide these outsiders with an adequate idea of the character and magnitude of the impact of macroeconomic variables on the company. The recommendations of International Accounting Standard 1, Presentation of Financial Statements (as revised in 1997), however, offer an improvement in this important area. This article presents four levels of implementation of IAS 1 and what these levels mean in terms of relevant information transmitted to outsiders. Illustrations are provided of current practices in two global industries and of a release that would meet the informational demands of shareholders and analysts. Increased economic and financial integration and substantial macroeconomic fluctuations require that corporate managers and financial analysts pay attention to the link between the “noise” that these fluctuations represent and a company's intrinsic growth and development. No company can claim any longer to be unaffected by what is happening in the global arena. Yet, the external reporting of most companies does not indicate the extent to which profits are affected by fluctuations in the company's macroeconomic environment during the reporting period.Without this information, outside shareholders and analysts have no chance of figuring out what has happened to the company's sustainable profits and, therefore, its intrinsic competitiveness. Consequently, as regards the effects of a volatile macroeconomic environment, current accounting practice is failing to achieve one of the fundamental goals of external reporting, namely, to provide information for evaluation purposes to shareholders and other stakeholders. Moreover, although the international standard-setting bodies support the notion of “decision relevance” for shareholders, no real progress has been made toward achieving the other fundamental goal of external reporting, namely, to provide shareholders with information about the future prospects of the company. However, International Accounting Standard (IAS) 1, Presentation of Financial Statements (as revised in 1997), indicates that an improvement in this important area may be in the offing.Corporate managers must weed out the effects of noisy macroeconomic factors to obtain a clear picture of the company's long-term sustainable profits and thus the company's intrinsic competitiveness. The question is: How far should this “revised” picture of corporate performance and expectations be extended to outside shareholders and investment analysts? I discuss the ways in which, despite IAS 1, corporate information on the impact of macroeconomic fluctuations that is supplied to outside users of financial statements does not meet their needs for such information. I go on to show how MUST-type analysis (MUST stands for “macroeconomic uncertainty strategy”), which was developed as a management tool, can also be used to report the effects of the macroeconomic environment on the company in the past, expected effects, and the company's strategy for combating adverse effects.If a report about the impact of macroeconomic variables on corporate performance is to be informative, the company has to have made and continue to make systematic analyses of this impact. Powerful outside forces—of which the one exerted by financial analysts may be the strongest—should be at work to increase company managers' interest in discerning to what extent the company's profits stem from its intrinsic competitiveness and to what extent they stem from changes in the macroeconomic environment. This information is needed to decide future strategy, set bonuses, and evaluate subsidiary managers. A MUST-type analysis filters out the (temporary) macroeconomic noise from corporate profits as a first step. After this filtering, an apparently favorable result may be transformed into a strong signal about reduced competitiveness and a “leading indicator” of the need to change product/service or production/distribution strategy. The second step is to formulate a risk management strategy for the future. Does the company need to handle the risks generated by future macroeconomic fluctuations, and if so, how? For companies that handle these steps intelligently, the final step is to communicate this valuable information to the company's outside shareholders and other stakeholders.The article discusses whether IAS 1, as it is likely to be interpreted and implemented, helps outside shareholders understand the impact of macroeconomic fluctuations on the company's performance and recognize the magnitude of macroeconomic risks. Four levels of response to IAS 1 are described in terms of how much and what kind of information is transmitted to outsider shareholders. For illustration, I categorize the annual reports of companies in the global automotive industry and paper/pulp industry for the fiscal years after the IAS 1 recommendations came into force. My conclusion is that at the end of the 1990s, no company in these industries included information in its external reporting that would enable outside shareholders or financial analysts to understand the extent of macroeconomic influences on corporate performance. I illustrate how valuable the information can be. Although technical and other barriers to publishing the output of a MUST-type analysis exist, I list seven compelling reasons that such releases will begin to appear in the not-too-distant future.
Journal: Financial Analysts Journal
Pages: 36-50
Issue: 4
Volume: 59
Year: 2003
Month: 7
X-DOI: 10.2469/faj.v59.n4.2544
File-URL: http://hdl.handle.net/10.2469/faj.v59.n4.2544
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Author-Name: Ananth Madhavan
Author-X-Name-First: Ananth
Author-X-Name-Last: Madhavan
Title: The Russell Reconstitution Effect
Abstract: 
 Significant returns were associated with the annual reconstitution of the Russell equity indexes from 1996 through 2002, which can be explained by both transitory price pressure and the permanent effects of index membership. On the one hand, the return effects represent a significant cost to index funds that rebalance on the reconstitution date. On the other hand, supplying immediacy at this time can be highly profitable. This strategy is typically undiversified, however, and involves high trading costs and price risk as positions are unwound. Indeed, dramatic intraday return volatility characterizes the day of reconstitution. These factors explain the persistence of the reconstitution effects documented here. Periodic index rebalancing is associated with substantial price movements for the stocks added to and deleted from the index. These price changes can significantly affect index managers who rebalance their portfolios on or around the reconstitution date and even traders and portfolio managers with other performance benchmarks who closely follow the reconstitution of widely followed indexes to anticipate buying and selling pressure on securities they plan to trade, as do certain hedge funds. In general, reconstitution effects raise questions about the nature of passive indexing, index construction, and market efficiency.This article examines the annual reconstitution in 1996–2002 of the equity indexes of the Frank Russell Company, which reconstitutes its indexes at the end of June each year on the basis of company market capitalizations at the end of May. The reconstitution of the Russell equity indexes is of particular interest for several reasons. First, the Russell indexes are widely used as performance benchmarks. Second, abnormal returns and volumes accompany the annual reconstitution of the Russell indexes as managers rebalance their portfolios; the effects are significant and pervasive and affect a large number of stocks simultaneously but have not previously been analyzed systematically. Finally, because the criterion for membership in the Russell indexes is based on market cap at the end of May, it can be readily computed in the month before the reconstitution. Consequently, the effects of reconstitution on returns provide valuable insights regarding market efficiency.I show that return effects associated with the Russell reconstitution are much larger in magnitude than the corresponding effects for S&P 500 Index revisions, which have been the focus of much previous research. Specifically, a portfolio (constructed after the determination of new index weights at the end of May) that was long additions to and short deletions from the Russell 3000 Index had a mean return of 14.94 percent in the month of June for the period 1996–2002. The difference in returns across stocks is explained by both permanent changes in liquidity associated with changes in index membership and by shorter-term price-pressure effects induced by fund flows. I confirmed these findings by decomposing returns around the reconstitution date.The findings I present have immediate practical implications. In particular, the return effects represent large hidden transaction costs for investment managers who rebalance portfolios on a reconstitution date to match index revisions. The findings suggest that investment managers can obtain higher realized or net returns by trading ahead of the reconstitution or achieving their desired exposures through swaps or derivatives. A passive fund that does not immediately rebalance to match changes in the benchmark can use passive trading strategies to reduce trading costs, albeit at the risk of increased tracking error. Such a trading strategy can have a high Sharpe ratio. These considerations might also drive the creation of new funds benchmarked to nondisclosed indexes or methods of index construction or revision that are different from those currently in use.Conversely, the results indicate that a strategy of trading on projected index revisions can be profitable. Because of the transparency of the reconstitution process, forecasts of the upcoming June index revision can be made at the end of May with a high degree of precision. Out-of-sample tests reported here indicate that these returns closely mimic the actual returns in June. Such a preemptive strategy can, however, be risky. One reason is that portfolios based on projected additions and deletions typically involve sectoral bets. In 2001, for example, the technology sector was heavily represented among the projected deletions and the financial services sector was prominent among projected additions. Also, when traders unwind their positions on or around the actual reconstitution date, they incur significant timing risk. Dramatic intraday price movements on the reconstitution date itself indicate the difficulty of anticipating excess demand from index funds whose positions may be large relative to the risk arbitrageurs on the opposite side. Liquidity is also paramount. The transaction costs associated with trading small-cap stocks are large, so scaling certain positions is difficult, and short positions in some stocks may simply be impossible. These considerations explain the persistence of index reconstitution effects in an efficient market.
Journal: Financial Analysts Journal
Pages: 51-64
Issue: 4
Volume: 59
Year: 2003
Month: 7
X-DOI: 10.2469/faj.v59.n4.2545
File-URL: http://hdl.handle.net/10.2469/faj.v59.n4.2545
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Author-Name: Michaël Dewally
Author-X-Name-First: Michaël
Author-X-Name-Last: Dewally
Title: Internet Investment Advice: Investing with a Rock of Salt
Abstract: 
 To investigate the origin and quality of investment advice on the Internet, I collected and categorized the stock recommendations (buy, sell, and neutral) distributed on major newsgroups (online discussion groups) for April 1999 and February 2001 and examined the return characteristics of the recommended stocks. I found, first, that Internet stock recommendations are overwhelmingly positive, with a ratio of buy advice to sell advice greater than 7:1. Moreover, most advisors on the Internet follow a momentum strategy: They recommend stocks after the stocks have experienced sharp price increases. In addition, the stock market does not appear to react to these recommendations. I found the two-day cumulative abnormal returns to be mostly insignificant, regardless of the recommendation characteristics. The longer-horizon returns are not significantly above the market's corresponding performance. In summary, I found no evidence that any new information is exchanged in these forums; the recommendations have no informational value. The fears raised by the media about the destabilizing power of such traders who participate in these discussions are thus groundless. With the advent of online trading came a multitude of online resources for individual investors, including websites, chat rooms, newsgroups, and mailing lists, through which investors exchange stock recommendations. The popular media view is that these activities are a destabilizing element in the equity markets. I investigated the origin and the quality of investment advice in a specific segment of the Internet.I collected and categorized the stock recommendations (buy, sell, and neutral) distributed on major newsgroups and examined the return characteristics of the recommended stocks. I chose a month during an up market (April 1999) and a month during a down market (February 2001). An analysis of 33,355 postings yielded 1,106 distinct recommendations during these months. The best-performing sector of the economy during the up market—technology stocks, especially Internet and telecommunications companies—represented more than half of the sample in both months.The reasons for recommending a company are diverse. Not surprisingly, the most commonly cited reason was a recent price upswing for the company's shares. Demands for additional information ranked next highest, and discussions about the prospects of the company's particular industry followed. The variety of reasons indicates a well-informed set of individuals who take advantage of the wealth of resources freely available online.In analyzing these recommendations, I addressed the following questions: (1) What drives advisors in their stock picking? (2) Does the market respond to these Internet recommendations? (3) And do the postings have informational value; that is, what is the subsequent performance of the recommended stocks?I found that newsgroup stock recommendations are overwhelmingly positive, with a ratio of buy advice to sell advice of more than 7:1. This ratio is commensurate with the empirical results for studies of professional analysts' behavior. My finding is striking because the individuals posting on newsgroups (“posters”) are not biased by the agency pressures facing analysts whose firms may be providing investment banking services to the companies they cover. Moreover, most advisors on the Internet follow a momentum strategy. They recommend stocks after the stocks have experienced sharp price increases. Also, the companies they added to and dropped from “coverage” between February 1999 and April 2001 differed significantly in industry-adjusted change in return on equity. Companies added performed significantly better than companies dropped.The stock market does not appear to react to these recommendations. The two-day cumulative market-adjusted returns (CARs) are mostly insignificant, regardless of the recommendation characteristics. Returns for a longer postrecommendation horizon are not significantly higher than the market's performance. In April 1999, a month during which markets were appreciating, the 20-day CAR accruing from following positive recommendations was 2.50 percent. In February 2001, as the market declined, a similar strategy over the same length of time yielded a 0.44 percent return. When I differentiated between one-time and frequent posters, I found that recommendations from frequent posters earned a significantly higher return than those from one-time posters. Although the recommendations had no informational value, frequent posters did exhibit more skill in selecting securities than did casual posters.In summary, the posters favored small technology companies with high price-to-book ratios and extremely good performance in the short term. Once returns were adjusted for the market's return, a strategy strictly following the recommendations did not generate either short- or long-term significant returns. Thus, I found no evidence that any new information is exchanged in these forums. Overall, the fears raised by the media about the destabilizing power of traders who participate in these discussions are unwarranted.
Journal: Financial Analysts Journal
Pages: 65-77
Issue: 4
Volume: 59
Year: 2003
Month: 7
X-DOI: 10.2469/faj.v59.n4.2546
File-URL: http://hdl.handle.net/10.2469/faj.v59.n4.2546
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# input file: UFAJ_A_12047426_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Honghui Chen
Author-X-Name-First: Honghui
Author-X-Name-Last: Chen
Author-Name: Vijay Singal
Author-X-Name-First: Vijay
Author-X-Name-Last: Singal
Title: A December Effect with Tax-Gain Selling?
Abstract: 
 We present evidence on the December effect. When investors do not sell winner stocks in December but postpone their sale to January so that capital gains will not be realized in the current fiscal year, the “winners” appreciate in December. The December effect is relatively easy to arbitrage. We also present evidence regarding the persistence of the January effect and note that the January effect continues because it is difficult to exploit profitably. The January effect is well known and largely explained by tax-loss selling. Tax-gain selling, however, is another activity driven by the tax code and has not received attention. If investors realize capital losses to offset capital gains, a natural strategy for investors is to postpone realization of capital gains so that they can postpone paying taxes on capital gains. Thus, rational investors will sell winner stocks in January instead of December. The selling pressure on “winners” should be small in December, causing the price of winners to rise.Indeed, we found a return of about 2.2 percent in the last five days of December (excluding the last trading day of the year) in the 1988–2000 period for winners, compared with a loss of 0.9 percent in the first five days of the subsequent January. (In our study, winners were those with the smallest price decline from a previously defined high price; losers were stocks with the largest price decline from the high price.) The higher five-day December return was accompanied by significantly lower volume turnover, whereas the five-day January return was accompanied by higher volume. The return and turnover patterns are consistent with tax-gain selling. The January and December effects, in turn, are consistent with the accepted hypothesis explaining turn-of-the-year trading.We analyze the results of simple trading strategies to exploit the December and January effects and discuss the persistence of the effects. The December effect is relatively easy to arbitrage because the winners are usually large-market-capitalization stocks that are liquid and have low transaction costs. A natural proxy for the large winners is the S&P 500 Index. Therefore, a simple, testable trading strategy is to buy S&P futures contracts or SPDRs (Standard & Poor's Depositary Receipts), which serve as an exchange-traded S&P 500 fund, at the close on the seventh trading day before year-end and to unwind the position at the close on the second trading day before year-end. Over the 1988–2001 period, trading SPDRs in this manner would have generated an average return of 1.88 percent. After transaction costs, the net return would have been at least 1.5 percent. Similarly, trading S&P futures would have generated a return of 2.1 percent before transaction costs.With such high realizable returns, a natural question is: Why hasn't the December effect been arbitraged away? The most likely explanation is that the December effect is not well known; it has not been previously documented. The effect is most likely to disappear as soon as arbitrageurs enter the market.The January effect is difficult to exploit profitably. Although losers can command as much as a 10 percent return in the first five days of January, this effect cannot be captured because, unlike strategies for capturing the December effect, low-transaction-cost instruments are not available for trading small-cap stocks. The January effect is concentrated among stocks in the bottom 30 percent of all stocks by market cap. For example, in 2000, the losers had a mean market cap of $108 million, a low median market cap of $26 million, and a median price of only $1.14. Such stocks have high transaction costs, are illiquid, and do not have listed options. Alternative financial instruments are inappropriate because these stocks do not carry a significant weight in any of the tradable indexes (or even in any of the so-called microcap mutual funds). The January effect persists because it cannot be arbitraged.Investors could take advantage of the January effect, however, by altering their trading behavior to hold onto their small-cap losers until the middle of the following January. Such a strategy has a high probability of capturing an extra 10 percent return.
Journal: Financial Analysts Journal
Pages: 78-90
Issue: 4
Volume: 59
Year: 2003
Month: 7
X-DOI: 10.2469/faj.v59.n4.2547
File-URL: http://hdl.handle.net/10.2469/faj.v59.n4.2547
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Author-Name: Andrew L. Berkin
Author-X-Name-First: Andrew L.
Author-X-Name-Last: Berkin
Author-Name: Jia Ye
Author-X-Name-First: Jia
Author-X-Name-Last: Ye
Title: Tax Management, Loss Harvesting, and HIFO Accounting
Abstract: 
 Virtually all companies and individuals are faced with the management of taxable assets. To manage these assets efficiently, investors need to be aware of the impact of taxes on investment returns. In the study we report in this article, we quantified the benefits of loss harvesting and highest in, first out (HIFO) accounting by using Monte Carlo simulations and investigated the robustness of these strategies in various markets and with various cash flows and tax rates. We concluded that a market with high stock-specific 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. Virtually all companies and individuals are faced with the management of taxable assets. To manage such assets efficiently, investors need to be aware of the impact of taxes on investment returns. Most investment managers serving the taxable investing market are happy to trade off known tax costs in the quest for stock-selection added value, or alpha, which is highly uncertain. But the alpha for a taxable portfolio consists not only of this unknown pretax alpha but also a tax alpha—the tax consequences of active management—which can be managed with precision. The largest source of negative tax alpha is capital gains taxes, which are incurred on any profitable sale; the largest source of positive tax alpha is tax savings from realizing losses. The strategy of realizing losses has become known as “loss harvesting” in the tax management arena.In the study reported here, we quantified the benefits of loss harvesting and highest in, first out (HIFO) accounting. We previously used Monte Carlo simulations to study the benefits of these two techniques only under standard market conditions. We review those results and report our findings from quantifying the separate effects of loss harvesting and HIFO accounting. We conclude that under normal market conditions, investors should harvest losses to generate tax credits and should use HIFO accounting whenever a security holding is sold. Next, we report our findings from expanding Monte Carlo simulations in several significant ways.First, we systematically varied the market conditions to observe the effects on the rewards from loss harvesting. In so doing, we determined the robustness of tax-efficient methods to changes in market environments. We found greater opportunity to harvest losses when individual stock prices are more volatile, but a high level of market volatility does not necessarily increase the value added from tax management. Not surprisingly, a depressed market creates more losses to be harvested and, therefore, better tax alpha than does a roaring bull market, although the increased tax alpha will compound at a lower rate. Increased dividends create more loss-harvesting opportunities from reinvestment, but the immediate tax hit creates a drag.Second, we addressed issues that tax-aware investors and managers can affect. Increased turnover in the index does not have a significant impact; the tax benefit is slightly less when the index turns over more frequently, but investors/managers can often moderate the effect. We also studied the issue of cash flow—the impact of contributions, withdrawals, and a mixture of the two. We found that a steady stream of contributions refreshes the portfolio and allows the benefits of loss harvesting to remain strong over time. Conversely, withdrawals reduce the advantages of realizing losses by accelerating the problem of locking in stocks with low cost basis. As for tax bracket, we found that the before-liquidation tax advantage associated with our tax-efficient portfolios is roughly linearly related to tax rates. On an after-liquidation basis, however, the marginal benefit of our strategies increases at a slower rate.Our findings show that no matter what market environment occurs in the future, managing a portfolio in a tax-efficient manner will provide substantially better after-tax performance than will a simple index fund, both before and after liquidation of the portfolio. The tax alpha that results from a combined loss-harvesting/HIFO accounting strategy is both significant and persistent; it stabilizes at about 40 bps annually. Active management would need to deliver a startlingly large alpha, and without triggering capital gains taxes, to merely match a simple loss-harvesting strategy. Taxes matter—a lot. But at least they are the one aspect of asset management known with certainty in advance and hence can be managed effectively to minimize their impact.
Journal: Financial Analysts Journal
Pages: 91-102
Issue: 4
Volume: 59
Year: 2003
Month: 7
X-DOI: 10.2469/faj.v59.n4.2548
File-URL: http://hdl.handle.net/10.2469/faj.v59.n4.2548
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:4:p:91-102




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# input file: UFAJ_A_12047428_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ronald L. Moy
Author-X-Name-First: Ronald L.
Author-X-Name-Last: Moy
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Theory and Practice of Investment Management (a review)
Abstract: 
 This collection brings together the insights of numerous respected academics and practitioners to blend standard aspects of investment management with other important but frequently omitted topics of interest to students and practitioners at all levels.
Journal: Financial Analysts Journal
Pages: 103-103
Issue: 4
Volume: 59
Year: 2003
Month: 7
X-DOI: 10.2469/faj.v59.n4.2549
File-URL: http://hdl.handle.net/10.2469/faj.v59.n4.2549
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:4:p:103-103




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# input file: UFAJ_A_12047429_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Risk Management and Value Creation in Financial Institutions (a review)
Abstract: 
 Theoretical and quantitative in orientation, this comprehensive survey of the research literature should be of most use to researchers and academics. 
Journal: Financial Analysts Journal
Pages: 102-102
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2550
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2550
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# input file: UFAJ_A_12047430_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Daren E. Miller
Author-X-Name-First: Daren E.
Author-X-Name-Last: Miller
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Take on the Street: What Wall Street and Corporate America Don't Want You to Know; What You Can Do to Fight Back (a review)
Abstract: 
 Theoretical and quantitative in orientation, this comprehensive survey of the research literature should be of most use to researchers and academics. 
Journal: Financial Analysts Journal
Pages: 103-103
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2551
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2551
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:5:p:103-103




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# input file: UFAJ_A_12047431_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: The Mystery of TIPS
Abstract: 
 Practitioners are accustomed to thinking of TIPS (Treasury Inflation Indexed Securities) as an alternative to conventional bonds, not an alternative to stocks. But TIPS are not much different from stocks: Both securities provide income that rises with inflation, or a fall in the relevant real cost of capital. So, TIPS should be viewed as "government stocks." Yet, TIPS have yielded as much as four times the stock yield. The only explanation for this mystery is that many in the investment community still consider TIPS (if they consider these securities at all) to be an alternative to conventional bonds rather than an alternative to stocks. TIPS yields and stock market yields (plus a 1 percent growth premium) are the best measures of the cost of capital for, respectively, the government and the corporate world. Because of the parallels in the ways the two assets deliver returns to their investors, a comparison of the two is today's best measure of the relative attractiveness of stocks and bonds. Hedge funds and other alternative investments are treated as a small and specialized part of the investment universe, but in fact, they are the broad part, representing just about every possible investment strategy outside the narrow set of “traditional” investments. Hedge funds encompass all investment strategies that allow both long and short positions and that allow leverage. They span all markets, from derivatives to emerging markets to real estate. And the focus of hedge funds is dynamic—waxing and waning as new markets and classes of financial instruments arise and other markets and securities become commoditized.Therefore, treating hedge funds as a category to study or monitor is all but impossible. I argue that, in fact, there is no such class as hedge funds. Hedge funds are not a homogenous class that can be analyzed in a consistent way. The “hedge funds/alternative investments” moniker is a description of what an investment fund is not rather than what it is. The universe of alternative investments is just that—the universe. It encompasses all possible investment vehicles and all possible investment strategies less the traditional investment funds and vehicles.This all-encompassing nature of hedge funds has important implications for the study of and attempts to classify hedge funds and is critical for the attempts to regulate and provide standardized risk management for hedge funds. To study hedge funds is to study the world of investment strategies. And with so broad a classification, seeking a uniform approach to regulating hedge funds or managing hedge fund risk is tantamount to setting up a standard for regulating the entire investment universe. It is like getting a committee together to develop a single set of traffic rules to apply to all modes of transportation from pedestrians to commercial jets. Faced with so general a task, what more can one say than “Be careful”? I believe that we will discover—as we continue our attempts to study, categorize, manage, and regulate hedge funds—either that we have failed or that we have enveloped the entire world of investments under a different name.
Journal: Financial Analysts Journal
Pages: 4-7
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2555
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2555
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:5:p:4-7




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# input file: UFAJ_A_12047432_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Michael Wolf
Author-X-Name-First: Michael
Author-X-Name-Last: Wolf
Title: “The Statistics of Sharpe Ratios”: A Comment
Abstract: 
 This material comments on “The Statistics of Sharpe Ratios”.
Journal: Financial Analysts Journal
Pages: 17-17
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2556
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2556
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# input file: UFAJ_A_12047434_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: William L. Valentine
Author-X-Name-First: William L.
Author-X-Name-Last: Valentine
Title: “What Risk Matters? A Call for Papers!”: A Comment
Abstract: 
 This material comments on “What Risk Matters? A Call for Papers!”.
Journal: Financial Analysts Journal
Pages: 18-18
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2558
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2558
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:5:p:18-18




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# input file: UFAJ_A_12047435_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard Bookstaber
Author-X-Name-First: Richard
Author-X-Name-Last: Bookstaber
Title: Hedge Fund Existential
Abstract: 
 Hedge funds defy classification—which spells trouble for broad-based attempts at regulation and risk management. Hedge funds and other alternative investments are treated as a small and specialized part of the investment universe, but in fact, they are the broad part, representing just about every possible investment strategy outside the narrow set of “traditional” investments. Hedge funds encompass all investment strategies that allow both long and short positions and that allow leverage. They span all markets, from derivatives to emerging markets to real estate. And the focus of hedge funds is dynamic—waxing and waning as new markets and classes of financial instruments arise and other markets and securities become commoditized.Therefore, treating hedge funds as a category to study or monitor is all but impossible. I argue that, in fact, there is no such class as hedge funds. Hedge funds are not a homogenous class that can be analyzed in a consistent way. The “hedge funds/alternative investments” moniker is a description of what an investment fund is not rather than what it is. The universe of alternative investments is just that—the universe. It encompasses all possible investment vehicles and all possible investment strategies less the traditional investment funds and vehicles.This all-encompassing nature of hedge funds has important implications for the study of and attempts to classify hedge funds and is critical for the attempts to regulate and provide standardized risk management for hedge funds. To study hedge funds is to study the world of investment strategies. And with so broad a classification, seeking a uniform approach to regulating hedge funds or managing hedge fund risk is tantamount to setting up a standard for regulating the entire investment universe. It is like getting a committee together to develop a single set of traffic rules to apply to all modes of transportation from pedestrians to commercial jets. Faced with so general a task, what more can one say than “Be careful”? I believe that we will discover—as we continue our attempts to study, categorize, manage, and regulate hedge funds—either that we have failed or that we have enveloped the entire world of investments under a different name.
Journal: Financial Analysts Journal
Pages: 19-23
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2559
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2559
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:5:p:19-23




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# input file: UFAJ_A_12047436_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: J.A. Adkisson
Author-X-Name-First: J.A.
Author-X-Name-Last: Adkisson
Author-Name: Don R. Fraser
Author-X-Name-First: Don R.
Author-X-Name-Last: Fraser
Title: Reading the Stars: Age Bias in Morningstar Ratings
Abstract: 
 Comparisons of Morningstar ratings may be affected by fund age and market conditions during the evaluation period. The 2002 revisions to the Morningstar rating system for mutual funds benefit all investors by providing a convenient signal of fund quality that is better grounded in investment theory than the old system was. The most significant improvement is the refinement of the benchmark groups against which the performance of individual funds is measured. An age bias still exists with the new ratings, however, and should be considered in the fund selection process.One source of the age bias is the differential weights that a fund's most recent 36-month returns receive in the calculation of its overall star rating. The younger the fund, the more its overall rating depends on these returns. In our examination of this source of age bias, we are able to reconcile some differences in previous findings.A second source of age bias is the market climate during the evaluation period. The time period over which relative performance is evaluated matters. A bull market can make even weak funds look enticing, and a bear market can make even the best funds look uninviting. Comparing funds is difficult when one fund's overall star rating reflects mostly bear market returns (the case with today's young funds) and another fund's overall rating contains both bull market and bear market returns (the case with today's older funds). To identify superior management, investors should compare fund performances in uniform market conditions.The third source of the age bias is an interaction between fund age and fund size. Young funds tend to be small, which makes their returns and ratings susceptible to manipulation. For example, the smaller the portfolio, the more a handful of fortunate stock picks can buoy the performance of the entire fund. The strategy of stuffing a young fund with a few hot stocks is likely to result in a higher star rating, but it may not result in sustainable long-run performance. Furthermore, because a young fund is typically small, mutual fund families may be able to waive some of its expenses. This strategy is likely to result in a higher star rating for the fund. Mutual fund management companies, which want to increase flows to the fund family as a whole, can exploit this aspect of the rating system by continuously introducing new funds. This practice tends to guarantee that the company always has at least some highly rated funds in its family, thus ensuring increased flows of new investment dollars.In summary, comparisons of funds on the basis of their overall star ratings must be made with three important considerations in mind. First, a fund's overall star rating is heavily influenced by its most recent 36-month returns, but the weight of these returns depends on the fund's age group. The older the fund, the lower the weight. Second, comparing star ratings earned over the same time period is more meaningful than comparing performance for different periods. Finally, young funds tend to be small, which makes their returns susceptible to manipulation. Investors should be cautious (1) when comparing funds that are in the same age group but for which the returns came from different time periods and (2) when comparing overall star ratings of funds in different age groups.
Journal: Financial Analysts Journal
Pages: 24-27
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2560
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2560
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:5:p:24-27




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# input file: UFAJ_A_12047437_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Title: The Higher Equity Risk Premium Created by Taxation
Abstract: 
 Taxation and inflation have some surprising investment effects, such as raising the equity risk premium. Taxation and inflation combine to create some surprising results, and examples probed in this article show that the results apply to both fixed-income and equity investments. Using reasonable assumptions as to tax rates and expected rates of inflation, the article works through examples to illustrate what happens in various cases. The result is the following surprising findings:Higher nominal interest rates can actually result in lower (and often negative) real after-tax yields.In a taxed portfolio, the equity risk premium relative to the taxable risk-free rate can be significantly greater than the original tax-free risk premium.This “tax enhancement” of the risk premium grows even larger with higher nominal interest rates (although this effect may be ameliorated when municipal bonds with a high yield ratio can be used as the risk-free rate).At first, these results seem to argue that more taxation is better, but note that, although the risk premium increases, the returns to both the equity and the fixed-income investments shift downward.What do these results imply for asset allocation? The allocation environment of a tax-free institution is typically quite different from that of a taxed individual: Institutions have longer time horizons and stronger standby resources; hence, they may have a considerably greater tolerance for risk. However, for situations in which the individual and institution have similar levels of risk tolerance, the greater risk premium in the taxed portfolio argues that it should be able to support a higher allocation to equities than the comparable tax-free framework.Although being taxed brings little joy, investors and investment managers should recognize that taxation can actually lead to a higher compensation for accepting long-term equity risk, and this incremental risk may provide some small modicum of comfort.
Journal: Financial Analysts Journal
Pages: 28-31
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2561
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2561
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:5:p:28-31




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# input file: UFAJ_A_12047438_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Noël Amenc
Author-X-Name-First: Noël
Author-X-Name-Last: Amenc
Author-Name: Sina El Bied
Author-X-Name-First: Sina
Author-X-Name-Last: El Bied
Author-Name: Lionel Martellini
Author-X-Name-First: Lionel
Author-X-Name-Last: Martellini
Title: Predictability in Hedge Fund Returns (corrected)
Abstract: 
 A significant amount of research has been devoted to the predictability of traditional asset classes, but little is known about the predictability of returns emanating from alternative vehicles, such as hedge funds. We attempt to fill this gap by documenting evidence of predictability in hedge fund returns. Using multifactor models for the return on nine hedge fund indexes, for which the factors were chosen to measure the many dimensions of financial risk, we found strong evidence of significant predictability in hedge fund returns. We also found that the benefits of “tactical style allocation” portfolios are potentially large. We obtained even more spectacular results for an equity-oriented portfolio that mixed traditional and alternative investment vehicles and for a debt-oriented portfolio that mixed traditional and alternative investment vehicles. These results do not seem to have been significantly affected by the presence of reasonably high transaction costs. The value of the hedge fund industry worldwide is estimated to be more than $500 billion, distributed among more than 5,000 funds, and most institutional investors seem to be moving toward holding hedge funds in their portfolios. As a result, portfolio managers face the challenge of making strategic and tactical asset-allocation decisions for multistyle, multiclass portfolios that mix traditional and alternative investment strategies.The consensus now in empirical finance is that the expected returns (and also the variances and covariances) of traditional assets, such as stocks and bonds, are to some extent predictable. But little is known about the predictability of returns emanating from alternative investment vehicles, such as hedge funds. Also, and not surprisingly given the absence of academic evidence on the predictability of hedge fund returns, little is known about the performance of tactical asset allocation involving hedge funds. In particular, although the out-of-sample performance of optimal strategic asset allocation decisions based on alternative investment vehicles has recently been documented, no such evidence is available on the ability of investors to generate superior risk-adjusted returns based on timing among various hedge fund styles.This article is, to the best of our knowledge, the first to document the existence of predictability in hedge fund index returns and to focus on its implications for tactical allocation decisions. Specifically, we examined (lagged) multifactor models for the return on nine hedge fund indexes. We chose factors that would measure the many dimensions of financial risk—market risks (proxied by stock prices, interest rates, and commodity prices), volatility risk (proxied by implicit volatilities from option prices), default risk (proxied by default spreads), and liquidity risk (proxied by trading volume). We show that a parsimonious set of models captures a significant amount of predictability for most hedge fund styles.We also found that the benefits of tactical style allocation are potentially enormous. The article first provides evidence of the economic significance of the performance of hedge fund style-timing models by comparing the performance of a market timer with perfect forecasting ability in the alternative investment universe with the performance of a perfect market timer in the traditional universe. Then, the performance of a realistic style-timing model is presented. An equity-oriented portfolio that mixed traditional and alternative investment vehicles and a similar debt-oriented mixed portfolio produced spectacular results. Moreover, the results do not seem to be significantly affected by the presence of reasonably high transaction costs.Some specific features of hedge fund investing do not facilitate the implementation of tactical allocation strategies. In particular, the absence of liquidity and the presence of lockup periods, which are typical of investments in hedge funds, are likely to prevent investors from implementing any kind of dynamic allocation among funds. We believe, however, that the future of hedge fund style timing is even brighter than its past or present. The hedge fund industry is still relatively new, and market conditions are evolving at an astounding pace. Although the world of alternative investing has consisted of a disparate set of managers following disparate specific strategies, significant attempts at structuring the markets have occurred in the past few years. Important, well-established firms are creating relatively liquid investment products designed to track the performance of hedge fund indexes.
Journal: Financial Analysts Journal
Pages: 32-46
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2562
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2562
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:5:p:32-46




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# input file: UFAJ_A_12047439_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: William J. Bernstein
Author-X-Name-First: William J.
Author-X-Name-Last: Bernstein
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Earnings Growth: The Two Percent Dilution
Abstract: 
 Two important concepts played a key role in the bull market of the 1990s. Both represent fundamental flaws in logic. Both are demonstrably untrue. First, many investors believed that earnings could grow faster than the macroeconomy. In fact, earnings must grow slower than GDP because the growth of existing enterprises contributes only part of GDP growth; the role of entrepreneurial capitalism, the creation of new enterprises, is a key driver of GDP growth, and it does not contribute to the growth in earnings and dividends of existing enterprises. During the 20th century, growth in stock prices and dividends was 2 percent less than underlying macroeconomic growth. Second, many investors believed that stock buybacks would permit earnings to grow faster than GDP. The important metric is not the volume of buybacks, however, but net buybacks—stock buybacks less new share issuance, whether in existing enterprises or through IPOs. We demonstrate, using two methodologies, that during the 20th century, new share issuance in many nations almost always exceeded stock buybacks by an average of 2 percent or more a year. The bull market of the 1990s was built largely on a foundation of two immense misconceptions:With a technology revolution and a “new paradigm” of low payout ratios and internal reinvestment, earnings will grow faster than ever before. Five percent real growth will be easy to achieve.When earnings are not distributed as dividends and not reinvested into stellar growth opportunities, they are distributed back to shareholders in the form of stock buybacks.In fact, neither of these widespread beliefs stands up to historical scrutiny. Since 1800, the economy, as measured by real GDP, has grown a thousandfold, averaging about 3.7 percent a year. The long-term uniformity of economic growth is remarkable; it is both a blessing and a curse. To know that real U.S. GDP doubles every 20 years is reassuring. But this growth is also a dire warning to those predicting rapid acceleration of economic growth from the computer and Internet revolutions.The relatively uniform increase in GDP implies a similar uniformity in the growth of corporate profits—which does, in fact, occur. Except for the Great Depression, during which overall corporate profits briefly disappeared, nominal aggregate corporate earnings have tracked nominal GDP growth, with corporate earnings staying at 8–10 percent of the GDP growth. The trend growth in corporate profits is identical, to within a remarkable 20 bps, to the trend growth in GDP.For 16 countries, with data spanning the 20th century, we compared dividend growth, price growth, and total return with GDP data from the same period. We found that in stable, non-war-torn nations, per share dividend growth was 2.3 percent less than growth in aggregate GDP and 1.1 percent less than growth in per capita GDP. In the war-torn nations, the situation was far worse—per share dividend growth 4.1 percent less than growth in aggregate GDP and 3.3 percent less than growth in per capita GDP.Data for the comprehensive CRSP 1–10 Index from 1926 to June 2002 show that, after adjustment for additions to the index, total U.S. market capitalization grew 2.3 percent faster than the price index. Thus, over the past 76 1/2 years, a 2.3 percent net new issuance of shares took place, which is the equivalent of negative buybacks. Although net buybacks occurred in the 1980s, by the 1990s, buyback activity had once again returned to historical norms.Earnings growth was indeed high during the 1990s. But the persistence of this growth is dubious for three reasons:The market went from trough earnings in the 1990 recession to peak earnings in the 2000 bubble. Measuring growth from trough to peak is meaningless; extrapolating that growth is even worse.Analysts frequently ignored write-offs while increasing their focus on operating earnings. This behavior is acceptable if write-offs are truly “extraordinary items” but not if write-offs become an annual or biannual event, as was commonplace in the 1990s. Furthermore, what are extraordinary items for a single company are entirely ordinary for the economy as a whole.The peak earnings of 1999–2000 consisted of three dubious components. The first was an underrecognition of the impact of stock options, which various Wall Street strategists estimated at 10 percent or more of earnings. The second was pension expense (or pension “earnings”) based on 9–10 percent return assumptions, which were realistic then but are no longer; this factor pumped up earnings by about 15 percent at the peak and 20–30 percent from recent, depressed levels. The third was Enron-style “earnings management,” which various observers have estimated at 5–10 percent of the peak earnings.In summary, in a dynamic, free-market economy, considerable capital is consumed funding new ventures. For this reason, per share growth of prices, earnings, and dividends will lag aggregate macroeconomic growth by an amount equal to the net issuance of new shares. In peaceful, stable societies, this gap appears to be about 2 percent a year. In war-torn nations, this gap is considerably larger. Although these nations' economies can recover relatively rapidly, the high degree of recapitalization that is required savages shareholders.
Journal: Financial Analysts Journal
Pages: 47-55
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2563
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2563
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:5:p:47-55




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# input file: UFAJ_A_12047440_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: R. Douglas Martin
Author-X-Name-First: R. Douglas
Author-X-Name-Last: Martin
Author-Name: Timothy T. Simin
Author-X-Name-First: Timothy T.
Author-X-Name-Last: Simin
Title: Outlier-Resistant Estimates of Beta
Abstract: 
 Depending on their location, outliers in returns can substantially bias ordinary least-squares estimates of beta. We introduce a new beta estimate that is resistant to outliers that cause the most bias in OLS estimates but produces estimates similar to OLS for outlier-free data. The outlier-resistant beta is an intuitively appealing weighted least-squares estimate with data-dependent weights. We show that the resistant beta is a better predictor of future risk and return characteristics than is the OLS beta in the presence of outliers and is, therefore, a valuable complement to the OLS beta. Our analysis reveals that small companies' betas are most susceptible to outliers. Recent surveys show that many analysts continue to use the capital asset pricing model and that most of them purchase betas from commercial providers, which invariably use a raw or adjusted ordinary least-squares estimate of beta. The sanctified use of OLS is justified by the fact that the OLS beta is statistically the best estimate of the linear model parameters under idealized assumptions.In practice, however, one of the ways these assumptions fail is associated with the occurrence of a small fraction of exceptionally large or small returns—that is, outliers. We show by using several examples that outliers can, depending on their location in the equity-market-returns space, substantially bias OLS estimates of beta. Furthermore, the weekly returns for 8,314 companies from the CRSP database that had at least two years of returns in the period January 1992 through December 1996 contained many examples in which the deletion of a few outliers, sometimes even a single outlier, dramatically affected the OLS beta.The vast majority of commercial providers do nothing to deal with outliers; the few that do deal with this problem use some form of outlier treatment without a solid statistical rationale. We deal with the vulnerability of the OLS beta to outliers by introducing a new beta estimate that is resistant to the types of outliers that cause the most bias in OLS estimates but that produces estimates similar to OLS for outlier-free data. The outlier-resistant beta is an intuitively appealing weighted-least-squares estimate with data-dependent weights. It has several advantages over other commonly used “robust” techniques.The outlier-resistant beta applied to the CRSP database shows that the absolute value of the difference between the resistant and OLS betas is greater than 0.5 for 13 percent of the companies and that this difference is considerably larger than 1.0 for 3.2 percent of the companies. Such extreme sensitivity of the OLS beta to outliers results in misleading interpretations of the risk and return characteristics of a company. This study shows that outlier distortion of the OLS beta is primarily a small-firm effect (i.e., there is a monotonic relationship between the median market capitalization of companies and the absolute difference between the resistant and OLS betas). Furthermore, the resistant beta has superior performance relative to the OLS beta for predicting future betas when influential outliers are present but suffers (at most) only a slight degradation in performance when no influential outliers are present.The new resistant beta will serve well as an important complement to the OLS beta and should be applied in the following ways: The two betas in close agreement signal the absence of distortion of the OLS beta by influential outliers; in such cases, the OLS beta is an accurate representation of risk and return. When the two betas substantially differ, as measured by an appropriate statistical test or perhaps by a subjective value that the user of the beta deems financially relevant, outliers have considerable influence on the OLS beta, so the OLS beta is not to be trusted. In these cases, the returns should be checked for the presence of outliers and their possible causes (e.g., an inadvertent lack of adjustment for a split or a reverse split in the data or, in fact, unusual conditions of the company relative to the market).We do not recommend blindly replacing the OLS beta with the resistant beta, but we emphasize that the resistant beta, which excludes at most a small fraction of outliers, accurately describes the “typical” risk and return characteristics of a company as represented by the bulk of the returns. Outliers are never predictable based on return data alone, so the resistant beta will provide a more reliable forecast of the predictable risk and return characteristics of a company as represented by the nonoutlier portion of the future returns than will the OLS beta.
Journal: Financial Analysts Journal
Pages: 56-69
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2564
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2564
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:5:p:56-69




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# input file: UFAJ_A_12047441_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Philippe Jorion
Author-X-Name-First: Philippe
Author-X-Name-Last: Jorion
Title: Portfolio Optimization with Tracking-Error Constraints
Abstract: 
 This article explores the risk and return relationship of active portfolios subject to a constraint on tracking-error volatility (TEV), which can also be interpreted in terms of value at risk. Such a constrained portfolio is the typical setup for active managers who are given the task of beating a benchmark. The problem with this setup is that the portfolio manager pays no attention to total portfolio risk, which results in seriously inefficient portfolios unless some additional constraints are imposed. The development in this article shows that TEV-constrained portfolios are described by an ellipse on the traditional mean–variance plane. This finding yields a number of new insights. Because of the flat shape of this ellipse, adding a constraint on total portfolio volatility can substantially improve the performance of the active portfolio. In general, plan sponsors should concentrate on controlling total portfolio risk. In typical portfolio delegation, the investor assigns the management of assets to a portfolio manager who is given the task of beating a benchmark. To control for excessive risk, institutional investors commonly impose a limit on the volatility of the deviation of the active portfolio from the benchmark, also known as tracking-error volatility (TEV). Traditionally, TEV has been checked after the fact (i.e., from the volatility of historical excess returns), but recently, the advent of forward-looking measures of risk, such as value at risk, has allowed the industry to forecast TEV. With a distributional assumption for portfolio returns, excess-return VAR is equivalent to a forward-looking measure of TEV.Imposing TEV constraints is seriously inefficient, however, for the investor. When myopically focusing on excess returns, the active manager ignores the total risk of the portfolio. An optimization in excess-return space that includes the benchmark assets will always increase total portfolio risk relative to the benchmark. This observation is important because of the widespread emphasis on controlling tracking-error risk.The problem with a focus on TEV is exacerbated by the widespread use of information ratios (the ratio of expected excess return to TEV) as performance measures. Because information ratios consider only tracking-error risk, total portfolio risk is ignored when managers focus on information ratios. This issue has major consequences for performance measurement: Part of the value added by active managers acting in this fashion is illusory because it could be naively obtained by leveraging up the benchmark.In this article, I investigate whether this problem can be corrected with additional restrictions on the active portfolio without eliminating the usual TEV constraint. I derive the constant-TEV frontier in the original mean–variance space and show that it is described by an ellipse. The primary contribution of this paper is the derivation and interpretation of these analytical results, which yield several new insights. The implications of the results are illustrated with an example.The analytical solution allows exploration of the effect of imposing additional constraints on the active manager. The simplest constraint is to force the total portfolio volatility to be no greater than that of the benchmark. With the advent of forward-looking risk measures, such as VAR, such a constraint is easy to set up. The question is whether the addition of this constraint creates too large a penalty in terms of expected returns.I show that because of the flat shape of the ellipse, adding such a constraint can substantially improve the performance of the active portfolio. The constraint on total risk lowers risk for a small penalty in terms of expected returns. The cost will be small when the value of the admissible TEV is low or when the benchmark is relatively inefficient. Thus, if the active manager is confident that he or she can add value, the manager should have no objection to an additional constraint on total portfolio risk.In summary, my first prescription for investors is to discard TEV optimization and focus on controlling total risk. Some indications are that pension plans with advanced risk management systems are indeed now moving in this direction. Otherwise, if TEV constraints are kept in place, my recommendation is to impose an additional constraint on total volatility.
Journal: Financial Analysts Journal
Pages: 70-82
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2565
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2565
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:5:p:70-82




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# input file: UFAJ_A_12047442_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Greg van Inwegen
Author-X-Name-First: Greg
Author-X-Name-Last: van Inwegen
Author-Name: John Hee
Author-X-Name-First: John
Author-X-Name-Last: Hee
Author-Name: Kenneth Yip
Author-X-Name-First: Kenneth
Author-X-Name-Last: Yip
Title: Preference-Based Strategic Currency Hedging
Abstract: 
 This article considers the value to a given investor of volatility reduction through currency hedging relative to taking an unhedged position. Included is a decision framework to help international investors analyze how the potential risk reduction benefits of hedging interact with the investor's beliefs about the currency risk premium, risk aversion, and investment constraints to determine an optimal currency-hedging strategy. In our framework, investors choose from nine hedging strategies, each of which may be optimal under a specific set of assumptions. The article concludes that a unitary hedge strategy is best for investors who do not forecast currency returns. For those who make strategic currency-return forecasts, our aggregated results suggest an optimized hedge strategy using expected return inputs from an asset-pricing model. Today, the majority of large institutional portfolios are invested internationally. With investment in global markets comes the challenge of establishing a policy for managing currency risk—which poses several difficult problems. Currency risk usually increases the volatility of portfolio returns, and the manager may address this issue by reducing or eliminating currency risk through hedging. If bearing currency risk brings positive average returns, however, hedging may reduce the portfolio's expected return. The article addresses several questions:Should currency risk be hedged?If so, how much of the risk should be hedged?How does the optimal choice relate to the portfolio manager's risk preferences and beliefs about a currency premium?If the portfolio manager uses expected currency returns to choose the hedge ratio, what estimation method works best?The article organizes a preference-based decision framework to assist international investors in choosing a currency-hedging strategy. Empirical evidence on the performance of the recommended alternative hedging strategies lends broad support to the decision framework.The article begins with descriptions of different approaches to hedging. The simplest type of hedge involves a currency position equal in magnitude and opposite in sign to the equity position—that is, a “unitary” or “100 percent” hedge. A less-restrictive strategy uses least-squares regression to obtain minimum-variance hedge ratios. These hedge ratios take into account the correlation between the underlying equity and the currency. In the multivariate formulation of minimum-variance hedge ratios, currency cross-hedging is allowed. A more general form of currency hedging involves solving for the optimal currency weights in light of fixed equity positions. Known as “partial optimization,” this approach results in optimal currency weights that include a hedging component and a speculative currency component. Finally, the most general form of hedging is joint optimization of currencies and equities.In practice, most international asset managers or their overlay submanagers use more restrictive strategies than joint optimization. Even partial optimization is often not implemented in its most general form: Managers often place constraints on the magnitude of currency positions. Academic research offers managers some help, but it frequently focuses on unconstrained problems for a general investor. Of more interest to practitioners is the analysis of constrained hedging for specific investor types.We used 17 years of data to examine the out-of-sample performance of nine hedging strategies. For investors who do not forecast currency returns, we tested and compared the following hedging rules: no hedge, a unitary hedge, a minimum-variance hedge ratio, and a constrained minimum-variance hedge ratio. Although theory suggests using a minimum-variance hedge, we found that this strategy is empirically indistinguishable from using a simple unitary hedge.For investors who are willing to incorporate estimates of expected currency returns in their hedging decisions, theory suggests using a hedging strategy involving partial optimization based on equilibrium returns. We tested and compared a set of hedging rules for these investors—no hedge, a unitary hedge, a minimum-variance hedge ratio, and preference-specific optimized hedge ratios. As inputs into the optimization problems, we tried three approaches to generate the expected currency returns—historically based expected returns, equilibrium-based expected returns using the international asset-pricing model, and zero expected returns. The results supported the superior performance of the theoretically motivated strategy of using optimal hedge ratios based on equilibrium expected returns.
Journal: Financial Analysts Journal
Pages: 83-96
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2566
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2566
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:5:p:83-96




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# input file: UFAJ_A_12047443_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Famous Fables of Economics: Myths of Market Failures (a review)
Abstract: 
 Through essays on a wide range of topics and case studies, this compendium mounts a persuasive assault on the idea that market failures are rampant. 
Journal: Financial Analysts Journal
Pages: 100-101
Issue: 5
Volume: 59
Year: 2003
Month: 9
X-DOI: 10.2469/faj.v59.n5.2567
File-URL: http://hdl.handle.net/10.2469/faj.v59.n5.2567
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:5:p:100-101




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# input file: UFAJ_A_12047446_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Who's Minding the Store?
Abstract: 
 A host of transgressions, outbreaks of corporate malfeasance, accounting chicanery, and scandals in the mutual fund business plus several articles in the November/December 2003 issue of the Financial Analysts Journal prompt musing on ethics in business and society as it applies to the analyst's job. 
Journal: Financial Analysts Journal
Pages: 4-8
Issue: 6
Volume: 59
Year: 2003
Month: 11
X-DOI: 10.2469/faj.v59.n6.2570
File-URL: http://hdl.handle.net/10.2469/faj.v59.n6.2570
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# input file: UFAJ_A_12047447_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bradford Cornell
Author-X-Name-First: Bradford
Author-X-Name-Last: Cornell
Author-Name: Wayne R. Landsman
Author-X-Name-First: Wayne R.
Author-X-Name-Last: Landsman
Title: Accounting Valuation: Is Earnings Quality an Issue?
Abstract: 
 From a valuation perspective, no “best”—or even consistent—measure of pro forma earnings exists. An increasing number of companies are including pro forma earnings together with net income figures in their earnings releases. The explanation offered by these companies is that the pro forma numbers reflect the company's true earning power more accurately than net income numbers based on generally accepted accounting principles. Company support for such estimates of earnings is echoed by analysts. Regulators, however, are concerned about the potentially misleading qualities of non-GAAP earnings measures.In response to concerns about pro forma earnings, the Financial Accounting Standards Board recently proposed an agenda project related to the use of pro forma data in which it cites three concerns. First, companies are increasingly relying on pro forma performance measures in earnings releases and other investor-related communications. Second, no common definitions of the elements of financial performance exist and practices regarding their presentation are inconsistent. Third, no consensus exists about which performance measures should be in financial statements.The concern over which measure of income is the most meaningful for valuation has produced a host of empirical studies designed to estimate the “quality” of competing earnings measures. The specific results are a mixed bag; findings depend on the earnings measures being compared, the time period, the sample of companies, and the metric used. The overall result, however, is that the differences in information conveyed by the competing definitions of earnings—from GAAP earnings to pro forma income—are not large. In addition, the empirical studies suffer from the problems that non-GAAP earnings also are not unambiguously defined and that different companies compute pro forma income differently. As a result, studies that compare GAAP earnings with pro forma income may not be comparing the same two measures for all companies.The thesis of this article is that, from a valuation perspective, the entire debate about earnings quality is theoretically unresolvable. No consistently meaningful way is available to condense all the historical financial information that is relevant for forecasting future performance into one measure (or a time series of one measure). Furthermore, attempts by regulatory/standard-setting bodies to determine an appropriate definition of “pro forma income” distracts attention from more-critical problems involving omissions and ambiguities in the constituent items that make up any measure of earnings.We make two arguments. First, none of the measures of earnings, including GAAP, condenses financial statement information satisfactorily for forecasting purposes. Second, no meaningful criterion exists for determining whether one earnings measure is better than another.The principal conclusion of the discussions is that efforts to determine which measure of earnings is appropriate for a company to disseminate are misguided. What is critical is that the basic elements that comprise any measure of earnings be presented with sufficient clarity and at a sufficient level of disaggregation that investors can answer fundamental questions about revenues, costs, and capital. If sufficient data are available to answer these questions, investors can aggregate the basic information into any earnings measure they believe provides the most insight into forecasting future cash flows.The second conclusion is that, although companies should be free to provide any aggregate measure of earnings that they deem appropriate, they should follow some basic guidelines. Because none of the alternatives to GAAP earnings is precisely defined or consistently applied, companies that release non-GAAP numbers should explain how the numbers differ from the GAAP numbers.
Journal: Financial Analysts Journal
Pages: 20-28
Issue: 6
Volume: 59
Year: 2003
Month: 11
X-DOI: 10.2469/faj.v59.n6.2571
File-URL: http://hdl.handle.net/10.2469/faj.v59.n6.2571
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:6:p:20-28




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# input file: UFAJ_A_12047448_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: John Dobson
Author-X-Name-First: John
Author-X-Name-Last: Dobson
Title: Why Ethics Codes Don't Work
Abstract: 
 Making codes of ethics work in the financial services industry requires defining self-interest in terms of the code's values. The recent stock market downturn brought to light numerous legal and ethical transgressions committed during the euphoria of the 1990s market boom. Various government and judicial authorities are investigating the behavior of investment bankers, securities analysts, and other individuals engaged in the finance industry.All this attention being paid to the finance profession is clearly not flattering. Although some of the allegations may prove unfounded, the evidence already brought to light is sufficient cause for concern. The behavior of some finance professionals, whether acting as individuals or under the auspices of an organization, appears to have fallen well short of what would generally be regarded as professional conduct.Ironically, at the same time, ethical guidelines and codes of conduct have never been more widespread in the financial services industry. Professional certifications, such as the Chartered Financial Analyst (CFA) and the Certified Financial Planner (CFP) designations, involve a significant ethics component. Few contemporary financial services professionals, therefore, can have escaped some exposure to guidelines on ethics and professional responsibility. So, why have some individuals ignored even the most basic precepts of these guidelines?My answer involves acculturation—that is, implicit education into a certain moral value system. Individuals become acculturated by the day-to-day behavior they see around them because they assume such behavior is what is rational and acceptable in their field. In the financial services industry, the implied moral education comes through exposure to the value systems displayed in their educational institutions, the industry, and their firms, particularly by the senior managers of a person's firm. For most individuals, acculturation begins, however, with the values espoused in business schools. There, students are persistently taught neoclassical economic rationality—a narrow, utilitarian notion of what constitutes rational, and thus reasonable, behavior.Neoclassical economic rationality focuses on a narrow notion of self-interest. It promotes the idea that the only conceivable justification for individual behavior is the persistent, atomistic, exclusive, and endless pursuit of personal material wealth. In financial economic theory, rational agents are always assumed to be material opportunists who will readily jettison honesty and integrity in favor of guile and deceit whenever the latter are more likely to maximize some payoff function; indeed, to act other than opportunistically is, by definition, irrational. Used out of context in an educational setting, this construct inculcates business students and professional trainees with an implicit moral agenda that is very different from that espoused by professional codes of conduct.For codes of ethics to work, therefore, finance professionals must be acculturated into the realization that premising behavior on honesty or integrity is in no way irrational; it is not contrary to their self-interest once self-interest is correctly defined in terms of pursuing goals set forth in the code of ethics. To place the values of honesty and integrity above all others is as rational as to place the value of material opportunism above all others. This equivalent rationality is the essence of any sound code of ethics, and it is a lesson that sorely needs to be taught to many in the financial services industry.To imbue finance professionals with a morally sound notion of professionalism requires—first and foremost—that the inconsistency in rationality concepts be addressed. The behavior espoused by professional codes of conduct must be reconciled with the economic rationality implicit in organizational culture.
Journal: Financial Analysts Journal
Pages: 29-34
Issue: 6
Volume: 59
Year: 2003
Month: 11
X-DOI: 10.2469/faj.v59.n6.2572
File-URL: http://hdl.handle.net/10.2469/faj.v59.n6.2572
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# input file: UFAJ_A_12047449_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Elroy Dimson
Author-X-Name-First: Elroy
Author-X-Name-Last: Dimson
Author-Name: Stefan Nagel
Author-X-Name-First: Stefan
Author-X-Name-Last: Nagel
Author-Name: Garrett Quigley
Author-X-Name-First: Garrett
Author-X-Name-Last: Quigley
Title: Capturing the Value Premium in the United Kingdom
Abstract: 
 Using a new data set of accounting information merged with share price data, we found a strong value premium in the United Kingdom for the period 1955–2001. It existed among small-capitalization and large-capitalization stocks. But small-cap stock managers who wish to capture the higher expected returns face some challenges. We show that rebalancing-induced portfolio turnover for indexed small-cap value strategies can be substantial. Coupled with the relative illiquidity of the U.K. market for small-cap value stocks, such high turnover calls for strategies that sacrifice tracking accuracy in favor of reducing trading needs and lowering trading costs. Value stocks appear to earn a premium in many markets around the world. Investigations of the value premium outside the United States have so far been hampered, however, by lack of data. Existing studies tend to focus on relatively large-capitalization stocks and recent time periods. In this study, we analyzed the U.K. evidence and addressed some of these problems. We used a new data set of accounting information that covers virtually all U.K. firms ever listed on the London Stock Exchange going back to the 1950s. Unlike many previously existing databases, this set of data is free of survivor bias.Using book value of equity to market value of equity (BE/ME) as the measure of value, we found a strong value premium in the United Kingdom for the 1955–2001 period. The return spread we found between our high-BE/ME and low-BE/ME portfolios (averaged across large- and small-cap stocks) is about 0.5 percent a month. The value premium was particularly strong among small-cap stocks, and it was surprisingly stable until the mid-1970s. In recent years, the spread between high-BE/ME and low-BE/ME stocks has been highly volatile. We also show that returns on value strategies based on dividend yield move closely with returns on BE/ME strategies. The premium earned by dividend yield strategies is smaller, but the results suggest that dividend yield may be a useful auxiliary measure of value when BE/ME data deliver doubtful results.Although the historical returns seem impressive, implementation of strategies designed to capture the value premium is potentially costly, particularly within the small-cap segment. Stocks migrating in and out of the small-cap value universe, dividends, and delistings—all give rise to trading needs, even for a passive manager. We found rebalancing-induced portfolio turnover for a passive small-cap value strategy to be approximately 40 percent a year. In a high-trading-cost environment, this mechanical trading strategy could easily cut several percentage points off annual performance.We show that high trading costs are an important concern in the U.K. market. Even today, the equity market for small-cap value stocks in the United Kingdom is substantially less liquid than the market for large-cap stocks. The typical small-cap value stock tends to trade only every other day. This illiquidity implies that traders who demand immediacy of execution are likely to face substantial trading costs. Patient investors, however, may find opportunities to earn a premium by supplying liquidity to less patient traders.Rebalancing strategies and trading costs are, therefore, an important determinant of achievable returns in the small-cap value segment. Pure indexing strategies designed to minimize benchmark tracking error require immediate execution of trading needs because of inflows and outflows or because of benchmark rebalancing. Rebalancing needs can be reduced by sacrificing tracking accuracy, however, by, for example, using a flexible definition of portfolio eligibility. Passive managers are likely to benefit from a patient approach to trading; active managers will need to incorporate trading costs (and possibly slow execution) into their assessments of prospective excess returns. Clever management of the trade-off between tracking accuracy and trading cost can thus be a source of substantial competitive advantage for small-cap value managers. Furthermore, small-cap value stocks in the United Kingdom may be most suitable for the managers who are less subject to daily inflows and outflows and the trading needs they cause.Finally, the concerns our results raise for the U.K. equity market may be even more relevant for other non-U.S. markets, where liquidity is likely to be even lower than in the United Kingdom.
Journal: Financial Analysts Journal
Pages: 35-45
Issue: 6
Volume: 59
Year: 2003
Month: 11
X-DOI: 10.2469/faj.v59.n6.2573
File-URL: http://hdl.handle.net/10.2469/faj.v59.n6.2573
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# input file: UFAJ_A_12047450_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Eric Jacquier
Author-X-Name-First: Eric
Author-X-Name-Last: Jacquier
Author-Name: Alex Kane
Author-X-Name-First: Alex
Author-X-Name-Last: Kane
Author-Name: Alan J. Marcus
Author-X-Name-First: Alan J.
Author-X-Name-Last: Marcus
Title: Geometric or Arithmetic Mean: A Reconsideration
Abstract: 
 An unbiased forecast of the terminal value of a portfolio requires compounding of its initial value at its arithmetic mean return for the length of the investment period. Compounding at the arithmetic average historical return, however, results in an upwardly biased forecast. This bias does not necessarily disappear even if the sample average return is itself an unbiased estimator of the true mean, the average is computed from a long data series, and returns are generated according to a stable distribution. In contrast, forecasts obtained by compounding at the geometric average will generally be biased downward. The biases are empirically significant. For investment horizons of 40 years, the difference in forecasts of cumulative performance can easily exceed a factor of 2. And the percentage difference in forecasts grows with the investment horizon, as well as with the imprecision in the estimate of the mean return. For typical investment horizons, the proper compounding rate is in between the arithmetic and geometric values. An unbiased forecast of the terminal value of a portfolio requires the initial value to be compounded at the arithmetic mean rate of return for the length of the investment period. An upward bias in forecasted values results, however, if one estimates the mean return with the sample average and uses that average to compound forward. This bias arises because cumulative performance is a nonlinear function of average return and the sample average is necessarily a noisy estimate of the population mean. Surprisingly, the bias does not necessarily disappear asymptotically, even if the sample average is computed from long data series and returns come from a stable distribution with no serial correlation. Instead, the bias depends on the ratio of the length of the historical estimation period to that of the forecast period.Forecasts obtained by compounding at the geometric average will generally be downwardly biased.Therefore, for typical investment horizons, the proper compounding rate is in between the arithmetic and geometric rates. Specifically, unbiased estimates of future portfolio value require that the current value be compounded forward at a weighted average of the two rates. The proper weight on the geometric average equals the ratio of the investment horizon to the sample estimation period. Thus, for short investment horizons, the arithmetic average will be close to the “unbiased compounding rate.” As the horizon approaches the length of the estimation period, however, the weight on the geometric average approaches 1. For even longer horizons, both the geometric and arithmetic average forecasts will be upwardly biased.The implications of these findings are sobering. A consensus is already emerging that the 1926–2002 historical average return on broad market indexes, such as the S&P 500 Index, is probably higher than likely future performance. Our results imply that the best forecasts of compound growth rates for future investments are even lower than the estimates emerging from the research behind this consensus.The choice of compounding rate can have a dramatic impact on forecasts of future portfolio value. Compounding at the arithmetic average return calculated from sample periods of either the most recent 77 or 52 years results in forecasts of future value for a sample of countries that are roughly double the corresponding unbiased forecasts based on the same data periods. Indeed, for reasonable risk and return parameters, at investment horizons of 40 years, the differences in forecasts of total return generally exceed a factor of 2.The percentage differences between unbiased forecasts versus forecasts obtained by compounding arithmetic or geometric average returns increase with the ratio of the investment horizon to the sample estimation period as well as with the imprecision in the estimate of the mean return. For this reason, emerging markets present the greatest forecasting problem. These markets have particularly short historical estimation periods and return histories that are particularly noisy. For these markets, therefore, the biases we analyzed can be especially acute. Even for developed economies, however, with their longer histories, bias can be significant if one disregards data from very early periods.
Journal: Financial Analysts Journal
Pages: 46-53
Issue: 6
Volume: 59
Year: 2003
Month: 11
X-DOI: 10.2469/faj.v59.n6.2574
File-URL: http://hdl.handle.net/10.2469/faj.v59.n6.2574
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:6:p:46-53




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# input file: UFAJ_A_12047451_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ulf Herold
Author-X-Name-First: Ulf
Author-X-Name-Last: Herold
Author-Name: Raimond Maurer
Author-X-Name-First: Raimond
Author-X-Name-Last: Maurer
Title: Bayesian Asset Allocation and U.S. Domestic Bias
Abstract: 
 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. The benefits of international diversification have been the subject of a controversial and ongoing debate in recent decades. According to standard mean–variance portfolio theory, an internationally diversified equity portfolio has risk–return characteristics that are preferable to those of a domestic-only benchmark portfolio. The behavior of investors, however, is often inconsistent with this normative theory. For example, U.S. investors hold much less non-U.S. stock than portfolio theory predicts should be optimal: According to mean–variance analysis, U.S. investors should allocate 30–40 percent of portfolio wealth to non-U.S. equities, but the actual allocation is 8–10 percent. This discrepancy is known as the “home bias puzzle.”To explain the home bias puzzle, some researchers have applied approaches other than mean–variance analysis, such as behavioral finance or nonexpected utility theory. Surprisingly little effort has been made to investigate approaches that are consistent with mean–variance analysis and that might establish a link between normative and descriptive research on international diversification. The key is to focus on the estimation of the input parameters for mean–variance optimization.The most crucial input for asset allocation is the set of expected returns. Expected returns can be estimated from historical returns, derived from a forecasting model, or inferred from an asset-pricing model. In each case, a substantial amount of uncertainty is attached to the estimates. The problem with mean–variance analysis is that it uses only a single set of estimates: Asset allocation is based only on sample means, in the case of identically and independently distributed data, or on personal judgments about the future performance of asset classes. Furthermore, estimated expected returns are treated as if they were true values. A better approach would be to assess the information content of the various information sources and combine them into a single estimate, which is the basic idea of Bayesian statistics.Bayesian inference combines extra-sample, or prior, information with sample returns. The sample means are shrunk toward a reference point that is inferred from economic theory. We investigated whether three Bayesian approaches can explain the home bias of U.S. investors. In the first approach, the mean–variance-efficient portfolio with the highest Sharpe ratio, which is called the tangency portfolio, is shrunk toward the minimum-variance portfolio. In the second approach, the tangency portfolio is shrunk toward the market portfolio. The prior expected returns are inferred from the capital asset pricing model, and the shrinkage effect depends on the degree of sample information in the data and the investor's confidence in the pricing model. In the third model, historical returns are discarded as worthless for estimating expected returns and the investor is allowed to express subjective views about future expected returns. These views and the investor's level of conviction determine the extent of deviation from the market portfolio. In addition to evaluating the three Bayesian approaches, we investigated the mean–variance/tracking-error (MVTE) criterion, under which an investor is concerned not only with expected portfolio return and its variance but also with regret aversion—the risk of underperforming a benchmark portfolio (U.S. equities in our case). Interestingly, the Bayesian approach of shrinking toward the market portfolio led to conclusions similar to those based on portfolios formed under the MVTE criterion.In our empirical study, we found that a substantial home bias can be explained when a U.S. investor has both a strong belief in the global mean–variance efficiency of the U.S. market portfolio and a high aversion to falling behind the U.S. market portfolio. (In this article, we also show how to quantify the strength of this belief.) We also found that the current level of the home bias can be justified whenever regret aversion is significantly greater than risk aversion. Furthermore, the results held qualitatively for non-U.S.-based investors.Finally, to assess the potential of various approaches for adding value in tactical asset allocation, we conducted an out-of-sample study to compare the risk-adjusted performance of the Bayesian approaches with the risk-adjusted performance of mean–variance analysis. We found mixed results. The Bayesian approaches proved to be superior to mean–variance tangency portfolios that rely on sample means, and the Bayesian portfolios exhibited higher risk-adjusted returns and lower turnover. The Bayesian approaches were not found to be systematically superior to heuristic strategies, however, such as the market portfolio or the minimum-variance portfolio. Thus, the empirical results confirm the well-known fact that accurately estimating expected returns from historical returns alone is hard.
Journal: Financial Analysts Journal
Pages: 54-65
Issue: 6
Volume: 59
Year: 2003
Month: 11
X-DOI: 10.2469/faj.v59.n6.2575
File-URL: http://hdl.handle.net/10.2469/faj.v59.n6.2575
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:6:p:54-65




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# input file: UFAJ_A_12047452_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: James J. Angel
Author-X-Name-First: James J.
Author-X-Name-Last: Angel
Author-Name: Stephen E. Christophe
Author-X-Name-First: Stephen E.
Author-X-Name-Last: Christophe
Author-Name: Michael G. Ferri
Author-X-Name-First: Michael G.
Author-X-Name-Last: Ferri
Title: A Close Look at Short Selling on Nasdaq
Abstract: 
 We examine the frequency of short selling in stocks listed in the Nasdaq market. Using previously unavailable transaction data, we can report several findings: (1) overall, 1 of every 42 trades involves a short sale; (2) short selling is more common among stocks with high returns than stocks with weaker performance; (3) actively traded stocks experience more short sales than stocks of limited trading volume; (4) short selling varies directly with share price volatility; (5) short selling does not appear to be systematically different on various days of the week; and (6) days of high short selling precede days of unusually low returns. To examine the frequency of short selling, we used a unique data set that identifies all short-sale transactions reported to Nasdaq through its ACT trade-reporting system during the fall of 2000. Our study differs from most prior empirical studies in that our sample consists of day-by-day short selling of individual stocks by investors expecting price declines whereas most prior research relied on the once-a-month report of total short interest.To investigate the frequency of short selling, we used two complementary metrics. The first is the “percentage of short trades,” which is the ratio of short trades to the total number of trades in a stock within a day. This percentage addresses the likelihood that the seller in a transaction is shorting. The second is “percentage of shorted shares,” which is the ratio of the shares in the short trades to the total number of a company's shares traded in the day. This percentage concerns the probability that a traded share is being shorted. We found that, on average, the seller in 1 of every 42 trades is shorting and that 1 of every 35 traded shares is a shorted share. These results indicate that short sellers tend to transact in larger volume than the typical nonshorting investor.The second issue we examined is whether short selling varies with a stock's price performance in a manner that is consistent with either a momentum or contrarian investing style. After partitioning the sample into quintiles based on the within-sample percentage change in the stock's price, we found that both the percentage of short trades and the percentage of shorted shares were highest for the quintiles containing the stocks with the highest returns and lowest for those with the lowest returns. These results are most consistent with the proposition that short sellers tend to follow a contrarian strategy.Next, we addressed the link between short selling and trading volume. The liquidity offered by high-volume stocks potentially reduces the probability that the short seller will experience a “short squeeze” (when the shares that have been lent to the investor for the short sale are recalled). After partitioning the sample according to trading volume, we found that both the percentage of short trades and the percentage of shorted shares declined monotonically with trading volume. Therefore, as hypothesized, short sellers tend to be more interested in high-volume stocks.Fourth, we examined the relationship between short selling and stock price volatility. Specifically, we searched for any contemporaneous connection between the two. After partitioning the sample into quintiles according to the standard deviation of within-sample stock return, we found that short selling is highest for the most volatile stocks and lowest for low-volatility stocks.A number of prior studies documented a trend in which returns on certain days of the week tend to be significantly lower than returns on other days. Therefore, we considered whether any such day-of-the-week pattern is to be found in short selling. Somewhat surprisingly, our results indicate little day-to-day variation in short selling.Finally, we examined the potential short-term profitability of short selling by examining market- adjusted returns following days of significantly high short selling. We found statistically significant three-day excess returns of −1.23 percent following days of high short selling, implying that an investor who opens a short position on a day of high short selling in a stock and closes it three days later can obtain a positive net profit.
Journal: Financial Analysts Journal
Pages: 66-74
Issue: 6
Volume: 59
Year: 2003
Month: 11
X-DOI: 10.2469/faj.v59.n6.2576
File-URL: http://hdl.handle.net/10.2469/faj.v59.n6.2576
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:6:p:66-74




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# input file: UFAJ_A_12047453_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark Hirschey
Author-X-Name-First: Mark
Author-X-Name-Last: Hirschey
Author-Name: Vernon J. Richardson
Author-X-Name-First: Vernon J.
Author-X-Name-Last: Richardson
Title: Investor Underreaction to Goodwill Write-Offs
Abstract: 
 Current accounting rules end regular amortization of goodwill and mandate annual tests for goodwill impairment and loss recognition, when appropriate. These rules make consideration of goodwill write-offs important and timely. In the study reported here, we found that the effects of goodwill write-off announcements were typically negative and material—on the order of −2.94 percent to −3.52 percent of the company's stock price. What makes goodwill write-off announcements especially noteworthy for investors is that additional effects of roughly −11.02 percent were realized by the end of a one-year post-announcement period. These results suggest that investors initially underreact to goodwill write-off announcements and that they need to be aware of the potential for further losses in the post-announcement period. Until recently, goodwill accounting was based on the premise that goodwill and other intangible items were wasting assets with a finite life. The values assigned to intangible assets were amortized over an arbitrary period of time not to exceed 40 years. Financial Accounting Standards Board's Statement No. 142, Goodwill and Other Intangible Assets, does away with the presumption that acquired goodwill and other acquired intangible assets have finite lives, however, and eliminates mandatory amortization. Acquired intangible assets that have finite lives will continue to be amortized over their useful lives but without the constraint of any arbitrary ceiling.Under FASB Statement No. 142 accounting standards, goodwill is to be tested for impairment, at least annually, by using a two-step process. The process begins with an estimation of the fair value of a reporting unit and is a screen for potential impairment. The second step measures the amount of impairment, if any. If the carrying amount of acquired goodwill or acquired intangible assets exceeds fair value estimates, an impairment loss must be recognized against net income in an amount equal to that excess.FASB Statement No. 142 improves financial reporting by helping users of financial statements understand corporate investments in goodwill and other intangible assets and the subsequent performance of those assets. Adoption of FASB Statement No. 142 is relevant for investors because this statement promises to make goodwill write-offs routine corporate events that are based on a quantitative approach.This article provides evidence about investor reactions to company announcements of goodwill write-offs. Investor reactions to such write-offs offer evidence about how investors process potentially important information about a company's profit-making potential. Stock price effects associated with goodwill write-offs offer evidence about the extent to which accounting goodwill numbers capture the economic value of intangible factors with assetlike characteristics.We found statistically significant negative abnormal returns tied to goodwill write-off announcements. Two-day announcement effects for our sample of 80 U.S.-listed companies announcing goodwill write-offs in the 1992–96 period were typically negative and material, on the order of −2.94 percent to −3.52 percent of the company's stock price. Importantly for investors, average one-year post-announcement period effects of roughly −11.02 percent suggest that a significant portion of the negative valuation effects tied to goodwill write-off announcements are realized after the announcement period. The evidence presented here suggests that investors must be wary of negative valuation effects tied to goodwill write-off decisions and the potential for continued underperformance in the post-announcement period.
Journal: Financial Analysts Journal
Pages: 75-84
Issue: 6
Volume: 59
Year: 2003
Month: 11
X-DOI: 10.2469/faj.v59.n6.2577
File-URL: http://hdl.handle.net/10.2469/faj.v59.n6.2577
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:6:p:75-84




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# input file: UFAJ_A_12047454_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Douglas J. Jordan
Author-X-Name-First: Douglas J.
Author-X-Name-Last: Jordan
Author-Name: J. David Diltz
Author-X-Name-First: J. David
Author-X-Name-Last: Diltz
Title: The Profitability of Day Traders
Abstract: 
 We used two distinct methodologies to examine the profitability of a sample of U.S. day traders. The results show that about twice as many day traders lose money as make money. Approximately 20 percent of sample day traders were more than marginally profitable. We found evidence that day-trader profitability is related to movements in the Nasdaq Composite Index. A detailed study of the profitability of day traders is important for several reasons. First, day trading sparks widespread public interest because it is often perceived as an easy way to make money. Second, there are conflicting claims about day-trader profitability. Government agencies maintain that almost all day traders lose money, but the day-trading industry claims that 60 percent of day traders are profitable after an initial learning period. Neither side has sufficient evidence to support its claims.We studied day-trading profitability by using data from February 1998 through October 1999 for seven branch offices of a national securities firm specializing in day trading. The original sample consisted of all orders sent by clients for each trading day. We extracted only the confirmed trades for analysis, and the final data set contained 324 individual day traders. We used two analytical techniques.In the “trade-matching” methodology, we matched daily buy and sell trades (also buy and short-sell trades) by the number of shares of a given order number. In the “flat-stock” technique, we sorted data for a given trader by stock, then by date, and by time. A “trade” was defined any time the trader had a “flat” position (zero net position) in the stock. The premise behind both methodologies was that price times number of shares bought is a cash outflow and price times shares sold is a cash inflow.We found that 116 traders (35.8 percent) had a net profit greater than zero after commissions and 208 traders (64.2 percent) had a net profit less than zero after commissions. Therefore, we found almost twice as many losing traders as winning traders in the data set. The most profitable trader made more than $197,000, and the least profitable trader lost more than $748,000. The average gross profit for all traders was more than $8,000, whereas the average net profit was about –$750. Thus, transaction costs apparently preclude earning an excess profit in most cases.The results also showed that 35.8 percent of traders made a positive net profit, 19.4 percent made more than $5,000, and 14.2 percent made more than $10,000. These figures contrast with the 64.2 percent of traders who had negative net profits, the 25.0 percent who lost at least $5,000, and the 13.0 percent who lost more than $10,000. More than 35 percent of sample traders at least broke even, and about one out of five made more than $5,000. The implication is that, in spite of the fact that making a profit by day trading is indeed difficult, the odds against being profitable are not overwhelming.Conventional Wall Street wisdom holds that day traders, in general, are profitable when the overall market is up (or, more specifically, when the Nasdaq Composite is up, because the vast majority of the trades in the study involve technology stocks) and lose money when the market (the Nasdaq) is down. To test this idea, we regressed overall trader profitability against movements in the Nasdaq Composite. We found, consistent with conventional wisdom, a significant positive relationship between movements in the Nasdaq and trader profitability.The main results of this analysis can be summarized as follows:About twice as many day traders lose money as make money.About one trader in five is more than marginally profitable.Statistical evidence supports the notion that day-trader profitability is related to movements in the Nasdaq.The fact that at least 64 percent of the day traders in this study lost money suggests that being a profitable day trader is more difficult than the industry maintains. The implication is that aspiring and novice day traders should give careful consideration to why they think they will be among the 20 percent of day traders who make at least $5,000 day trading. At a minimum, novice day traders should make sure they have enough initial capital to survive the three- to five-month learning period that the industry suggests is necessary to become successful.
Journal: Financial Analysts Journal
Pages: 85-94
Issue: 6
Volume: 59
Year: 2003
Month: 11
X-DOI: 10.2469/faj.v59.n6.2578
File-URL: http://hdl.handle.net/10.2469/faj.v59.n6.2578
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Handle: RePEc:taf:ufajxx:v:59:y:2003:i:6:p:85-94




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# input file: UFAJ_A_12047455_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Peter L. Bernstein
Author-X-Name-First: Peter L.
Author-X-Name-Last: Bernstein
Title: “Points of Inflection: Investment Management Tomorrow”: Author's Response
Abstract: 
 This material comments on “Points of Inflection: Investment Management Tomorrow”.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2489
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2489
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# input file: UFAJ_A_12047456_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Is Our Industry Intellectually Lazy?
Abstract: 
 Part of the mission of the Financial Analysts Journal is to stimulate creative thinking about financial analysis, including investment valuation, risk management, fiduciary issues, and asset allocation. As part of that mission, the editor raises questions about and calls for investigation of the following practices:  Why does our industry forecast aggregate corporate earnings growth rates that are faster than sustainable GDP growth? Why do we not question pension return assumptions? Why accept rising pension return expectations in a rising market? Why allow actuarial or accounting assumptions to drive investment practice? Why readily accept return forecasts based on extrapolating the past? Why not “normalize” return assumptions? Why is the topic of expensing management stock options controversial? When various “earnings” figures diverge, why not ask why? Why is a negative equity risk premium considered shocking? Why is our industry often surprised and distrustful when empirical tests fail to support accepted dogma?  
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2585
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2585
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:1:p:6-8




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# input file: UFAJ_A_12047457_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Author-Name: Harry M. Markowitz
Author-X-Name-First: Harry M.
Author-X-Name-Last: Markowitz
Title: With Growth, a Growing Obligation
Abstract: 
  With Growth, a Growing Obligation The FAJ has much to offer potential authors—notably, in reaching the investment practitioner community more effectively, arguably, than any other journal. Since the launch of the Financial Analysts Journal in 1945, the FAJ has had a perhaps lofty but nonetheless admirable vision: to help shape a world where investment practitioners are knowledgeable and wise and where their clients are served with the highest ability and integrity. Although a lot has changed in the nearly 60 years since the FAJ began, that vision remains central to our mission. The FAJ's continuing goal is to publish the finest practitioner-oriented thinking and research in the field of investment management. What has certainly changed is the reach of the FAJ, in both numbers and geographic scope. What was once a journal that served fewer than 100 readers, primarily in New York City, is now sent to more than 65,000 people located around the globe. Our total readership is well over 100,000. Growth in numbers and dispersion of readers has increased the FAJ's obligations to advance knowledge about the investment management field. And to meet these obligations, the FAJ cannot passively wait for good manuscripts to arrive at its door. Instead, we must actively reach out and encourage others to research, write, and submit articles to the journal. We at the FAJ, therefore, are strongly encouraging the submission of papers that represent an idea or research that is sound, well reasoned, clearly presented, and useful to the practitioner community. We want papers that will extend knowledge about practices, tools, and theory in investment management. We want papers from practitioner and academic authors alike that are written for a practitioner audience. Among practitioners, we already are an “automatic” venue for sharing new and interesting ideas. For academic writers, we want to be the “first call” for papers that are of practical use to the practitioner community. In short, we want to be the natural choice for articles that target the needs of the practitioner world. Having an article published in the FAJ is a mark of distinction. We are one of the most selective journals in the finance community. The FAJ has a rigorous editorial selection process: All articles are subject to a double-blind review by both an academic referee focusing on correctness and a practitioner referee focusing on usefulness. In essence, an article published in the FAJ has passed two important hurdles—a correctness level established by the academic community and a high level of relevance to the practitioner community. With its large circulation and readership, the FAJ provides unparalleled distribution of an author's ideas and research. Readers are investment practitioners and academics from New York City to Zurich to Hong Kong to Miami. This circulation rivals or exceeds the combined circulation of all other finance journals, academic or practitioner. Readers range from portfolio managers and equity analysts to company presidents, board chairs, and chief investment officers. They work in giant investment management firms with the equivalent of hundreds of billions of dollars under management and in small firms managing private client portfolios. There is no better way to expose research and ideas to the global investment community than by publishing in the FAJ. The FAJ has a long and proud heritage. It has published the works of many of the leading investment thinkers and researchers of the last half of the 20th century. As noted in the January/February 2003 “From the Editor,” the FAJ has published 14 articles by Benjamin Graham over a 30-year span, 19 articles by Fischer Black over two decades, 13 articles by William Sharpe over three decades, and 11 articles by Peter Bernstein over three decades. Furthermore, eight Nobel Prize winners in economics have written articles for the Financial Analysts Journal—Robert Engle, Milton Friedman, Clive Granger, Harry Markowitz, Robert Merton, Franco Modigliani, William Sharpe, and Jan Tinbergen. By publishing in the FAJ, an author becomes a part of this proud tradition. To be instrumental in creating a world in which investment practitioners are knowledgeable and clients are well served, the FAJ strives to publish the very best articles. Clearly, however, the path to achieving our vision starts with authors. We hope authors, researchers, and thinkers in the field of investment management will consider publishing their best-articulated and most practitioner-relevant work in the Financial Analysts Journal and will encourage their colleagues to do so. 
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2586
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2586
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# input file: UFAJ_A_12047459_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: R. Douglas Van Eaton
Author-X-Name-First: R. Douglas
Author-X-Name-Last: Van Eaton
Author-Name: James A. Conover
Author-X-Name-First: James A.
Author-X-Name-Last: Conover
Title: “Misconceptions about Optimal Equity Allocation and Investment Horizon”: Authors' Response
Abstract: 
 This material comments on “Misconceptions about Optimal Equity Allocation and Investment Horizon”.
Journal: Financial Analysts Journal
Pages: 14-14
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2588
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2588
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Author-Name: Elroy Dimson
Author-X-Name-First: Elroy
Author-X-Name-Last: Dimson
Author-Name: Paul Marsh
Author-X-Name-First: Paul
Author-X-Name-Last: Marsh
Author-Name: Mike Staunton
Author-X-Name-First: Mike
Author-X-Name-Last: Staunton
Title: Irrational Optimism
Abstract: 
 Investors who assume stocks will give safe, favorable returns in the long run are suffering from irrational optimism. This article addresses the tendency of many investors to overestimate the rewards and underestimate the risks of investing in stocks over the long term—that is, investors’ irrational optimism. In particular, it examines the widely held belief that stocks are a “safe” investment for the long run. The probability of experiencing a real loss on equities depends on the expected real return and standard deviation of stocks. Judgments about the future magnitude of these two parameters typically involve extrapolating from history. In the study reported here, we used a unique global database of real equity returns from 16 countries during the 103-year period from 1900 through 2002 to confront the optimism of investors with the reality of history.Since 1900, as measured for all 16 countries, the worldwide real return on equities averaged close to 5 percent a year (before costs, fees, and taxes). This percentage is appreciably lower than is frequently quoted from historical averages.The difference arises because we used a longer time frame (1900–2002) than other studies and we adopted a global focus. Prior views have been heavily influenced by the U.S. experience, but the United States has been an exceptionally successful economy; so, not surprisingly, we found that U.S. stock returns have been somewhat higher than the average for the other 15 countries.Prior views on the long-run safety of equities have also been overly influenced by the U.S. experience. Furthermore, the U.S. evidence that over the long haul, stocks have beaten inflation over all 20-year periods is based on relatively few nonoverlapping observations and is hence subject to large sampling error. To counteract this dependency on projections of the U.S. experience, we examined the histories of other countries. We found only three equity markets other than the United States (with a fourth on the borderline) that never experienced a shortfall in real returns over a 20-year period. The worst 20-year real returns of 11 countries were negative. Indeed, historically, in 6 of the 16 countries, investors would need to have waited more than 50 years to be assured of a positive return.Ultimately, investors are concerned with the future rather than the past. Thus, in addition to examining historical data, we also analyze the future shortfall risk of an equity portfolio. The base case for the projections is a worldwide historical volatility level of 20 percent and mean real return of 5 percent. We also examine a lower return of 4 percent—on the grounds that financial history has been kind to investors, especially in the second half of the 20th century. Over that period, equity cash flows almost certainly exceeded expectations, and past returns were advantaged by upward revaluations. Stock markets have thus risen for reasons that are unlikely to be repeated.The projected shortfall risk exceeds the historical risk of shortfall—partly because of the lower assumed real returns (relative to the U.S. market) of 5 percent and 4 percent and partly because, even though volatility was projected to be the same as in the past, the shortfall analysis focuses on the full range of possible future returns rather than a single historical outcome. By construction, historical returns converged on long-term realized performance, but the forward-looking analysis shows that there is always risk from investing in volatile securities. Although the probable rewards from equity investment are clearly attractive, stocks did not and cannot offer a guaranteed superior performance over the investment horizon of most investors. Furthermore, their prospective returns are lower than the performance that many investors project whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational.
Journal: Financial Analysts Journal
Pages: 15-25
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2589
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2589
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:1:p:15-25




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# input file: UFAJ_A_12047461_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bruce I. Jacobs
Author-X-Name-First: Bruce I.
Author-X-Name-Last: Jacobs
Title: Risk Avoidance and Market Fragility
Abstract: 
 Products that promise protection from the risks of investing can contribute to market fragility. The era of “stocks for the long run” is over. Risk, dormant through much of the 1990s, has been rediscovered, and there is no shortage of experts willing to share their wisdom on how to stomp it out. But is there such a thing as being “too safe”?When products purporting to “insure” against declines in broad financial markets attract large numbers of investors, the financial institutions offering such products are exposed to significant amounts of systematic risk. They frequently control their exposure to this risk by purchasing options or by replicating options via dynamic hedging, buying the underlying asset as its price rises and selling as its price falls. The dealers from whom options are purchased control their own exposure by either buying options or replicating them. Financial institutions’ ability to “insure” themselves against the insurance products they have sold is thus dependent on the presence of counterparties willing to sell them options or, equivalently, to take the other side of their dynamic hedging trades. As more and more investors demand insurance, however, insurers may face increasing difficulty in finding counterparties. Furthermore, more insuring is likely to lead to more trend-following dynamic hedging, which can exacerbate market volatility. As volatility increases, the demand for insurance may increase, heightening the demand for options and thus the amount of option-replicating trades, leading to even greater market volatility.When market prices fall, the selling required to replicate an option on the market may overwhelm the willingness of other market participants to buy, creating a liquidity crisis. In such an event, the trades needed to replicate options will not get off at the prices required to guarantee the insured value and the trades will have to be executed (if at all) at much lower prices. The “insurance” can fail. When that insurance underlies the insurance products sold by a financial institution, those products, along with the institution itself, can fail. What is more, because of the linkages between counterparties, one institution’s failure can lead to systemic failure and broad economic disruption. Insurance products have taken financial markets to the brink before, in the 1980s with portfolio insurance and in the 1990s with the collapse of Long-Term Capital Management (LTCM).In both cases, the market could not accommodate the amount of trading required to “insure” supposedly “riskless” products. Market prices gapped discontinuously. Insured investors could not get their trades off at the prices required to guarantee the insured values. Thus, portfolio insurance failed to provide the promised protection. LTCM incurred substantial losses on trades that had been designed to be relatively riskless. Furthermore, the aftershocks of the portfolio insurance and LTCM debacles were felt globally. In both 1987 and 1998, markets effectively had to be bailed out by the U.S. Federal Reserve Board, which provided liquidity in the wake of both crises and also orchestrated the rescue of LTCM in 1998.With traditional insurance, risk of loss is essentially shared by many policyholders, with the insurance provider acting as intermediary. Those who buy “insurance” against a stock market decline, however, are really shifting this risk onto the insurance provider. But who is the risk bearer of last resort? It may be the taxpayer, if the government decides that the firms that offered these products are “too big to fail.” Often, it is investors in general who bear the risk, in the form of the substantial declines in prices that are required to entice risk bearers back into the market. Ironically, products designed to reduce financial risk can end up creating even more risk.
Journal: Financial Analysts Journal
Pages: 26-30
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2590
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2590
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:1:p:26-30




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# input file: UFAJ_A_12047462_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard Roll
Author-X-Name-First: Richard
Author-X-Name-Last: Roll
Title: Empirical TIPS
Abstract: 
 U.S. Treasury Inflation-Indexed Securities (commonly known as TIPS) were first issued in January 1997. Through the third quarter of 2003, 12 TIPS had been issued, with original maturities ranging from 5 to 30 years. One TIP bond has already matured. This study documents the correlations of TIPS returns with the returns on nominal bonds and with equity returns over the past seven years; TIPS real and effective nominal durations; and changes in the volatility of TIPS over time. TIPS are used here to estimate real yield curves, which are then compared against nominal yield curves to derive the term structure of anticipated inflation on a daily basis. An explanation offered for the dramatic decline in TIPS real yields since 1999 is supported by empirical tests. Finally, given plausible assumptions about future expected returns, the article shows that an investment portfolio diversified between U.S. equities and nominal bonds would be improved by the addition of TIPS. U.S. Treasury Inflation-Indexed Securities (commonly known as TIPS) were first issued in January 1997. Through the third quarter of 2003, 12 TIPS have been issued, with original maturities ranging from 5 years to 30 years. One TIP bond has already matured. With the accumulation of almost seven years of daily TIPS trading experience, sample sizes are more than adequate to establish some empirical facts about TIPS behavior. So, now seems to be a good moment to undertake a systematic empirical study of these interesting new assets. This study reports correlations of TIPS returns with the returns on nominal bonds and with equity returns over the past seven years. It calculates TIPS real and effective nominal durations and traces changes in the volatility of TIPS returns over time. It presents empirical measures of the effective nominal durations of TIPS and their return sensitivities to changes in the shape of the nominal term structure of interest rates. The study finds that TIPS return volatility has varied remarkably over their available history. TIPS provide an opportunity to estimate the entire term structure of anticipated inflation by comparing real yields on TIPS and ordinary yields on nominal bonds.TIPS real yields have declined dramatically since 1999. The article offers a tax-based explanation (with some supporting evidence). Finally, the article assesses the benefits of including TIPS in a balanced and diversified investment portfolio.
Journal: Financial Analysts Journal
Pages: 31-53
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2591
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2591
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# input file: UFAJ_A_12047463_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: S.P. Kothari
Author-X-Name-First: S.P.
Author-X-Name-Last: Kothari
Author-Name: Jay Shanken
Author-X-Name-First: Jay
Author-X-Name-Last: Shanken
Title: Asset Allocation with Inflation-Protected Bonds
Abstract: 
 In the study reported here, we set out to examine whether and how the availability of indexed bonds might affect investors' asset allocation decisions. We used historical yields on conventional U.S. T-bonds and an inflation-forecasting model to create a series of hypothetical indexed bond returns. We found that the real (inflation-adjusted) returns on indexed bonds are less volatile than the returns on otherwise similar conventional bonds. Moreover, the correlation with stock returns is much lower for the indexed bonds. An examination of asset allocation among stocks, indexed bonds, conventional Treasuries, and a riskless asset suggests that substantial weight should be given to indexed bonds in an efficient portfolio. These conclusions are generally supported by analysis of the history of actual returns on U.S. Treasury Inflation-Indexed Securities (commonly known as TIPS) for February 1997 through July 2003. After much debate, the U.S. Treasury began issuing U.S. Treasury Inflation-Indexed Securities (commonly known as TIPS)in 1997. Such bonds, generically known as indexed bonds, have long been a topic of interest to the investment community and government policymakers. Advocates of indexed bonds have argued the benefits of such bonds to retirees and other investors who are vulnerable to inflation risk. Somewhat surprisingly, limited work has been done on the impact of the availability of indexed bonds on investors’ asset allocation decisions. Should investors hold a different mix of stocks and bonds in the presence of indexed bonds than otherwise? Although long historical time series of stock and conventional bond prices are available, the same is not true for indexed bonds in the United States. Therefore, we began the study reported in this article by constructing a monthly time series of hypothetical zero-coupon indexed bond prices as if the bonds had been available since the 1950s. These prices were calculated each month by discounting the real payoff to the hypothetical indexed bond by the relevant real rate of interest. The interest rate was estimated by subtracting a forecast of inflation from the corresponding nominal bond yield. The forecasts (measures of expected inflation) were obtained from time-series regression models. Returns were then computed from the hypothetical indexed bond prices.Based on the hypothetical indexed bond returns, we found that these bonds provide considerable diversification benefits for investors. Data from 1953 through 2000 indicate that the real returns estimated for indexed bonds are virtually uncorrelated with stock returns whereas the nonindexed bonds exhibit positive correlation near 0.4. The stock–conventional bond correlation is not surprising because stock prices and conventional bond prices react negatively to news of increased inflation. In addition, we found that indexed bond returns, particularly the real returns, are less variable than nonindexed bond returns.Naturally, the risk-reduction benefits of indexed bonds must be weighed against the possibility of a relatively low expected return. Interest rates on conventional bonds can be viewed as the sum of expected inflation, a real riskless rate of return, and a premium for inflation risk. If the inflation risk premium is positive, indexed bonds will have lower expected returns than conventional bonds. The pricing of TIPS traded in the market in the past few years suggests that the inflation risk premium may be close to zero or even negative, however, perhaps as a result of the lower liquidity of the indexed bonds. Because of these considerations, our base computations assume an inflation risk premium of zero, but we also consider alternative scenarios in which the risk premium is 50 bps or 100 bps.In the asset allocation analysis, we examined the weights on indexed bonds, conventional Treasury bonds, and a value-weighted stock market index in a mean–variance efficient portfolio (i.e., a portfolio that maximizes expected return for a given level of risk) when a riskless asset is available. The investment horizon was one year. The hypothetical indexed bond returns were combined with the historical returns on conventional bonds and stocks to estimate return standard deviations and correlations. Interestingly, using real returns, we found no role for conventional bonds unless the inflation risk premium exceeds 55 bps.We also analyzed actual indexed bond data for 1997 through July 2003 to see whether the initial U.S. experience has been anything like our model-based predictions. The recent data confirm the suggestion of substantial diversification benefits to be had from adding TIPS. The volatility of TIPS returns has, in fact, been much lower than that observed in our historical simulation. Using the recent data to estimate risks and correlations, we again found that an efficient portfolio should give considerable weight to indexed bonds. This conclusion held for a wide range of scenarios for expected returns.Indexed bonds dominated the efficient “tangency” portfolio in the absence of any inflation risk premium, and even with a risk premium of 50 bps, the allocation to indexed bonds exceeded that of conventional bonds. Although we do not recommend that an investor’s asset allocation be based solely on observations of this sort, we do think indexed bonds should be given serious consideration by investors.
Journal: Financial Analysts Journal
Pages: 54-70
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2592
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2592
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# input file: UFAJ_A_12047464_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Louis K.C. Chan
Author-X-Name-First: Louis K.C.
Author-X-Name-Last: Chan
Author-Name: Josef Lakonishok
Author-X-Name-First: Josef
Author-X-Name-Last: Lakonishok
Title: Value and Growth Investing: Review and Update
Abstract: 
 A great deal of academic empirical research has been published on value and growth investing. We review and update this literature, discuss the various explanations for the performance of value versus growth stocks, review the empirical research on the alternative explanations, and provide some new results based on an updated and expanded sample. The evidence suggests that, even after taking into account the experience of the late 1990s, value investing generates superior returns. Common measures of risk do not support the argument that the return differential is a result of the higher riskiness of value stocks. Instead, behavioral considerations and the agency costs of delegated investment management lie at the root of the value–growth spread. Value and growth investing are widely recognized specializations adopted by money managers. These specializations draw on, and stimulate, a large body of academic empirical research. Building on earlier studies of stock market “anomalies,” the research on value versus growth generally agrees that value investment strategies, on average, outperform growth investment strategies. The reward to value investing is more pronounced for small-capitalization stocks and is present in equity markets outside the United States as well. The reasons for the superior performance of value investing, however, are controversial. Some researchers attribute the higher returns to the higher risk of value stocks; other researchers contend that the rewards to value investing stem from cognitive biases underlying investor behavior and the agency costs of delegated investment management.We summarize and bring up to date the academic empirical research on value and growth investing. The bulk of current research stopped short of the late 1990s, a period that was not kind to value stocks. When the data through 2001 are considered, however, value investing still outperforms growth investing. During the 1990s, the performance of growth stocks rocketed, prompting speculation that value investors were an endangered species. The careful examination of the data that we present suggests that the differences among equity asset classes with respect to their performance in the late 1990s were not grounded in fundamental patterns of profitability growth. A more plausible interpretation is that investor sentiment reached exaggerated levels of optimism about the prospects for such “growth” opportunities as telecommunications, media, and technology stocks. This interpretation is consistent with evidence that investors tend to focus on past growth and extrapolate too far into the future. Furthermore, the sharp rise and decline in recent years of these growth-oriented stocks calls into question the argument that growth stocks are the less risky investments. In fact, the superior returns on value stocks for the overall period were not accompanied by higher risk, as calculated by a variety of indicators. We also suggest methods of enhancing the returns to value strategies by defining value and growth by more than the familiar ratio of book value to market value. A value portfolio based on book value to market value, cash flow to price, earnings to price, and sales to price dominated the Russell 1000 Value Index large-cap value benchmark by 5 percentage points a year on average for the 1979–2001 period. Favorable results were also obtained when this enhanced value strategy was applied to U.S. small-cap stocks and to the largest stocks in the MSCI Europe/Australasia/Far East universe.
Journal: Financial Analysts Journal
Pages: 71-86
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2593
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2593
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:1:p:71-86




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# input file: UFAJ_A_12047465_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Wenling Lin
Author-X-Name-First: Wenling
Author-X-Name-Last: Lin
Author-Name: Lisa Kopp
Author-X-Name-First: Lisa
Author-X-Name-Last: Kopp
Author-Name: Phillip Hoffman
Author-X-Name-First: Phillip
Author-X-Name-Last: Hoffman
Author-Name: Mark Thurston
Author-X-Name-First: Mark
Author-X-Name-Last: Thurston
Title: Changing Risks in Global Equity Portfolios
Abstract: 
 Given recent changes in sector and style risk and in manager betting behavior in the global equity markets, we analyzed the relative importance of the major active-risk drivers and the implications of their relative importance for global multimanager portfolio construction. Using cross-sectional regressions and multimanager portfolio simulations, we found that the effect of style and sector bets on active manager risk increased after 1998 and that using style-balanced portfolios could have substantially reduced active risk during the 1998–2002 period. Most of the risk reduction, however, would have come from the diversification of stock/sector selection risk, because growth and value managers make different bets on certain sectors. Common bets on major countries, such as Japan or the United States, persisted during this period, but their importance decreased because of smaller benchmark-relative bets and country risk. In light of the changes, using multiple risk-control strategies to construct multimanager portfolios may be an effective way to thrive in different market environments. In the early to mid-1990s, country factors were the dominant drivers of risk and return for global equity portfolios. Thus, the key to controlling this risk was using low-country-bet managers or overlaying portfolios with country futures. Since this period, however, the importance of sector and style risk has increased and managers have changed their bets, which suggests that the prior focus on country risk should be reconsidered. To this end, we investigated changes in the relative importance of active risk drivers for global equity portfolios and the implications of their importance for constructing global multimanager portfolios.Manager data come from the Russell/Mellon Company’s InterWorld and RepEAFE equity universes with, respectively, the MSCI World and MSCI Europe/Australasia/Far East indexes as benchmarks. Using these data for the 1990–2002 period, we show that since 1998, the country factor has not exerted a dominant influence on the active risk of EAFE and World portfolios; instead, sector and style (value versus growth) risk have become increasingly important. The primary causes of the shift in active risk were (1) a gradual reduction in managers’ country bets, (2) the increasing significance of sector and style risk relative to country risk, and (3) the rising influence of investment style on manager sector/style views. These findings suggest that investors should diversify portfolios among country, sector, and style (and market capitalization) risk rather than emphasizing only one factor.To help investors cope with the rising influence of sector and style risk on active risk, we investigated various strategies for constructing global equity portfolios. We found a potential diversification benefit from combining growth and value managers. The two groups have had disparate views on certain sectors (particularly the technology sector and the materials and processing sector), but their country views have been highly correlated, primarily because of their common history of betting against Japan. Using multimanager portfolio simulations, we demonstrate that diversifying according to manager style could have substantially lowered active risk after 1998, when sector and style risk was rising. Much of the reduction in risk came from stock/sector selection rather than country allocation, suggesting that the style-balanced strategy diversified away style risk as well as some sector risk. Our simulation results affirm the benefit of balancing manager style in portfolio construction. 
Journal: Financial Analysts Journal
Pages: 87-99
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2594
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2594
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:1:p:87-99




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# input file: UFAJ_A_12047466_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Charles P. Jones
Author-X-Name-First: Charles P.
Author-X-Name-Last: Jones
Author-Name: Jack W. Wilson
Author-X-Name-First: Jack W.
Author-X-Name-Last: Wilson
Title: The Changing Nature of Stock and Bond Volatility
Abstract: 
 This article examines the changing nature of U.S. stock and bond risk from 1871 through 2000 and the implications for asset allocation. Using geometric means and standard deviations, we examine nominal and inflation-adjusted monthly returns over nonoverlapping 5-year periods, as well as annual returns over periods of approximately 25 years, and we document how stock and bond volatility changed over the period. Our analysis suggests that the relative change in the volatility of stocks and volatility of bonds over the past 50 years has increased the importance of stocks in asset allocation. The change is even more pronounced when inflation is considered. This article examines the changing nature of stock and bond risk from 1871 through 2000 and the implications for asset allocation. Using geometric means and standard deviations, we examine nominal and inflation-adjusted monthly returns over five-year periods, as well as annual returns over periods of approximately 25 years, and document how stock and bond volatility changed over the sample period. Our analysis suggests that the change in the relative volatility of stocks and bonds over the past 50 years has increased the attractiveness of stocks in asset allocation, and the change is even more pronounced when inflation is considered.Since about 1940, stock volatility has fluctuated in a narrow range, and both low and high mean stock returns have been associated with similar levels of volatility. But bond volatility increased during the last 35 years of the series. The best 5-year nominal mean returns on bonds occurred during a 10-year period when bond volatility was at its highest level in history.The geometric mean nominal returns of stocks exceeded those of bonds in 18 of the 26 nonoverlapping five-year periods. Inflation-adjusted geometric mean stock returns were negative in only 3 of the 26 periods, but for bonds, they were negative in 10 of the 26 periods. The inflation-adjusted geometric standard deviation of bonds was 30 percent higher than the nominal standard geometric deviation for the 1871–2000 period. For stocks in this period, however, there was little difference between inflation-adjusted and nominal geometric standard deviations.The relative riskiness of stocks and bonds has undergone a long-term change. Until roughly 1950, the ratio of the two variances (stocks to bonds) was much greater than it has been subsequently except for a single five-year period. An examination of five-year standard deviations indicates that bond risk has increased since the 1960s whereas stock risk has remained relatively steady.The correlation between bond returns and stock returns, although fluctuating, has been increasing. Combined with the increase in bond volatility relative to stock volatility, this rising correlation has important implications for asset allocation. Our analysis of the nominal risk–return trade-off available to investors shows that the situation changed after World War II. For the later two 25-year periods examined here, a 100 percent bond portfolio, or a portfolio invested primarily in bonds, compared unfavorably on a return–risk basis with several portfolios that had larger stock allocations. This outcome was most pronounced in the last period, 1974–2000, when a 70/30 stock/bond allocation had less risk and a much larger return than did a 100 percent bond portfolio. Clearly, during the last half of the 20th century, the changes in relative stock and bond volatility increased the attractiveness of stocks relative to bonds.On an inflation-adjusted basis, the case for portfolios heavily invested in bonds is even weaker than it is on a nominal basis. Bonds are affected more severely when adjusted for the increased risk caused by the covariance of nominal bond returns and inflation.
Journal: Financial Analysts Journal
Pages: 100-113
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2595
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2595
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# input file: UFAJ_A_12047467_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: John Hull
Author-X-Name-First: John
Author-X-Name-Last: Hull
Author-Name: Alan White
Author-X-Name-First: Alan
Author-X-Name-Last: White
Title: How to Value Employee Stock Options
Abstract: 
 One of the arguments often used against expensing employee stock options is that calculating their fair value at the time they are granted is very difficult. This article presents an approach to calculating the value of employee stock options that is practical, easy to implement, and theoretically sound. It explicitly considers the vesting period, the possibility that employees will leave the company during the life of the option, the inability of employees to trade their options, and the relevant dilution issues. This approach is an enhancement of the approach suggested by the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 123 because it does not require an arbitrary reduction in the life of the option to allow for early exercise caused by the inability of employees to trade their options. The issue of whether companies should be required to expense employee stock options has received a great deal of attention in recent years. In October 1995, the Financial Accounting Standards Board published Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation. This statement encourages companies to expense employee stock options, but it does not require them to do so. Immediately following the publication of FAS 123, few companies opted to expense stock options. Recently, however, a marked increase has taken place in the number of companies doing so, and in all likelihood, the International Accounting Standards Board and a number of national accounting boards will require expensing in the near future.One of the arguments often used against expensing employee stock options is that calculating their fair value at the time they are granted is very difficult. We present an approach to calculating the value of employee stock options that is practical, easy to implement, and theoretically sound. It explicitly considers the features of executive stock options that make them different from regular options. These features are (1) the vesting period, (2) the possibility that employees will leave the company at some time during the life of the option, (3) the inability of employees to trade their options, and (4) the potential dilution.Our approach is an enhancement of the approach suggested by FAS 123 in that our approach does not require an arbitrary reduction in the life of the option to allow for early exercise caused by the inability of employees to trade their options. Instead, our approach assumes that the option is exercised when the stock price reaches a certain multiple of the exercise price. This multiple, called “the early exercise multiple,” is determined empirically. In addition to the parameters usually required to value an option, the enhanced FAS 123 model requires the vesting period, the early exercise multiple, and the average employee turnover rate (both pre- and postvesting).In the valuation approach, the analyst may use a binomial or trinomial tree similar to that used for valuing American-style options. The calculation of the value of the option at each node is different from the calculation used in valuing a regular American option because of the following aspects:The enhanced FAS 123 approach does not test for early exercise during the vesting period.The option is assumed to be exercised when the ratio of the stock price to the exercise price reaches the early exercise multiple.The “roll back” calculations account for the possibility that part of the value may be lost when the employee, voluntarily or involuntarily, leaves the company.The issue of dilution causes a great deal of confusion in the valuation of executive stock options. We show that the stock price used when an employee stock option is valued should be the price immediately after the news reaches the market that the options have been granted. When this stock price is used, no further adjustment for dilution is necessary. The impact of dilution is already reflected in the stock price. 
Journal: Financial Analysts Journal
Pages: 114-119
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2596
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2596
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# input file: UFAJ_A_12047468_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issues.
Journal: Financial Analysts Journal
Pages: 120-120
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2597
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2597
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# input file: UFAJ_A_12047469_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Michael Stutzer
Author-X-Name-First: Michael
Author-X-Name-Last: Stutzer
Title: “Misconceptions about Optimal Equity Allocation and Investment Horizon”: A Comment
Abstract: 
 This material comments on “Misconceptions about Optimal Equity Allocation and Investment Horizon”.
Journal: Financial Analysts Journal
Pages: 12-14
Issue: 1
Volume: 60
Year: 2004
Month: 1
X-DOI: 10.2469/faj.v60.n1.2598
File-URL: http://hdl.handle.net/10.2469/faj.v60.n1.2598
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# input file: UFAJ_A_12047470_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Integrating Investments and the Tax Code (a review)
Abstract: 
 The authors provide an essential reference tool for investment professionals who manage taxable accounts. The book contains comprehensive discussions, with case studies, of the issues important to maximizing after-tax ending wealth: how to analyze asset allocation and asset location (whether assets are kept in taxable or tax-deferred vehicles), choosing between low- and high-turnover investment vehicles, and choosing among investments that vary with respect to the proportion of expenses borne by investors.
Journal: Financial Analysts Journal
Pages: 102-103
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.1954
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.1954
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:2:p:102-103




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# input file: UFAJ_A_12047471_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issues.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.1955
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.1955
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:2:p:104-104




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# input file: UFAJ_A_12047472_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: The Meaning of a Slender Risk Premium
Abstract: 
 The superiority of stocks over bonds for the long-term investor is typically supported by two ideas—a hefty equity risk premium and the growth of dividends vs. nongrowing bond coupons. This piece challenges both ideas. The equity risk premium is unknown. We can estimate it (and all too often, we do so badly by merely extrapolating the past). Should a risk premium exist? Of course. Is its existence written into contract law for any assets we buy? Of course not. This piece develops the outcomes of stock versus bond returns if we accept a skinny risk premium. These “worst reasonable” (5th-percentile-outcome chance of a shortfall) calculations indicate that if the risk premium is 2 percent, wealth from stocks will be 50 percent behind wealth from bonds even after 35 years of patient investing. If dividend growth matches the 4 percent average rate for the 20th century, (1) dividend income (starting from the current 1.5 percent) will need 32 years to overtake bond coupon income and (2) cumulative income from stocks will require a startling 54 years to keep pace with that from bonds. 
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.2600
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.2600
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# input file: UFAJ_A_12047473_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Joseph C. Zavalishin
Author-X-Name-First: Joseph C.
Author-X-Name-Last: Zavalishin
Title: “Who's Minding the Store?”: A Comment
Abstract: 
 This material comments on “Who's Minding the Store?”.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.2601
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.2601
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# input file: UFAJ_A_12047475_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jonathan A. Hayes
Author-X-Name-First: Jonathan A.
Author-X-Name-Last: Hayes
Title: “Why Ethics Codes Don't Work”: A Comment
Abstract: 
 This material comments on “Why Ethics Codes Don't Work”.
Journal: Financial Analysts Journal
Pages: 14-14
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.2603
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.2603
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# input file: UFAJ_A_12047477_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: O. Whitfield Broome
Author-X-Name-First: O. Whitfield
Author-X-Name-Last: Broome
Title: Statement of Cash Flows: Time for Change!
Abstract: 
 The statement of cash flows is one of the three basic financial statements required under generally accepted accounting principles (GAAP). Recent financial reporting scandals have shown that this basic financial statement is in need of reform. The presentation of operating cash flow using the indirect method is confusing to many readers, including financial analysts. The terminology used in the statement is unclear and unhelpful. The misclassification of specific cash flows in the operating, financing, or investing sections can result in overstatement of operating cash flow. The direct method for reporting cash flow from operations is recommended, together with an improved reconciliation of operating cash flow to net income. Moreover, companies need better guidance on classifying individual cash flows; the statement itself needs improved descriptions and straightforward terminology. The statement of cash flows is a key financial statement used by analysts and other readers to assess the financial performance of publicly held corporations, but this statement has serious deficiencies. In Statement of Financial Accounting Standards (SFAS) No. 95, issued in 1987, the Financial Accounting Standards Board (FASB) recommended that the direct method be used to report operating cash flows. An AIMR white paper of 1993 also expressed a strong preference for the direct method. Yet, more than 90 percent of corporate statements of cash flow use the permissible indirect method. Equally troubling is that the cash flows are sometimes misclassified among the operating, investing, and financing sections. Moreover, the terminology used in the statement of cash flows is often unclear and unhelpful.Analysts have commonly believed that, unlike the income statement and balance sheet, the statement of cash flows cannot be manipulated by company managers if it is prepared in accordance with generally accepted accounting principles. Recent financial reporting scandals have shown, however, that the statement of cash flows can be subject to management manipulation. Therefore, now is the time to make improvements in this important statement.After a review of the requirements of SFAS No. 95 and illustration of typical statements of cash flows, this article presents a comparison of the alternative methods for reporting operating cash flow—the direct and indirect methods. Because the direct method reports operating cash flow in more understandable categories than the indirect method, the direct method allows analysts to identify trends in the major causes of cash inflows and outflows, which raises the question of why corporations predominantly use the indirect method. Although cost considerations are often cited, the short answer is that the indirect method can provide a kind of “cover” for potential manipulation of the statement. In addition to using the more confusing indirect method, corporations can misclassify transactions to overstate operating cash inflows and use unclear terminology in the statement of cash flows. Several high-profile financial reporting failures—Tyco, Dynegy, Qwest, Adelphia, and WorldCom—show how the statement of cash flows can be manipulated in the company's favor.Financial reporting should provide information to help investors, creditors, and other users assess the amounts, timing, and uncertainty of prospective cash flows. The manipulation of the statement indicates that this important report does not meet those criteria. Therefore, now that confidence in financial statements is at low ebb, the time has come for the FASB to tighten standards for the statement of cash flows. The FASB should require use of the direct method and provide additional guidance on the proper classification of cash flows in the operating, investing, and financing sections.In addition to use of the direct method, the FASB should require an understandable reconciliation of operating cash flow to net income. This reconciliation should report adjustments in four distinct categories: (1) operating cash inflows not recognized as revenues during the current year, (2) operating cash outflows not recognized as expenses during the current year, (3) current revenues for which there were no current cash inflows, and (4) current expenses for which there were no current cash outflows. The article includes a representative list of adjustments classified into these categories and provides a model statement of cash flows to illustrate the recommended format and terminology.
Journal: Financial Analysts Journal
Pages: 16-22
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.2605
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.2605
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# input file: UFAJ_A_12047478_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ira G. Kawaller
Author-X-Name-First: Ira G.
Author-X-Name-Last: Kawaller
Title: What Analysts Need to Know about Accounting for Derivatives
Abstract: 
 By the end of 2002, public companies in the United States were required to comply with a new set of accounting rules related to corporate use of derivative instruments. Financial Accounting Statement (FAS) No. 133 has subsequently become widely recognized as the most complex set of accounting rules yet to be promulgated. And just as those who prepare financial statements had to learn how to accommodate to the new requirements, analysts also must understand this standard in order to interpret derivative results appropriately. Despite the added transparency of FAS No. 133, a lack of familiarity with it can easily lead analysts to erroneous conclusions. Financial Accounting Statement (FAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, and subsequent amendments (FAS Nos. 138 and 149) reflect the Financial Accounting Standard Board's effort to add transparency and consistency to corporate accounting for derivative instruments and hedging transactions. Despite the objectives, these relatively new rules (initially adopted in 2000) have been the subject of much criticism.Under FAS No. 133, a derivative contract must be recorded as an asset or liability on the balance sheet and marked to market. Exactly how changes in value are treated, however, depends on whether the derivative was used for hedging purposes or not. If it was not used for hedging, the gains or losses flow through earnings. If it was used for hedging (and assuming the qualifying criteria are satisfied), special hedge accounting generally is to be applied. This treatment assures that the income effects from both components of the hedge relationship (i.e., the hedged item and the hedging derivative) affect earnings in a common accounting period, thereby minimizing income volatility.Many entities that are affected by FAS No. 133 consider it to be overly complicated and difficult to implement—at least insofar as qualifying for special hedge accounting. The alternative treatments that companies may choose and the uncertainty associated with qualifying for special hedge accounting (whether because of substantive issues or deficiencies in documentation) have resulted in a less-than-hoped-for level of consistency in accounting practices. Some companies apply hedge accounting; others with virtually the same kinds of exposures and derivative transactions do not.In comparing two companies that apply different accounting treatments, analysts should recast the reported results of at least one of these companies to assure that the comparison is of apples to apples. This issue brings up the question of which presentation is more appropriate. Is the hedge accounting approach the more meaningful depiction of the company's performance, or is the nonhedge treatment a better representation? Although this determination is best left to the analyst, hedge results should be assessed, not in isolation, but relative to the exposures of the company.This article makes a distinction between, on the one hand, the assessment of the derivative's gains or losses relative to the changes in value associated with the hedged item and, on the other hand, the derivative's results relative to the overall exposure of the business entity—a distinction that is ignored by the rules of FAS No. 133. The first of these comparisons is certainly central to the evaluation of the hedging relationship, the question of whether or not hedge accounting may be applied, and the determination of hedge ineffectiveness, which must be disclosed. But the derivative's results relative to the company's overall exposure is much more relevant for the analyst who is seeking to project coming performance of the company or to value its stock. For either of these objectives, the analyst needs to determine the magnitude of risks (and opportunities) the company bears (or enjoys) and, presumably, must make a judgment about the relative probabilities associated with the market conditions that could occur.The article highlights the fact that a proper valuation must go beyond merely examining financial statements, because much critical information related to derivatives transactions may not be reported in these statements in a transparent way. For instance, for an analyst to evaluate the company, the analyst should know the nature of the company's price risks (including the hedging positions used) and how the hedges tend to be managed. In many situations, however, a complicating factor is that companies may be protective of this information for fear that its release could jeopardize a competitive advantage.The caution offered by the article is that whereas FAS No. 133 is responsible for much new information that had not been publicly reported, this new information is easily misinterpreted unless the analyst fully appreciates the hedging objectives and capabilities of the companies being analyzed.
Journal: Financial Analysts Journal
Pages: 24-30
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.2606
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.2606
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:2:p:24-30




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# input file: UFAJ_A_12047479_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Kees G. Koedijk
Author-X-Name-First: Kees G.
Author-X-Name-Last: Koedijk
Author-Name: Mathijs A. van Dijk
Author-X-Name-First: Mathijs A.
Author-X-Name-Last: van Dijk
Title: Global Risk Factors and the Cost of Capital
Abstract: 
 Analysis of 3,300 stocks from nine industrialized countries over the 1980–99 period indicates that whether the capital asset pricing model or some form of international CAPM is used makes little difference in the cost-of-capital estimate for most companies in most countries. The international CAPM yielded an estimate of the cost of equity capital that was significantly different from that of the domestic CAPM in only 4–5 percent of the sample companies. For the vast majority of companies, the domestic market factor is an adequate benchmark against which to measure an individual company's exposure to both global market and currency risk factors. International financial markets are becoming integrated; hence, global risk factors are increasingly important for portfolio selection and asset pricing. Recent research in the empirical finance literature confirms that global risk factors—notably, the global market portfolio and exchange rate risk—are indeed important determinants of asset returns. This research suggests that practitioners interested in estimating a company's cost of equity capital should use an international version of the capital asset pricing model (CAPM) that includes global market and currency risk factors. Recent survey evidence indicates, however, that the single-factor CAPM, in which the local market factor is the only priced risk factor, is still the dominant model used in practice.From a practical perspective, then, whether incorporating global risk factors would significantly alter cost-of-capital computations is of considerable importance. But empirical literature on the subject is virtually nonexistent. We report empirical evidence on the practical effects of incorporating global risk factors in cost-of-capital computations.We analyzed almost 3,300 stocks from nine industrialized countries over the 1980−99 period to discover whether the single-factor domestic CAPM provided a substantially different cost of capital than provided by two versions of the international CAPM—a single-factor ICAPM in which the global market factor is the only priced risk factor and a multifactor ICAPM that includes currency risk factors as well as the global market factor.We found that the choice of model does not make a difference if the domestic market factor effectively captures an individual company's exposure to the global risk factors. In the case of the single-factor ICAPM, our sample yielded an estimate of the cost of equity capital that was significantly different from that of the domestic CAPM for only approximately 4 percent of the companies. In the case of the multifactor ICAPM, the difference was significant for only 5 percent of the companies.The conclusion is that for the vast majority of companies, the domestic market factor is an adequate benchmark against which to measure an individual company's exposure to both global market and currency risk factors. Incorporating global risk factors into cost-of-capital estimations led to an adjustment of roughly 50 bps a year on average for the U.S. sample and 70–100 bps a year for the other countries. Adjustments of this magnitude easily fall inside the confidence interval associated with actual cost-of-capital computations. Specifically for U.S. companies, the change in the cost-of-capital estimate from using an ICAPM is so small that we can conclude that global risk factors do not really matter for computing the cost of capital of U.S. companies.Although empirical evidence indicates that security returns are more and more driven by industry factors than by country factors, we contend that the domestic CAPM is not likely to become redundant in the context of valuation and capital budgeting. This finding has important implications for financial analysts, because using a multifactor ICAPM for computations of the cost of capital can be cumbersome and estimating currency risk premiums and exposures is extraordinarily complicated. Our study reveals that for a large number of companies, practitioners can rely on the straightforward single-factor domestic CAPM for calculating the cost of equity capital.
Journal: Financial Analysts Journal
Pages: 32-38
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.2607
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.2607
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# input file: UFAJ_A_12047480_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Conrad S. Ciccotello
Author-X-Name-First: Conrad S.
Author-X-Name-Last: Ciccotello
Author-Name: C. Terry Grant
Author-X-Name-First: C. Terry
Author-X-Name-Last: Grant
Author-Name: Gerry H. Grant
Author-X-Name-First: Gerry H.
Author-X-Name-Last: Grant
Title: Impact of Employee Stock Options on Cash Flow
Abstract: 
 Exercise of stock options provides a source of operating cash flow because of the accounting treatment of reduced income tax payments. Tax savings from option exercises can generate a high percentage of a company's total operating cash flow, although this source of cash varies substantially among companies and from year to year. The net effect of option exercises on cash is a function of tax savings, exercise volume and depth, and funding policy. From 1999 through 2001, companies in the S&P 100 Index repurchased stock well in excess of option exercises whereas Nasdaq 100 Index companies tended to meet exercise demand with previously unissued shares. On average, Nasdaq 100 companies would have had to spend 39 cents of every dollar of revenue over the 1999–2001 time frame to fully fund option exercises and avoid increasing the number of shares outstanding. Cash flow effects of option exercises will remain an issue regardless of the expense treatment of stock option grants. Debates about the expense treatment of employee stock option grants have raged on for more than a decade, whereas the effect on cash flow of stock option exercises has gone virtually unnoticed. Income and expenses are important, but analysts generally consider cash flow a more reliable indicator of performance than accounting income. Operating cash flow is thought to represent a relatively “clean” measure of performance. Thus, if option exercises have large effects on cash flows in general and on operating cash flow in particular, the understanding and evaluation of these effects are critical for analysts.Using data from companies in the S&P 100 Index and the Nasdaq 100 Index, we examined the impact on cash flow of the exercise of employee stock options from 1999 through 2001. Stock option exercises provide a source of operating cash flow because they are an expense that reduces taxable income. This situation is strange because options are not required to be expensed for financial reporting purposes. Furthermore, the tax savings from option exercises can generate a high percentage of a company's total operating cash flow, although this source of cash varies substantially among companies and from year to year. Microsoft Corporation, for example, had more than $5 billion in tax savings from option exercises in 1999—nearly half of its operating cash flow. By 2001, however, the company's tax savings had dropped to about 11 percent of cash flow.Option exercises' net effect on cash is a function of tax savings, exercise volume and depth, and funding policy. For 1999–2001, companies in the S&P 100 repurchased stock well in excess of option exercises whereas Nasdaq 100 companies tended to meet exercise demand with previously unissued shares. On average, Nasdaq 100 companies would have had to spend 39 cents of every dollar of revenue during the 1999–2001 period to fully fund option exercises and avoid increasing the number of shares outstanding. Because the majority of Nasdaq 100 companies did not repurchase any shares in this period, the result was a growth in the number of shares outstanding from option exercises for most Nasdaq 100 companies. In contrast, most S&P 100 companies experienced no significant growth in shares outstanding from option exercises.Growth in shares outstanding is not necessarily evidence that shareholders are being harmed. Along with understanding how option exercises can affect operating cash flow, analysts should evaluate whether a company's option-funding policy is consistent with value creation. If a company has abundant investment opportunities, then investing in those projects might be more prudent than repurchasing shares. The differences in the S&P 100 and Nasdaq 100 companies' funding policies for options are consistent with differences in the investment opportunities for different sectors of the economy.Option exercises can claim a large percentage of revenues, and options have real cash costs. Regardless of what happens to the expense treatment of stock option grants, the impact on cash flows when employees exercise their stock options will remain. Thus, analyzing the effect of option exercises focuses the debate on a lasting concern in valuation.
Journal: Financial Analysts Journal
Pages: 39-46
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.2608
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.2608
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:2:p:39-46




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# input file: UFAJ_A_12047481_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hemang Desai
Author-X-Name-First: Hemang
Author-X-Name-Last: Desai
Author-Name: Prem C. Jain
Author-X-Name-First: Prem C.
Author-X-Name-Last: Jain
Title: Long-Run Stock Returns Following Briloff's Analyses
Abstract: 
 Abraham Briloff is well known for more than four decades of insightful analysis and criticism of the accounting practices of various companies. His critiques, in the form of articles published in Barron's, consist of detailed financial analyses of the questionable accounting practices of the companies he examines. Previous research has shown that the companies criticized by Briloff in Barron's experience significant negative abnormal returns around the article's publication date. To understand the valuation effect associated with his financial analyses, this article examines long-run abnormal returns following the publication date. In addition to the initial negative reaction on publication of the articles, the companies in the sample experienced further significant risk-adjusted returns for one and two years of, respectively, −15.51 percent and −22.88 percent. The results show that a decline in future operating performance appears to be an important reason for the poor stock market performance of the companies. Thus, Briloff could apparently foresee the coming decline in operating performance better than the market could. These results underscore the importance of understanding a company's accounting and of the role of careful financial statement analysis. Abraham Briloff is a well-known financial analyst and accounting scholar who has since the 1960s published several insightful articles in Barron's analyzing and criticizing the financial statements of individual companies. We studied the performance of these companies before and after Briloff's critiques.Previous research has shown that, on average, the companies criticized by Briloff experience statistically significant abnormal returns of −8.6 percent around the time of publication of his article. We examined abnormal returns for a longer period—three years following article publication.We found that the common stocks of the companies analyzed and criticized by Briloff continue to perform negatively for a period of two years following publication of the articles. The two-year buy-and-hold abnormal returns of approximately −23 percent following the month of publication are statistically significant. If the initial announcement period (Month 0 in our study) is included, the overall effect of Briloff's articles on the stock prices of the companies is approximately −33 percent.To understand the connection between stock market performance and the companies' performance, we also examined return on assets of the companies following the publication of the Briloff articles. A decline in operating performance would be consistent with the hypothesis that Briloff is able to foresee a decline in operating performance through an analysis of financial statements. Our results show a significant decline in operating performance following the publication of Briloff's articles. Thus, the operating performance results are consistent with the stock market results.The results we report strongly suggest that a careful analysis of companies' published financial statements can help an analyst or investor identify mispriced stocks. Thus, this study underscores the importance of fundamental analysis in valuation.After reading all of Briloff's articles, we attempted to develop a pattern in his criticism, but we could not. He has been critical of a wide range of practices used by companies to inflate their performance. Examples include accounting for mergers, leases, restructuring charges, gain or loss on sales of assets, and accounting for in-process research and development. In general, Briloff is apparently able to spot several potential abuses of accounting by companies—even large companies. A mechanical model that would imitate Briloff is unlikely—there does not appear to be a shortcut to careful financial statement analysis—but financial analysis, while time consuming, can be rewarding.
Journal: Financial Analysts Journal
Pages: 47-56
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.2609
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.2609
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:2:p:47-56




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# input file: UFAJ_A_12047482_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Turan G. Bali
Author-X-Name-First: Turan G.
Author-X-Name-Last: Bali
Author-Name: Nusret Cakici
Author-X-Name-First: Nusret
Author-X-Name-Last: Cakici
Title: Value at Risk and Expected Stock Returns
Abstract: 
 Stock size, liquidity, and value at risk (VAR) can explain the cross-sectional variation in expected returns, but market beta and total volatility have almost no power to capture the cross-section of expected returns at the stock level. Furthermore, the strong positive relationship between average returns and VAR is robust for different investment horizons and loss-probability levels. In addition to the cross-sectional regressions at the stock level, this study used a time-series approach to test the empirical performance of VAR at the portfolio level. The results, based on 25 size/book-to-market portfolios, indicate that VAR has additional explanatory power after the characteristics of market return, size, book-to-market ratio, and liquidity are controlled for. Although previous empirical studies have used a variety of stock characteristics and other factors, such as total risk and diversifiable risk, to explain the cross-section of expected returns, researchers have not investigated value at risk (VAR) as an alternative risk factor that can explain stock returns. In conducting this study, our goal was to test whether the maximum likely loss measured by VAR can explain cross-sectional and time-series differences in expected returns.Using monthly and annual regressions, we provide evidence that size, liquidity, and VAR could capture the cross-sectional variation in expected returns of NYSE, Amex, and Nasdaq stocks for the period January 1963 to December 2001. Furthermore, we show that market beta and total volatility have almost no power to explain average stock returns at the individual-stock level. We also compared the relative performance of size, beta, and VAR in explaining the cross-sectional variation in portfolio returns. The results show that all the risk factors considered in the article can capture the cross-sectional differences in portfolio returns but that VAR has the best performance in terms of R2 values. The strong positive relationship between stock (or portfolio) returns and VAR turns out to be robust over various investment horizons and loss-probability levels.In addition to using cross-sectional regressions in an asset-pricing framework, we also used time-series regressions to evaluate the empirical performance of VAR at the portfolio level. To mimic the risk factor in returns related to VAR, we devised an alternative factor, HVARL, the difference between the simple average of the high-VAR portfolio returns and the low-VAR portfolio returns. Using 25 portfolios, we investigated the relative performance of total volatility, VAR, and liquidity in terms of their ability to capture time-series variation in stock returns. When we regressed monthly returns for a stock portfolio on the returns for portfolios based on market return, company size, the book-to-market ratio, liquidity, and VAR, we found that VAR can capture substantial time-series variation in stock returns and provide additional explanatory power even after the characteristics of market return, size, book-to-market ratio, and liquidity are controlled for. The results also imply that the relationship between VAR and expected stock returns is not the result of a reversal in long-term returns, of liquidity, or of volatility.Modern portfolio theory determines the optimum asset mix by maximizing the expected risk premium per unit of risk in a mean–variance framework or the expected value of some utility function approximated by the expected return and variance of the portfolio. In both cases, market risk of the portfolio is defined in terms of the variance (or standard deviation) of expected portfolio returns. Modeling portfolio risk as defined by traditional volatility measures implies that investors are concerned only about the average variation (and covariation) of individual stock returns and does not allow investors to treat the negative and positive tails of the return distribution separately. The standard risk measures determine the volatility of unexpected outcomes under normal market conditions, which corresponds to the normal functioning of financial markets during ordinary periods. Neither the variance nor the standard deviation, however, can yield an accurate characterization of actual portfolio risk during highly volatile periods. Therefore, the set of mean–variance-efficient portfolios may lead to an inefficient strategy for maximizing expected portfolio return while minimizing risk. Our findings suggest a new approach to optimal portfolio selection in a VAR framework. A mean–VAR approach can be introduced to allocate financial assets by maximizing the expected value of some utility function approximated by the expected return and VAR of the portfolio, as well as the investor's aversion to VAR.
Journal: Financial Analysts Journal
Pages: 57-73
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.2610
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.2610
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:2:p:57-73




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# input file: UFAJ_A_12047483_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Stan Beckers
Author-X-Name-First: Stan
Author-X-Name-Last: Beckers
Author-Name: Michael Steliaros
Author-X-Name-First: Michael
Author-X-Name-Last: Steliaros
Author-Name: Alexander Thomson
Author-X-Name-First: Alexander
Author-X-Name-Last: Thomson
Title: Bias in European Analysts' Earnings Forecasts
Abstract: 
 Forecasting company earnings is a difficult and hazardous task. In an efficient market where analysts learn from past mistakes, there should be no persistent and systematic biases in consensus earnings accuracy. Previous research has already established how some (single) individual-company characteristics systematically influence forecast accuracy. So far, however, the effect on consensus earnings biases of a company's sector and country affiliation combined with a range of other fundamental characteristics has remained largely unexplored. Using data for 1993–2002, this article disentangles and quantifies for a broad universe of European stocks how the number of analysts following a stock, the dispersion of their forecasts, the volatility of earnings, the sector and country classification of the covered company, and its market capitalization influence the accuracy of the consensus earnings forecast. Earnings forecasts play a central role in most equity valuation models. In an efficient market where analysts learn from past mistakes, we would expect the average or consensus forecast to be an unbiased estimate of future realized earnings. Academic research has documented persistent and systematic biases, however, in earnings forecasts.To the extent that asset prices largely reflect the consensus earnings number, these biases present opportunities for active portfolio managers. In fact, buy-side analysts already try, at least in part, to distinguish themselves by improving upon the consensus forecast. Asset managers must be selective, however, in the number and types of companies they have in their investable universe. So, they would obviously like to focus their efforts on the companies that are most likely to be mispriced. This article is an attempt to help identify these companies by establishing the characteristics that are most likely to be associated with optimistic (positively biased) consensus earnings forecasts.Our study focused on a broad cross-section of European companies for which we collected the earnings forecasts for the 10 years from May 1993 to April 2002. We establish that the well-documented anomalies of herding (too narrow a dispersion of analyst forecasts for a given company) and optimism (systematic positive bias) were prevalent in our sample.We review the literature on factors that have been associated with the forecast bias. Virtually all of these studies concentrated on the effect of single variables. None systematically explored sector and country effects while simultaneously controlling for other fundamental company characteristics (such as market capitalization or number of analysts following a stock). Our empirical study contributes to filling this gap.We used a multiple-regression framework to verify which factors significantly affect the sign and magnitude of the forecast bias. We establish that analyst forecast dispersion and stock price volatility (which we used as a surrogate for earnings volatility) were consistently and significantly associated with larger forecast bias in the study period. The number of analysts following a stock had no impact on the forecast bias (but reduced the forecast error); the company's market capitalization did not affect the accuracy of the consensus number.We also confirmed the existence of significant sector effects. The forecasts for the consumer nondurables, health care, public utilities, and transportation sectors were, on average, more correct than those for the other industries.Significant geographical differences in forecast accuracy used to exist at the country level, with the companies in the core “Euroland” countries (France, Germany, and Italy) showing particularly poor earnings forecast accuracy. These geographical differences have lost significance in the recent past, however, which probably helps explain the disappearance of country effects in stock returns.By identifying which types of companies are most likely to have the largest earnings forecast bias, we hope to provide guidance to sell-side analysts as to how they can distinguish themselves from the consensus. For the buy-side analyst, these persistent and systematic anomalies should provide interesting investment opportunities.
Journal: Financial Analysts Journal
Pages: 74-85
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.2611
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.2611
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:2:p:74-85




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# input file: UFAJ_A_12047484_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Andrew Ang
Author-X-Name-First: Andrew
Author-X-Name-Last: Ang
Author-Name: Geert Bekaert
Author-X-Name-First: Geert
Author-X-Name-Last: Bekaert
Title: How Regimes Affect Asset Allocation
Abstract: 
 International equity returns are characterized by episodes of high volatility and unusually high correlations coinciding with bear markets. This article provides models of asset returns that match these patterns and illustrates their use in asset allocation. The presence of regimes with different correlations and expected returns is difficult to exploit within a framework focused on global equities. Nevertheless, for global all-equity portfolios, the regime-switching strategy dominated static strategies in an out-of-sample test. In addition, substantial value was added when an investor switched between domestic cash, bonds, and equity investments. In a persistent high-volatility market, the model told the investor to switch primarily to cash. Large market-timing benefits are possible because high-volatility regimes tend to coincide with periods of relatively high interest rates. International equity returns are more highly correlated with each other in high-volatility bear markets than in normal times. Regime-switching (RS) models perform well at replicating the degree of asymmetric correlations observed in the data because they draw data from a normal regime most of the time but transition to a bear market regime when asset returns are, on average, lower and much more volatile than in normal times. The regimes are persistent, and in the bear markets, asset correlations are higher than in the normal regime.We show that the presence of regimes in international returns is exploitable in active asset allocation programs. We illustrate how the presence of regimes can be incorporated into two asset allocation programs—a global equity allocation setting (with six equity markets) and a market-timing setting for U.S. cash, bonds, and equity. For global portfolios, the optimal equity portfolio in the high-volatility bear market is very different from the optimal portfolio in the normal regime; for example, it is more home biased in bear markets. For a domestic U.S. portfolio, optimally exploiting regime switches implies portfolio shifts into bonds or cash when a high-volatility bear market regime is expected.To build a quantitative model for the international asset classes, we incorporated two regimes in the basic capital asset pricing model. Conditional means, volatilities, and correlations in this model depend on which regime prevails at each time. The RS model can produce rich patterns of stochastic volatility and time-varying correlations. The regimes are identified endogenously through the estimation procedure, which provides an easy way for an investor to determine which regime is prevailing at a given time.The regime-dependent strategies have the potential to outperform static investment strategies because they set up a defensive portfolio in the bear market regime that hedges against high correlations and low returns. Theoretically, the presence of two regimes implies two mean–variance frontiers, one for each regime. The presence of two regimes and two frontiers means that the regime-switching investment opportunity set dominates the investment opportunity set offered by one unconditional frontier. For example, in the global asset allocation setting in the normal regime, the unconditional tangency portfolio yielded a Sharpe ratio of 0.619. The investor could improve this trade-off to 0.871 by holding the risk-free asset and the optimal tangency portfolio. Similarly, in the bear market regime, the unconditional tangency portfolio had a Sharpe ratio of only 0.129, but it could be improved to 0.268 by holding the optimal regime-dependent tangency portfolio.To illustrate the practical implementation of the regime-dependent strategies, we used an out-of-sample analysis starting in 1985 and ex post Sharpe ratios as a performance criterion. For the global asset allocation example, the regime-switching strategy's Sharpe ratio was more than double the world market portfolio's Sharpe ratio.In an out-of-sample test of the market-timing model for U.S. equities, bonds, and cash, we found that substantial value could be added when an investor moved assets among cash, bonds, and equity investments. When a persistent high-volatility market hit, the investor switched primarily to cash. Market-timing benefits were large because high-volatility markets tend to coincide with periods of relatively high interest rates.The results reported here provide a clear demonstration of how active managers can incorporate regime-switching strategies to enhance returns in market-timing models. Our results lead to two robust conclusions. First, one can add value by considering regime switches in global all-equity portfolios; the presence of a bear market regime does not negate the benefits of international diversification. Although portfolios in the high-correlation regime are more home biased, they still involve significant international exposure. Second, an even more valuable situation in which to consider regime-switching models is tactical asset allocation programs that allow switching to a risk-free asset.
Journal: Financial Analysts Journal
Pages: 86-99
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.2612
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.2612
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:2:p:86-99




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# input file: UFAJ_A_12047485_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ronald L. Moy
Author-X-Name-First: Ronald L.
Author-X-Name-Last: Moy
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Asset Price Bubbles: The Implications for Monetary, Regulatory, and International Policies (a review)
Abstract: 
 This fascinating look at price bubbles from a range of viewpoints is the collected papers and discussions of a conference cosponsored by the Federal Reserve Bank of Chicago and the World Bank Group. It provides the perspectives of an impressive list of financial economists, economic historians, macroeconomic theorists, and economic regulators and is a must read for policymakers, economists, investors, academics, and anyone else who needs a clear understanding of bubbles in asset prices.
Journal: Financial Analysts Journal
Pages: 100-101
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.2613
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.2613
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:2:p:100-101




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# input file: UFAJ_A_12047486_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Beyond the Random Walk: A Guide to Stock Market Anomalies and Low Risk Investing (a review)
Abstract: 
 This highly readable volume, which is targeted to individual investors, reviews in nontechnical language the empirical evidence for 10 prominent market imperfections and explains precisely how to exploit each one—if an investor wants to devote the time to the sometimes data-intensive methods.
Journal: Financial Analysts Journal
Pages: 101-102
Issue: 2
Volume: 60
Year: 2004
Month: 3
X-DOI: 10.2469/faj.v60.n2.2614
File-URL: http://hdl.handle.net/10.2469/faj.v60.n2.2614
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:2:p:101-102




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# input file: UFAJ_A_12047487_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Ethics and Unintended Consequences
Abstract: 
 The gravity of the ethical lapses and illegal behavior confronting the financial community is undeniable. Equally important is that in dealing with the problems, the community avoid harmful unintended consequences of actions to eliminate the problems. Arnott raises questions about some of the rules and legislation already proposed, the capricious enforcement of some rules, and vast areas (such as aggressive accounting) that are almost being ignored. He then calls on the financial community to forestall heavy-handed laws and rules by taking a stand for ethical business dealing. The community can, for example, make unethical conduct unprofitable by selling holdings in companies that engage in unethical activities or accept ethical ambiguity. 
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 3
Volume: 60
Year: 2004
Month: 5
X-DOI: 10.2469/faj.v60.n3.2615
File-URL: http://hdl.handle.net/10.2469/faj.v60.n3.2615
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:3:p:6-8




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# input file: UFAJ_A_12047488_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jack L. Treynor
Author-X-Name-First: Jack L.
Author-X-Name-Last: Treynor
Author-Name: Dean LeBaron
Author-X-Name-First: Dean
Author-X-Name-Last: LeBaron
Title: Insider Trading: Two Comments
Abstract: 
 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. Two old friends ruminate about insider trading. Treynor points out that the two purposes of the U.S. insider trading laws are (1) to protect dealers and (2) to give investors the confidence that they are protected from people who know more than they do. If dealers play an essential role in making securities markets liquid, capitalist societies have a stake in protecting dealers. If people who feel protected from insiders are more likely to invest, capitalist societies have a reason for providing that protection. So, capitalist societies are probably healthier with insider trading laws, but the laws are protecting dealers, not individual investors. Insider trading laws are not helpful to markets and most market participants.LeBaron considers laws against insider trading to be akin to excluding the most knowledgeable students from a test—with skewed results. He argues that if one of the primary jobs of markets is accurate price discovery, this exclusion makes no sense. When insiders are restricted, markets become less informed. Therefore, insider trading should be encouraged at all times—but with the proviso that insiders be required to identify their market orders so that other investors can judge whether the trading contains information. Moreover, companies should make continuous public markets—for example, as a specialist function with an open book and in continuous registration for capital raising or share buybacks. Companies should be the most informed insiders and should continuously reveal their pricing ideas by market behavior.
Journal: Financial Analysts Journal
Pages: 10-12
Issue: 3
Volume: 60
Year: 2004
Month: 5
X-DOI: 10.2469/faj.v60.n3.2616
File-URL: http://hdl.handle.net/10.2469/faj.v60.n3.2616
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:3:p:10-12




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# input file: UFAJ_A_12047489_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Lawrence N. Bader
Author-X-Name-First: Lawrence N.
Author-X-Name-Last: Bader
Title: Pension Deficits: An Unnecessary Evil
Abstract: 
 Many companies believe that underfunding pension plans is an inexpensive way to borrow from employees and that mismatching equity investments to bondlike pension promises creates shareholder value. To the contrary, financial economics calls for fully funding and immunizing accrued pensions. For nonguaranteed pensions, inadequate funding magnifies employees' exposure to their employers' financial health—exposure that they cannot diversify. Fully securing the pensions eliminates this inefficiency in employee compensation. Governmental guarantees eliminate the employees' pension risk but invite weak sponsors to extract subsidies from strong ones through underfunding. A statutory requirement of full funding and immunization would eliminate these subsidies. The recent swing from abundant pension surpluses to massive deficits has been an unpleasant surprise worldwide. U.S. pension plans have experienced an adverse shift approaching a half-trillion dollars—a heavy blow to shareholders, the Pension Benefit Guaranty Corporation (PBGC), and to many employees.Pension deficits are commonly viewed as an acceptable risk of efficient long-term funding programs. This article argues, to the contrary, that deficits reflect glaring inefficiencies in employee compensation and the regulatory framework.In the absence of governmental guarantees, a pension promise is economically equivalent to the employer’s issuing its own nontransferable bond to its employees as part of their pay package. Unless the bond is fully collateralized—or the pension is fully funded—its value depends on the plan sponsor’s health. Employees cannot diversify this company-specific risk, to which they are already overexposed through their employment. Informed, rational employees would not pay full market price for a risky employer bond, nor would they give up enough salary to cover the cost of a risky pension. Pensions whose security depends on their sponsors’ creditworthiness are, therefore, inefficient; they cost the sponsors more than they are worth to the employees. A sponsor can eliminate a pension deficit by borrowing in the capital markets to cover the deficit; it can eliminate pension investment risk by exchanging its risky portfolio for an immunizing bond portfolio. In either case, the shareholders suffer no loss. To the contrary, the company improves the efficiency of its employee compensation and tax management. In an unregulated but transparent pension system, the interests of enlightened plan sponsors, companies, and capital providers should lead to a robust version of full funding, in which all accrued pensions are secured by immunizing bond portfolios.The existence of the PBGC changes this full-funding rationale. PBGC guarantees, although limited, shift most pension risk from employees to all plan sponsors jointly. This risk shifting replaces one set of problems with another. Weak companies can make outsized pension promises and then underfund their pensions. In effect, these companies extract involuntary loan guarantees for their risky pension promises from the companies with whom they compete for labor and capital.Two broad legislative solutions to this problem are available: mandatory full funding and risk premiums that accurately reflect each plan’s risk of failure. Only the first solution is feasible. It holds pension plans to standards like those governing other financial intermediaries; that is, it requires them to cover their liabilities at all times with adequate and reasonably well matched assets. A risk-based premium system is appealing because it would give sponsors freedom to manage their plans. But this solution would not hold pension plans to the usual standards for financial intermediaries. Instead, it would leave them dependent on their sponsors’ financial health. To set accurate risk-based premiums, the PBGC would have to monitor not only the pension plans but also the operations of every plan sponsor—a Herculean task in both its difficulty and its unpleasantness.A full-funding requirement would leave the PBGC (apart from legacy costs) covering rare misfortunes rather than inevitable outcomes of widespread risky practices. Successful transition to such a regime would eliminate the remote, but not unimaginable, danger of an assessment spiral among plan sponsors and an eventual taxpayer bailout of the PBGC.Pension risk is inefficiently borne by employees or governmental guarantors. With or without guarantees, full funding is the optimal condition for the pension system.
Journal: Financial Analysts Journal
Pages: 15-21
Issue: 3
Volume: 60
Year: 2004
Month: 5
X-DOI: 10.2469/faj.v60.n3.2617
File-URL: http://hdl.handle.net/10.2469/faj.v60.n3.2617
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:3:p:15-21




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# input file: UFAJ_A_12047490_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Gary L. Gastineau
Author-X-Name-First: Gary L.
Author-X-Name-Last: Gastineau
Title: Protecting Fund Shareholders from Costly Share Trading
Abstract: 
 In the wake of revelations that many mutual funds have not protected fund shareholders from abuse by late traders and market timers, the emphasis of most regulators and pundits has been on strengthening compliance. But although stopping abuses is important, most of the abuses cited are possible only because the standard mutual fund pricing and trading processes are inherently flawed. Most fund share trades that arrive late in the day are costly to existing fund shareholders whether the trades were initiated by short-term traders or by other investors. Investors and regulators need to understand how costly the current trading and pricing processes are and how to fix the problems. In the wake of revelations that many mutual funds have not protected fund shareholders from abuse by late traders and market timers, the emphasis of most regulators and pundits has been on strengthening compliance with existing trading rules and with policies stated in fund prospectuses. But although stopping abuses is important, most of the abuses cited are possible only because the industry standard for mutual fund pricing and trading is inherently flawed. Most fund share trades that arrive late in the day are costly to existing fund shareholders whether they were initiated by short-term traders (e.g., market timers) or by ordinary investors.Orders the fund does not receive by early afternoon cost fund shareholders about $40 billion, or 1 percent of equity fund assets, each year. A study to measure the cost of providing liquidity to entering and leaving fund shareholders found that the trading costs attributable to offering liquidity created an average net reduction in annual investor return of about 1.43 percent. With the latest available figures showing assets in U.S. stock and hybrid funds at about $4 trillion, applying a cost of providing liquidity of only 1 percent puts the estimate easily at $40 billion. A few funds have succeeded in eliminating the impact of these trading costs by cutting off buy, sell, and exchange orders early in the afternoon. They trade for the fund portfolio before the market close so that the cost of flow trading is reflected in the net asset value (NAV) calculation that prices the shares for entering and leaving shareholders. If all funds had such policies, fund investors’ returns might improve by more than $40 billion a year.I suggest a possible solution to this free-liquidity problem based on three policy changes:For domestic equity or balanced funds, any open mutual fund would accept purchase orders and all redeemable funds would accept redemption orders delivered to the advisor until 2:30 p.m. on any normal business day for pricing at that day’s NAV. No order cancellations would be permitted after 2:30 p.m., and the fund could trade to adjust its portfolio for these investor orders before the market close.After 2:30 p.m., market makers unaffiliated with the fund advisor would be able to provide liquidity to investors who wanted to enter orders for execution at share prices based on that day’s NAVs.For funds holding more than 3 percent of their assets in stocks traded in one or more primary markets outside the United States, orders would be accepted until 4:00 p.m. on any U.S. business day for pricing at the NAV next determined for the fund after a full trading day in the primary markets for stocks accounting for 97 percent of the fund’s equity portfolio.This proposal would eliminate the need for redemption fees. Advocates with diverse perspectiveshave endorsed redemption fees to discourage short-term traders in fund shares. If a trader avoids the redemption fee by staying past the redemption fee cutoff date, however, the cost of the fund’s portfolio trading to accommodate the trade becomes a permanent cost to other shareholders—without any offsetting benefit from a redemption fee.With a 2:30 p.m. cutoff, the portfolio manager has the opportunity to invest money coming in or liquidate positions to cover redemptions at contemporary prices. Moreover, the fund’s trades between 3:00 p.m. and 4:00 p.m. will affect and help update the prices used in the NAV calculation. To the extent that a 2:30 p.m. order cutoff encourages more trading in domestic securities in the last hour before fund pricing, the prices used in the NAV calculation will be more current than they are now. And redemption fees and fair value pricing will be less necessary.
Journal: Financial Analysts Journal
Pages: 22-32
Issue: 3
Volume: 60
Year: 2004
Month: 5
X-DOI: 10.2469/faj.v60.n3.2618
File-URL: http://hdl.handle.net/10.2469/faj.v60.n3.2618
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:3:p:22-32




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# input file: UFAJ_A_12047491_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hatice Uzun
Author-X-Name-First: Hatice
Author-X-Name-Last: Uzun
Author-Name: Samuel H. Szewczyk
Author-X-Name-First: Samuel H.
Author-X-Name-Last: Szewczyk
Author-Name: Raj Varma
Author-X-Name-First: Raj
Author-X-Name-Last: Varma
Title: Board Composition and Corporate Fraud
Abstract: 
 The study reported here examined how various characteristics of the board of directors and other governance features affected the occurrence of U.S. corporate fraud in the 1978–2001 period. The findings suggest that board composition and the structure of a board's oversight committees are significantly correlated with the incidence of corporate fraud. In the sample, as the number of independent outside directors increased on a board and in the board's audit and compensation committees, the likelihood of corporate wrongdoing decreased. The scandals at numerous high-profile companies have led to public perception of a crisis in corporate governance, to passage of the Sarbanes–Oxley Act, and to establishment by the NYSE and Nasdaq of strengthened governance requirements, including enhanced oversight by independent company directors. We investigated how various characteristics of the board of directors and board committees affect the occurrence of corporate fraud. To conduct our investigation, we constructed a database for a sample of companies that have been accused of committing fraud over the 1978–2001 period from the Wall Street Journal Index. We also constructed an industry- and size-matched control sample of companies that were not accused of committing fraud. For both of these samples, we collected data on the board of directors and other governance attributes from the proxy statements, and we then examined how various characteristics of the board and governance features affect the occurrence of corporate fraud. We found that board composition and the structure of its oversight committees are significantly related to the incidence of corporate fraud. The new NYSE and Nasdaq rules require companies to have a majority of independent directors on their boards so as to enhance the quality of the board and reduce the possibility of damaging conflicts of interest. Our results support this requirement and its underlying motivation. We found that a higher proportion of independent outside directors is associated with less likelihood of corporate wrongdoing.The Sarbanes–Oxley Act of 2002 instructs public corporations to create an independent audit committee from its board of directors. Since 1978, the NYSE has required listed companies to have audit committees also composed of independent directors. The NYSE and Nasdaq now require companies to have a compensation committee and a nominating committee composed solely of independent directors. Our findings support these requirements and the recent tightening of the definition of “independent” by the NYSE and Nasdaq. We found the lack of audit committees and compensation committees and the lack of independent members of these committees to be significantly related tothe occurrence of fraud. In particular, although independent outside directors predominated on the audit and compensation committees, the presence of outside directors who were not independent because they had business or personal ties to the company significantly increased the likelihood of fraud in the sample.A troubling finding of our study is that, in general, the presence of a compensation committee increased the likelihood of corporate fraud in the sample. The implication is that compensation committees have been inefficient in evaluating and properly rewarding the performance of top executives. They may also have designed compensation packages with dysfunctional incentives, as claimed by many critics. Whatever the reason for our finding, compensation committees deserve more attention from regulators, rule-making bodies (such as the NYSE and Nasdaq), and shareholders.
Journal: Financial Analysts Journal
Pages: 33-43
Issue: 3
Volume: 60
Year: 2004
Month: 5
X-DOI: 10.2469/faj.v60.n3.2619
File-URL: http://hdl.handle.net/10.2469/faj.v60.n3.2619
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:3:p:33-43




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# input file: UFAJ_A_12047492_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: James Scott
Author-X-Name-First: James
Author-X-Name-Last: Scott
Author-Name: Peter Xu
Author-X-Name-First: Peter
Author-X-Name-Last: Xu
Title: Some Insider Sales Are Positive Signals
Abstract: 
 Not all insider sales are the same. In the study reported here, a variable for shares traded as a percentage of insiders' holdings was used to separate information-driven sales from sales driven by liquidity or risk-reduction needs. In the insider trades from 1987 through 2002, only large sales that also accounted for large percentages of insiders' holdings predicted significantly negative future abnormal returns. Small sales that accounted for small percentages of shares owned not only did not predict poor performance but were correlated with significantly positive abnormal returns. The percentage of shares owned by insiders is also useful for predicting future returns following insider purchases. Most previous studies of insider trading have found that, although insider purchases are typically associated with positive future abnormal returns, insider sales tend to predict small, sometimes insignificant, negative abnormal returns. This asymmetry between the effects of insider purchases and sales may reflect differences in these transactions’ information content. When insiders purchase shares of their companies, the primary reason is to make money (i.e., they think the stock is undervalued). When insiders sell, however, the motivation may be either a perception that the stock is overvalued or simply a need for liquidity or portfolio diversification. The need-based insider sale does not contain negative information and, if all insider sales are considered together, reduces the strength of the signal about perceived valuation.We used information on insiders’ share holdings as well as their trades to measure the information content of insider sales. Specifically, we calculated the shares traded as a percentage of shares owned and used the ratio to separate informational sales from noninformational sales. We hypothesized that if insiders sell shares because they have a negative view about the company’s outlook, they will probably sell a larger percentage of their holdings than if they are selling only for liquidity or diversification. Thus, we hypothesized that insider sales that represented large percentages of shares owned should be associated with more negative future returns.The empirical results support this hypothesis. Using insider transaction data from 1987 through 2002, we found shares sold as a percentage of shares owned to be significantly correlated with future returns. Only insider sales of a large volume that also accounted for a large percentage of insider holdings predicted significantly negative future abnormal returns. Small sales that represented small percentages of shares owned not only did not predict poor performance but were correlated with significantly positive abnormal returns. Although this outcome may be specific to the time interval we studied (a period when option and stock compensation became common), we believe that comparing shares traded with shares held is useful for differentiating the signal of insider sales. We found that percentage of shares owned is also useful for predicting future returns following insider purchases. We found that insider purchases that were small relative to shares already owned predicted lower positive future returns than purchases that were large relative to shares already owned.
Journal: Financial Analysts Journal
Pages: 44-51
Issue: 3
Volume: 60
Year: 2004
Month: 5
X-DOI: 10.2469/faj.v60.n3.2620
File-URL: http://hdl.handle.net/10.2469/faj.v60.n3.2620
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:3:p:44-51




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# input file: UFAJ_A_12047493_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: George S. Oldfield
Author-X-Name-First: George S.
Author-X-Name-Last: Oldfield
Title: Bond Games
Abstract: 
 Corporate debt indentures are complex contracts that include a variety of restrictions and options. On one side, an issuing corporation can engineer game-based transactions to escape covenant restrictions or capture option value for its stockholders. On the other side, bondholders can form coalitions to resist a corporation's endeavors and capture option value for the coalition. This article analyzes several types of such strategic debt transactions. The examples show that corporate debt games can strongly influence corporate bond prices. Corporations can issue a myriad of financial claims—some pure equity, some straight debt, and some that combine elements of both. The various types of claims have embedded option features. Direct options are conveyed through specific contract provisions; indirect ones are conveyed through claims in restructuring, bankruptcy, and liquidation. The embedded options, although more or less clear in their apparent influence on pricing, can also have significant but less obvious valuation consequences. In particular, normal conflicts between issuers and investors can generate strategic trading games in which debt prices deviate substantially from their apparent option-based values even though a default is not part of the game. I show how some of these games work. I use three examples to illustrate the impact of strategic behavior on pricing—a bond indenture “freeze-out” or a defeasance alternative, a sinking-fund “squeeze,” and a forced bond conversion. The emphasis is on standard types of transactions that happen regularly in secondary corporate debt markets.Option-pricing techniques have brought an important element of realism to corporate claim pricing. Game analysis takes valuation a step further by showing how interested parties can find strategies to neutralize or capture the option features of other parties’ claims. Even fairly standard corporate bonds have indenture provisions that make strategic or game-based trading of the instruments an influence on their values. The examples in this article demonstrate how various groups can modify contingent-claim value through coordinated behavior. In each case, concerted action nullifies a contract option whose apparent value is based on uncoordinated action by dispersed investors. In some cases, a combination of strategies can be pursued. For example, a convertible bond transaction may require a freeze-out prior to a forced conversion. Conversely, a corporation’s convertible bond game can be defeated with a structured “corner.” These strategic transactions can strongly influence the values of a corporation’s bonds throughout the life of each issue.Effective management of a corporate bond portfolio requires a working knowledge of how such strategies and games work, how the trades create opportunities and risks, and what types of risks of strategic trades exist in any large corporate bond portfolio. This knowledge is particularly important because certain types of coordinated trading by the issuer or other owners can nullify indenture options that appear to offer risk protection.
Journal: Financial Analysts Journal
Pages: 52-66
Issue: 3
Volume: 60
Year: 2004
Month: 5
X-DOI: 10.2469/faj.v60.n3.2621
File-URL: http://hdl.handle.net/10.2469/faj.v60.n3.2621
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:3:p:52-66




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# input file: UFAJ_A_12047494_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Paul Irvine
Author-X-Name-First: Paul
Author-X-Name-Last: Irvine
Author-Name: Paul J. Simko
Author-X-Name-First: Paul J.
Author-X-Name-Last: Simko
Author-Name: Siva Nathan
Author-X-Name-First: Siva
Author-X-Name-Last: Nathan
Title: Asset Management and Affiliated Analysts' Forecasts
Abstract: 
 The interaction between the various departments of a full-service brokerage firm can have positive effects. An asset management department operates the firm's mutual funds and has a need for high-quality information. Thus, the firm's sell-side analysts in the research department are motivated to gather information about particular securities and to use the asset management department as an additional information source. The outcome can be to raise the quality of sell-side analysts' earnings forecasts. In the study reported here, affiliated analysts' earnings forecasts for a security became significantly more accurate as the fund family's percentage ownership of that security increased. Also, the study found a significant positive relationship between the accuracy of an affiliated analyst before the new investment and the percentage of the company's shares acquired by that fund family. The implication is that fund families make the largest purchases of stocks for which their affiliated analysts provided the most accurate forecasts ex ante. These results have implications for investors who are using analysts' earnings forecasts. Full-service brokerage firms offer a wide variety of services to their clients, including investment banking, broker/dealer services, fundamental research, and asset management. The interactions among the various departments of a full-service brokerage firm are of great interest among practitioners, have recently been discussed extensively in the business press, and have been studied by academics. For example, the influence of investment banking on the earnings forecasts and investment recommendations of the firm’s sell-side analysts has been well chronicled.The attention to interactions between the various departments of a full-service brokerage firm often focuses on the deterioration in research quality because of the pressures other departments within the brokerage firm bring to bear on the sell-side analyst. What is often missing from the debate is the notion that positive effects (or externalities) can sometimes arise from these interactions. A potential synergy comes from the demand by in-house asset managers for high-quality financial information within the brokerage firm. The demand for information by the asset management department may motivate the firm’s sell-side analysts to gather information about particular securities and, similarly, to use the asset management department as an additional information source.The evidence on whether the asset management and the research departments of a full-service brokerage firm communicate with each other is limited, although the business press has alluded to such practices. Communication between these two departments has implications, however, for the quality of sell-side analysts’ earnings forecasts and the investment decisions of the asset management department. This study evaluates this issue by examining the association between two variables that capture the information environments of asset management and research—the asset management department’s level of stock ownership and the earnings forecast accuracy of affiliated sell-side analysts.We studied security purchases by the mutual fund families of 17 full-service brokerage firms over the years 1994–2001. We focused on a security purchase in a given period because it provides an unambiguous positive signal about the nature of information within the fund family. We used the semiannual Morningstar OnDisc database to gather information on security purchases by mutual fund families run by brokerage firms; the I/B/E/S database was used to gather sell-side analysts’ earnings forecasts. We found that affiliated analysts’ earnings forecasts for a security become significantly more accurate as the fund family’s percentage ownership stake in that security increases. In particular, we show a significant relationship between affiliated analysts’ forecast accuracy and the fund family’s stock ownership in the highest ownership decile, a level that approximates 1 percent of ownership. We also found a significant positive relationship between affiliated analysts’ accuracy before the new investment and the percentage of the company’s shares outstanding acquired by the fund family. In particular, fund families in our study made the largest purchases in those stocks for which their affiliated analysts were the most accurate ex ante.Overall, our findings are consistent with prior research showing that the various departments of a full-service brokerage firm do not operate independently. We show for the first time, however, that these externalities are not necessarily negative but that synergies can be obtained by providing multiple services within a brokerage firm.
Journal: Financial Analysts Journal
Pages: 67-78
Issue: 3
Volume: 60
Year: 2004
Month: 5
X-DOI: 10.2469/faj.v60.n3.2622
File-URL: http://hdl.handle.net/10.2469/faj.v60.n3.2622
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:3:p:67-78




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# input file: UFAJ_A_12047495_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Chun I. Lee
Author-X-Name-First: Chun I.
Author-X-Name-Last: Lee
Author-Name: Leonard Rosenthal
Author-X-Name-First: Leonard
Author-X-Name-Last: Rosenthal
Author-Name: Kimberly Gleason
Author-X-Name-First: Kimberly
Author-X-Name-Last: Gleason
Title: Effect of Regulation FD on Asymmetric Information
Abstract: 
 On 23 October 2000, the U.S. SEC put Regulation Fair Disclosure into effect. It requires companies to disseminate releases of material information to all investors, not selectively. Proponents of Regulation FD argued that the flow of information would improve; critics of the regulation asserted that Regulation FD would increase volatility and reduce the quantity of information being released into the market, resulting in an increase in asymmetric information. We examined components of the bid–ask spread surrounding news releases and trading activity by retail versus institutional investors before and after the institution of Regulation FD. Our results indicate no significant increase in volatility after Regulation FD, and we found little or no increase in the adverse-selection component of bid–ask spreads. Overall, our results do not support critics of Regulation FD. On 23 October 2000, the U.S. SEC put Regulation Fair Disclosure into effect. It requires companies to disseminate releases of material company information to all investors rather than to select investors. The idea was to create a level playing field for all market participants. For example, prior to Regulation FD, companies could restrict who could be part of a conference call. The exclusion of retail investors, some institutional analysts and investors, and in particular, the media, was a significant catalyst in bringing about Regulation FD.Regulation FD requires that companies release material, market-moving information to all investors simultaneously through a press release or an 8-K filing with the SEC. If a company holds a press conference, it must provide adequate time for investors to learn of the conference before it is held, and the conference must be made available to the widest audience possible—by allowing anyone to dial into a conference call or by making a webcast available in real time over the Internet. Regulation FD also provides a mechanism for dealing with the unintentional disclosure of material nonpublic information.Proponents of Regulation FD argued that it would improve the flow of information. Critics asserted that the regulation would decrease information coming out of companies, which was expected to increase volatility and reduce the quantity of information being released into the market, resulting in an increase in asymmetric information. When asymmetric information increases, market makers widen their bid–ask spreads to compensate for the increased risk of trading against an informed investor. To analyze the effects of Regulation FD, we examined—before and after Regulation FD—volatility, trading activity by retail versus institutional investors, and bid–ask spreads (and the spread’s components) to determine whether the regulation has increased the cost of trading to investors. Among the components of the spread, we focused on adverse selection because it should be the most sensitive to the impact of changes in information flows from companies. If Regulation FD reduced the amount and quality of information put out by companies, the adverse-selection component should have increased. If Regulation FD has not affected the information flow, the adverse-selection component should not have changed.We analyzed 4,278 conference calls made prior to Regulation FD and 3,322 calls made after Regulation FD. The total period covered is 1 January 1999 through 27 February 2001. We broke down the full sample of calls by the subject of the call and focused analysis on the largest group, namely, calls to make earnings announcements. We also broke out from the sample calls that were closed before Regulation FD. We found for the post-FD period an increase in the number of conference calls per day and in the number of companies per day making calls. Tests on volatility in the pre- and post-FD periods indicate that volatility did not increase after implementation. Indeed, it is more likely that Regulation FD contributed to lower volatility.When we examined bid–ask spreads and their components before and after Regulation FD, we found that both absolute (in dollar terms) and relative (in percentage terms) mean and median spreads increased significantly after Regulation FD. The adverse-selection component of the bid–ask spread, however, has had no significant change since Regulation FD in either absolute or relative terms. These results are contrary to the expectations of critics of Regulation FD.Overall, our results indicate that Regulation FD has not been detrimental to investors.
Journal: Financial Analysts Journal
Pages: 79-89
Issue: 3
Volume: 60
Year: 2004
Month: 5
X-DOI: 10.2469/faj.v60.n3.2623
File-URL: http://hdl.handle.net/10.2469/faj.v60.n3.2623
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:3:p:79-89




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# input file: UFAJ_A_12047496_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The New Economy: What It Is, How It Happened, and Why It Is Likely to Last (a review)
Abstract: 
 In this book (reviewed with The Investor's Guide to Economic Fundamentals), a staunch supporter of the so-called New Economy maintains that the economic transformations responsible for it are real, substantial, and likely to persist. 
Journal: Financial Analysts Journal
Pages: 91-92
Issue: 3
Volume: 60
Year: 2004
Month: 5
X-DOI: 10.2469/faj.v60.n3.2624
File-URL: http://hdl.handle.net/10.2469/faj.v60.n3.2624
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:3:p:91-92




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# input file: UFAJ_A_12047498_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Michael A. Martorelli
Author-X-Name-First: Michael A.
Author-X-Name-Last: Martorelli
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Detecting Earnings Management (a review)
Abstract: 
 In the sea of books on accounting problems, this book stands out as a guide to the environment in which earnings management exists and a framework for evaluating the financial and nonfinancial signals that might alert analysts to future debacles. 
Journal: Financial Analysts Journal
Pages: 92-93
Issue: 3
Volume: 60
Year: 2004
Month: 5
X-DOI: 10.2469/faj.v60.n3.2626
File-URL: http://hdl.handle.net/10.2469/faj.v60.n3.2626
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:3:p:92-93




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Author-Name: Ronald L. Moy
Author-X-Name-First: Ronald L.
Author-X-Name-Last: Moy
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Investment Leadership: Building a Winning Culture for Long-Term Success (a review)
Abstract: 
 Not a discussion of financial modeling or computerized trading techniques, this book is the book to read for those interested in learning how to build and sustain a great investment firm. 
Journal: Financial Analysts Journal
Pages: 94-94
Issue: 3
Volume: 60
Year: 2004
Month: 5
X-DOI: 10.2469/faj.v60.n3.2627
File-URL: http://hdl.handle.net/10.2469/faj.v60.n3.2627
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:3:p:94-94




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# input file: UFAJ_A_12047500_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issues.
Journal: Financial Analysts Journal
Pages: 96-96
Issue: 3
Volume: 60
Year: 2004
Month: 5
X-DOI: 10.2469/faj.v60.n3.2628
File-URL: http://hdl.handle.net/10.2469/faj.v60.n3.2628
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:3:p:96-96




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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: The Policy Portfolio Problem
Abstract: 
 Practitioners need to rethink the long-term, static policy portfolio—for example, a portfolio of 70 percent equities/30 percent bonds—that is so embedded in much of the institutional investing world. The problem is that the policy portfolio is based on a narrow view of asset allocation. The challenge of asset allocation boils down to three problems: (1) asset allocation has many elements, (2) asset allocation requires ongoing management, and (3) liabilities do not always track assets. 
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 4
Volume: 60
Year: 2004
Month: 7
X-DOI: 10.2469/faj.v60.n4.2630
File-URL: http://hdl.handle.net/10.2469/faj.v60.n4.2630
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# input file: UFAJ_A_12047502_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Clifford S. Asness
Author-X-Name-First: Clifford S.
Author-X-Name-Last: Asness
Title: Stock Options and the Lying Liars Who Don't Want to Expense Them
Abstract: 
 The debate about whether stock options should be expensed at the time they are issued is really no debate at all. Although legitimate issues exist about how to carry out this endeavor (what model to use, what time period to expense them over, how and when to tax them), there is simply no strong argument against expensing—and very powerful arguments in its favor. This article reviews many of the arguments against expensing and the slam-dunk case for it. A great many attacks on expensing have been undertaken, but they systematically fall short of the mark, with some of them intellectually dishonest to a degree not normally observed in dialogue among serious people. The debate about whether stock options should be expensed at the time they are issued is really no debate at all. Although legitimate issues exist about how to carry out this endeavor, no strong argument exists against expensing—and very powerful arguments exist in its favor.I first review the arguments for expensing options: Options are valuable in or out of the money. They are something people want and desire. So, when a company gives them away, the company is giving away something of value, and that is called an expense. Money is involved: When options are traded on an exchange (as they are every day in large quantities), money changes hands and the prices are printed in the newspaper. So, again, issued options are an expense.After the pro-expensing review, I systematically eviscerate and ridicule the many specific arguments against expensing options when granted, including:Options have no value when issued and should be expensed only when exercised (if at all).Option values are difficult to calculate.The expense is already reported in the footnotes.Issuing options is a capital structure/balance sheet transaction, not an income statement transaction.Options are worth less than their market prices to executives because the executives are not diversified.Mandatory expensing of options will destroy technology companies.Expensing will hurt the little guy, who won't get options.Options are an expense only if and when companies repurchase shares and thus spend cash at time of exercise to prevent dilution.The effect of options should be recognized by using fully diluted shares, not by showing an expense.If companies have to move options to the top line, companies will lie about them more and analysts will “go pro forma” and ignore them.The market is efficient, so expensing does not matter because the information must be in prices already.The issue of expensing options when they are issued is one of those rare cases in an area as nuanced as financial accounting in which we have a bright line dividing right and wrong. If, ultimately, we decide not to expense employee stock options when they are granted, we will have knowingly chosen a falsehood over truth.
Journal: Financial Analysts Journal
Pages: 9-14
Issue: 4
Volume: 60
Year: 2004
Month: 7
X-DOI: 10.2469/faj.v60.n4.2631
File-URL: http://hdl.handle.net/10.2469/faj.v60.n4.2631
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:4:p:9-14




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Author-Name: Thomas Peterffy
Author-X-Name-First: Thomas
Author-X-Name-Last: Peterffy
Author-Name: David M. Battan
Author-X-Name-First: David M.
Author-X-Name-Last: Battan
Title: Why Some Dealers and Exchanges Have Been Slow to Automate
Abstract: 
 Prepared in November 2002 for hearings sponsored by the U.S. SEC on market structure issues, this article outlines structural problems in the listed stock and option markets and explains why many exchanges have resisted automation. The authors conclude that various market structure rules, including order-handling rules, have made it hard for specialists/market makers to profit in the decimalized environment so some have resorted to improperly exploiting the time and place advantages of manual-execution floor markets. The authors recommend restoring economic incentives for professional liquidity providers and eliminating customer priority rules, eliminating the Intermarket Trading System, and replacing trade-through rules with broker/dealer “smart-routing” systems. They also urge regulators to encourage the development of new electronic markets that provide incentives for existing players to use them. A “Postscript” provides further information on aspects of the original presentation and describes how some of the issues have evolved. This article is primarily the text of a paper presented in November 2002 at hearings sponsored by the U.S. SEC on market structure. The paper addresses the anomaly that, although many aspects of the securities and futures business have been automated over the past 20–30 years, the central function of handling and executing orders is still surprisingly manual. This situation is unfortunate, in that handling and executing securities and futures orders is essentially a recordkeeping process that is ideally suited to being done by computers, which are cheaper, faster, and less susceptible to mistakes and fraud than people are.We point out that a variety of market structure rules, including order-handling rules and customer priority rules, have made it hard for specialists/market makers to profit in the decimalized environment. Designated liquidity providers, therefore, have had to rely on their inherent time and place advantage in the manual marketplace—specifically, that they can see orders before others can see them and can take their time (sometimes up to 90 seconds) to decide whether to interact with those orders or not—to reap a reward for the services they provide. Complete automation of order handling and execution, by eliminating latency and creating a perfectly clear time sequence of trading events, would negate this advantage.Even if such change would ultimately be in the public interest, however, the exchanges and their professional member constituents are reluctant to invest heavily in technology that may reduce specialists' trading advantages and eliminate certain market participants altogether.We also address the fact that some market mechanisms, such as the Intermarket Trading System (ITS) and the trade-through rule for listed stocks, have outlived their usefulness and now act as further disincentives to the development of automated trading.The paper suggests several ways to break the logjam preventing automation of order handling and execution. First, the industry must develop innovative ways to make automation palatable by ensuring the economic incentives for existing exchanges and their professional traders to provide liquidity to the marketplace while nevertheless automating. One way would be to enhance liquidity payments and specialist participation rights in electronic trades. In addition, the industry should reverse or eliminate customer priority rules, which create only an illusion of customer benefit. ITS and the trade-through rule also should be eliminated, and best execution of customer orders should be achieved through improved disclosure of realized spreads and by broker/dealer use of “smart” order-routing systems (systems connected to all-electronic markets). Finally, regulators must not impede the development of new electronic markets that will force existing players to automate in order to compete with the speed, certainty, and lower trade-processing costs that these new markets offer.A postscript to the article describes recent developments at the NYSE and the SEC and how they relate to the themes of the original paper.
Journal: Financial Analysts Journal
Pages: 15-22
Issue: 4
Volume: 60
Year: 2004
Month: 7
X-DOI: 10.2469/faj.v60.n4.2632
File-URL: http://hdl.handle.net/10.2469/faj.v60.n4.2632
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:4:p:15-22




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Author-Name: Kenton K. Yee
Author-X-Name-First: Kenton K.
Author-X-Name-Last: Yee
Title: Combining Value Estimates to Increase Accuracy
Abstract: 
 The estimates provided by discounted cash flow, the method of comparables, and market prices usually disagree. Combining two or more of these value estimates makes sense because every bona fide estimate provides information and because relying on one estimate ignores the information content of the others. How, then, should financial analysts combine different value estimates to form a more accurate estimate than that provided by any one method? Drawing from Bayesian decision theory, the Delaware Block Method, and forecasting research, this article suggests five rules of thumb for combining two or more value estimates into a superior value estimate. According to finance theory, value equals the sum of expected free cash flow suitably discounted. Yet, different valuation procedures, such as discounted cash flow (DCF) analysis and the “method of comparables,” usually yield discrepant value estimates. When no single estimate is clearly the most precise and accurate in a given situation, combining two or more of the available value estimates makes sense. Every bona fide estimate provides some incremental information, and relying on only one estimate ignores the information offered by the others.How should financial analysts combine discrepant value estimates to form a more accurate estimate? Drawing from the Delaware Block Method used by the courts in many bankruptcy cases, Bayesian decision theory, and forecasting research, this article proposes and elaborates on five rules of thumb:Estimate value as a linear weighted average of all bona fide available value estimates, including current market price if it is available.Take advantage of the benefits of diversification by incorporating as many bona fide value estimates as available.If you believe some of the estimates are more accurate and precise than others, assign greater weight to the more accurate and precise estimates.Take an equally weighted “simple” average of all available estimates. In practice, this approach usually works just as well as more sophisticated weighting procedures.Perhaps try statistical back testing to peer-group or historical data but be careful. Back testing may help determine the optimal weights, but it comes with its own set of caveats.The method of combining does have unresolved issues. Bayesian theory says that value estimates should be combined as a linear weighted average. Without a reliable peer group of efficiently priced comparable firms, however, determining what the weights should be is usually difficult. Moreover, there is no way to evaluate whether the weights, once chosen, are correct. If the optimal weights vary over time, estimating them by back testing to historical time series is inappropriate.Nevertheless, despite these problems, combining promises enough benefits to warrant much more attention from practitioners, as well as academic researchers, than it has attracted in the past.
Journal: Financial Analysts Journal
Pages: 23-28
Issue: 4
Volume: 60
Year: 2004
Month: 7
X-DOI: 10.2469/faj.v60.n4.2633
File-URL: http://hdl.handle.net/10.2469/faj.v60.n4.2633
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# input file: UFAJ_A_12047505_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Laura Frieder
Author-X-Name-First: Laura
Author-X-Name-Last: Frieder
Author-Name: Avanidhar Subrahmanyam
Author-X-Name-First: Avanidhar
Author-X-Name-Last: Subrahmanyam
Title: Nonsecular Regularities in Returns and Volume
Abstract: 
 This study addressed U.S. stock daily returns and volume around days when the market is open that correspond to religious or cultural occasions—specifically, St. Patrick's Day and the Jewish High Holy Days of Rosh Hashanah and Yom Kippur. On Rosh Hashanah and Yom Kippur, volume was found to be down relative to volume on all trading days in the sample. The reason may be that the nonfinancial opportunity cost of trading is high for a considerable number of traders on these days. Returns were significantly higher on the days preceding St. Patrick's Day and Rosh Hashanah, which is consistent with the notion that market returns reflect the festive nature of these occasions. Evidence was also found of significantly negative returns after Yom Kippur in the second half of the sample period, which accords with the idea that the market reflects the solemn nature of this occasion. Overall, the results are consistent with the view that “mood” is a viable explanation for some market movements. Past analyses of stock return behavior found economically and statistically higher returns on days preceding holidays on which the equity market is closed than on other trading days. Possible reasons include speculators wanting to cover short positions before closed-market days and positive sentiment before a festive occasion. The issue of whether it is the closed market or the nature of the impending occasion (e.g., Christmas) that causes the anomalous return patterns has not been addressed. Thus, we proposed to examine what happens to the U.S. equity market before, during, and after a religious or cultural occasion on which the market stays open. We considered how returns and volume behaved on the days of and surrounding St. Patrick's Day, Rosh Hashanah, and Yom Kippur in the years 1946–2000.We found that on both Rosh Hashanah and Yom Kippur, volume (proxied by the NYSE) was down relative to volume on all days in the period, indicating that the nonfinancial opportunity cost of trading is high for many investors on those days. Indeed, in the 1946–2000 period, the median decrease in volume on Rosh Hashanah relative to the preceding trading day was about 19 percent; the corresponding number for Yom Kippur was about 24 percent.We also found that returns (proxied by the S&P 500 Index) were significantly higher on the days preceding St. Patrick's Day and Rosh Hashanah, which is consistent with the notion that market returns reflect the festive mood of investors on these occasions. We found significantly negative returns after Yom Kippur in the second half of our sample period (1973–2000), which accords with the idea that the market reflects the solemn nature of this occasion.The absolute average returns surrounding all three occasions were large relative to the overall mean return of the market. For example, during the full sample period, the average S&P 500 return on the two days preceding Rosh Hashanah was 13 times the average return on this index for the entire sample and the average absolute return on Yom Kippur was about 6 times the index mean return. Thus, our study throws light on the notion that nonfinancial opportunity costs are an important source of variation in trading activity.The anticipatory effects on returns of the festive occasions, St. Patrick's Day and Rosh Hashanah, were strong. The price pattern before these days indicates that people look forward to these uplifting occasions, which is reflected in their trading. We propose that optimism and/or increased investor confidence (and, consequently, decreased risk aversion) accompany these festive occasions and can be seen in increased buying of risky assets, with a concomitant run-up in prices.Overall, our results are consistent with the view that “mood” is a viable explanation for some market movements. Our results have implications for practitioners who wish to forecast trading activity (and, in turn, liquidity) as well as returns.
Journal: Financial Analysts Journal
Pages: 29-34
Issue: 4
Volume: 60
Year: 2004
Month: 7
X-DOI: 10.2469/faj.v60.n4.2634
File-URL: http://hdl.handle.net/10.2469/faj.v60.n4.2634
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# input file: UFAJ_A_12047506_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ryan Garvey
Author-X-Name-First: Ryan
Author-X-Name-Last: Garvey
Author-Name: Anthony Murphy
Author-X-Name-First: Anthony
Author-X-Name-Last: Murphy
Title: Are Professional Traders Too Slow to Realize Their Losses?
Abstract: 
 Data on a U.S. proprietary stock-trading team provide evidence of the tendency of traders to hold on to their losers too long and sell their winners too soon—that is, the “disposition effect.” The group of traders studied earned more than $1.4 million in intraday trading profits, but they realized their winning trades at a much faster rate than their losing trades. This tendency lowered their profitability. When the traders limited their risk exposure by trading in small share sizes, in low-priced stocks, or during periods of low volatility, the discrepancy between losing and winning holding times rose. An analysis of intraday prices suggests that traders could increase trading profits by holding winners longer and selling losers sooner. The behavioral finance theory that predicts individuals will hold their losing investments too long and sell their winning investments too soon is known as the “disposition effect.” Past research has demonstrated this tendency for individual investors, but we used a unique dataset to test whether highly and consistently profitable professional stock traders are susceptible to the same behavioral tendency. The extent to which professional stock traders suffer from the disposition effect has implications not only for the traders' profitability but also, because of these professionals' trading frequency and large block trades, for the price discovery process for active stocks.The 15-member trading team we studied generated more than $1.4 million in intraday trading profits over a 68-day trading period in a downward-trending market. But we show that these professional traders held their losing trades much longer than their winning trades. On average, losers were held for 268 seconds with an absolute price change and trading profit of, respectively, $0.10 and $100.46. Winning trades, on average, were held for 166 seconds with an average absolute price change and trading profit of $0.09 and $85.43. The traders were profitable because they completed more winning trades than losing trades overall.The traders minimized their loss exposure by trading few shares, trading low-priced stocks, or trading during times of low-market activity, but as far as holding losers too long and selling winners too quickly, they exhibited risky behavior. We considered intraday prices and the market trend before and after traders realized their open positions. When traders realized a profitable roundtrip, the price continued to increase for a long position and continued to decrease for a short position. When traders realized an unprofitable roundtrip, they could have lessened the loss if they had sold their long positions and covered their short positions sooner.These findings have implications not only for proprietary traders but also for other practitioners. For instance, portfolio managers who suffer from the disposition effect reduce investor returns. As is the case with proprietary traders, portfolio managers are generally considered to have a high level of financial sophistication, they trade the capital of others, and their actions are monitored by their employers. Our findings imply that a fund manager might outperform a standardized benchmark and receive a performance bonus but still produce returns that could have been higher in the absence of the costly disposition effect. Moreover, long-term investors may suffer from the disposition effect as much as the highly skilled traders we studied. In addition, because active traders affect market prices, those who suffer from the disposition effect are affecting all market participants. For instance, these professional traders accounted for nearly 2 percent of the share volume of Dell and WorldCom over our sample period. The tendency of these traders to refrain from selling losers could have slowed the rate at which negative news about these two companies was translated into prices. The sluggish response of other traders trading on the same signals could have slowed this rate even more.
Journal: Financial Analysts Journal
Pages: 35-43
Issue: 4
Volume: 60
Year: 2004
Month: 7
X-DOI: 10.2469/faj.v60.n4.2635
File-URL: http://hdl.handle.net/10.2469/faj.v60.n4.2635
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Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: The Diversification Puzzle
Abstract: 
 The levels of diversification in U.S. investors' equity portfolios present a puzzle. Today's optimal level of diversification, measured by the rules of mean–variance portfolio theory, exceeds 300 stocks, but the average investor holds only 3 or 4 stocks. The diversification puzzle can be solved, however, in the context of behavioral portfolio theory. In behavioral portfolio theory, investors construct their portfolios as layered pyramids in which the bottom layers are designed for downside protection and the top layers are designed for upside potential. Risk aversion gives way to risk seeking at the uppermost layer as the desire to avoid poverty gives way to the desire for riches. But what motivates this behavior is the aspirations of investors, not their attitudes toward risk. Some investors fill the uppermost layer with the few stocks of an undiversified portfolio; others fill it with lottery tickets. Neither lottery buying nor undiversified portfolios are consistent with mean–variance portfolio theory, but both are consistent with behavioral portfolio theory. The levels of diversification in U.S. investors' equity portfolios present a puzzle. The benefits of diversification as measured by mean–variance portfolio theory have increased in recent years, yet the average level of diversification has not. It remains well below the optimal level.The optimal level of diversification is reached when its marginal benefits exceed its marginal costs. The benefits of diversification in mean–variance portfolio theory are in the reduction of risk; the costs are transaction and holding costs. Risk is measured by the standard deviation of portfolio returns. Investors can choose to diversify in two ways—by assembling individual stocks into a portfolio or by buying a diversified portfolio in the form of a mutual fund. Investors who use a mutual fund save the cost of buying, holding, and selling stocks, but they pay, year by year, the cost of the fund.Recently, the Vanguard Total Stock Market Index Fund contained 3,444 stocks and its annual cost was 0.20 percent. I estimated the benefit of an increase of diversification from fewer than 3,444 stocks to 3,444 stocks by calculating the value of the reduction of risk, expressed in units of expected returns. The relative benefits of diversification depend on the average correlation between stocks, the equity premium, and the cost of a portfolio versus the cost of investing through the Total Market fund. I found that the Total Market fund offers a better way to diversify than a portfolio of 300 or fewer stocks.Although today's optimal mean–variance diversification exceeds 300 stocks, the average investor holds only 3 or 4 stocks. Large holdings of company (employer) stock in 401(k) accounts, concentration of portfolios in particular styles, and geographical bias add to the diversification puzzle.The diversification puzzle can be solved, however, within the framework of behavioral portfolio theory. Whereas “mean–variance investors” consider their portfolios as a whole and are always risk averse, “behavioral investors” do not consider their portfolios as a whole and are not always risk averse. Behavioral theory posits that risk aversion and risk seeking share roles in our behavior. In behavioral portfolio theory, investors construct their portfolios as layered pyramids in which the bottom layers are designed for downside protection and the top layers are designed for upside potential.The article shows that what is motivating this behavior of investors is aspirations, not attitudes toward risk. In behavioral theory, investors do not diversify fully because diversified portfolios leave them with too little hope of attaining their aspirations. But behavioral investors who select a few stocks for the upside-potential layers of their portfolios do not necessarily neglect the downside-protection layers. Some evidence shows that gamblers, for example, are more likely to have their future secured by Social Security and pensions than nongamblers.The rules of diversification in behavioral portfolio theory are not as precise as the rules in mean–variance portfolio theory, but they are clear enough. The optimal number of individual stocks under the rules of behavioral portfolio theory is the number that balances the chance for an uplift into riches against the chance of a descent into poverty. Investors, financial advisors, and companies sponsoring 401(k) plans must be careful to draw the line between upside potential and downside protection so that dreams of riches do not plunge investors into poverty.
Journal: Financial Analysts Journal
Pages: 44-53
Issue: 4
Volume: 60
Year: 2004
Month: 7
X-DOI: 10.2469/faj.v60.n4.2636
File-URL: http://hdl.handle.net/10.2469/faj.v60.n4.2636
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Author-Name: Xu-Shen Zhou
Author-X-Name-First: Xu-Shen
Author-X-Name-Last: Zhou
Author-Name: Ming Dong
Author-X-Name-First: Ming
Author-X-Name-Last: Dong
Title: Can Fuzzy Logic Make Technical Analysis 20/20?
Abstract: 
 One of the most challenging areas in technical analysis is the automatic detection of technical patterns that would be similarly detected by the eyes of experts. In this study, cognitive uncertainty was incorporated in technical analysis by using a fuzzy logic–based approach. The results show that the algorithm can detect subtle differences in a clearly defined pattern. Significant postpattern abnormal returns were found that varied directly with the fuzziness of a pattern. This approach can be valuable for investors as a way to incorporate human cognition into historical trading statistics so as to form future winning strategies. Technical analysis has been practiced for many decades. The effect of using technical analysis, especially in the area of spotting visual technical patterns, however, is controversial. The reason is, in part, that a subtle difference in technical patterns may be apparent and important to experienced traders but not to average investors. One of the most challenging areas in technical analysis, therefore, is the automatic detection of technical patterns that would be similarly detected by the eyes of experts.We incorporated cognitive uncertainty into technical analysis by using a fuzzy logic–based approach. We first used Gaussian kernels to smooth the time series of adjusted stock prices and identify five extrema—that is, the local stationary maximum and minimum values for the price—that met the definition of eight widely used technical pattern templates, such as the head-and-shoulders pattern. We then “fuzzified” the patterns and assigned a membership value from 0 to 1 to each pattern found in the price data. Membership value represented the degree of resemblance to the clearly defined pattern template. A membership value of 0 meant the chart did not resemble the predefined ideal pattern. A membership value of 1 meant that the chart fully resembled it.We then tested whether the occurrence of technical patterns with a certain membership value would signal certain kinds of future returns on the stocks. We selected a random sample of 1,451 U.S. stocks for the 1962–2000 period. We matched each sample company with a control company on the basis of their market capitalizations and previous year's returns. We then compared the returns of two portfolios—one containing the sample companies and the other containing the corresponding matched companies. We calculated the cumulative abnormal returns of sample companies relative to the control companies up to 120 days after the occurrence of technical patterns.Our results show that stocks with certain technical patterns in their price charts can generate abnormal returns after the occurrence of the patterns for up to 120 days. We found the approach does detect subtle differences in the patterns. Some abnormal returns were generated mainly by stocks with trading prices below $2.00. Such stocks are primarily NASDAQ-listed stocks. For stocks with raw prices of $2.00 or above, the postpattern performances are statistically significantly different among stocks with the same pattern but with different membership values. Some postpattern stock performances were even opposite to the direction the pattern would have led investors to expect. For example, stocks with a head-and-shoulders pattern are expected to underperform. Our results showed, however, that stocks with head-and-shoulders membership no higher than 0.7 significantly outperformed the control companies.Thus, the findings suggest that the fuzzy logic approach can be used to detect subtle differences even within a pattern. The findings can also explain why so much controversy surrounds technical analysis: A pattern can produce entirely different subsequent results. The difference within a pattern detected by our fuzzy logic algorithm may not be apparent to average investors, only to certain experts. Thus, only the experienced technical analysts can avoid using a pattern with a low membership value.The company-matched abnormal returns suggest that forming portfolios with high membership value patterns can be profitable. Using our approach, investors can first examine the historical trading statistics, then use the proposed fuzzy logic–based approach to find visual technical patterns with high membership values, and take a trading position largely in stocks with strong pattern confirmation. They can also set their own parameters and develop their own future winning strategies based on the fuzzy membership values.
Journal: Financial Analysts Journal
Pages: 54-75
Issue: 4
Volume: 60
Year: 2004
Month: 7
X-DOI: 10.2469/faj.v60.n4.2637
File-URL: http://hdl.handle.net/10.2469/faj.v60.n4.2637
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# input file: UFAJ_A_12047509_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jose Menchero
Author-X-Name-First: Jose
Author-X-Name-Last: Menchero
Title: Multiperiod Arithmetic Attribution
Abstract: 
 This article presents a set of qualitative characteristics and quantitative properties for arithmetic multiperiod performance attribution. Such characteristics and properties are essential for ensuring a sound and accurate linking of attribution effects over time. A comparison of various linking algorithms within this framework shows that linking algorithms that are not consistent with this set of quantitative properties can exhibit spurious effects that distort the attribution analysis. Performance attribution is a powerful and widely used analysis for explaining the sources of portfolio return relative to a benchmark. The objective is to quantify the impact of active management decisions and thereby be able to evaluate the effectiveness of an investment strategy. Active returns are decomposed into attribution effects, which are identified with the active management decisions. These attribution effects, when aggregated together, fully account for the active return.For such an analysis to be meaningful, the performance attribution model must reflect the decision-making process. As a consequence, a variety of models have been developed (during roughly the past 20 years) for decomposing active returns. The active returns for fixed-income portfolios, for instance, are commonly decomposed into effects related to yield-curve movements and/or credit spreads. The active return for equity portfolios may be decomposed within the context of a multifactor risk model or according to a sector-based approach that measures the effects of the allocation and selection decisions. These methodologies have also been generalized for the case of multiple currencies with hedging.Although these attribution models decompose active returns in distinct ways, they are similar in that all are based on single-period analyses. Practitioners, however, typically want to explain the sources of active return for an investment period of, say, a quarter or a year. During this longer period of time, portfolios may be rebalanced several times, thereby rendering the single-period assumption invalid. What is needed, therefore, is a means of linking attribution effects across multiple periods.The first articles on the subject of multiperiod attribution appeared only as recently as 1999. Since then, a flurry of papers on the subject have been published. The multiperiod algorithms can be grouped into four classes: (1) linking coefficient approaches, (2) compounded notional portfolio methods, (3) recursive models, and (4) ad hoc smoothing algorithms. But although there is no shortage of methodologies to choose from, what is noticeably lacking is a conceptual framework by which to understand and compare the various approaches.The purpose of this article is to provide such a framework and, in doing so, to provide insight into the underlying structure of multiperiod attribution. At the outset, the article argues that a multiperiod linking algorithm must meet certain qualitative conditions: It should be intuitive, transparent, and robust (meaning that it should yield reasonable results under any set of market conditions). More importantly, the method must satisfy four quantitative properties: The algorithm should be (1) residual free, (2) commutative, (3) metric preserving, and (4) fully linkable. The commutative property implies that the results of the analysis are independent of the ordering of the periods. The metric-preserving property requires that the linking be performed in a manner consistent with the basic measure of relative performance (i.e., arithmetic or geometric) being used.The article describes tests of the arithmetic algorithms with respect to the quantitative properties. Some of the distortions and nonintuitive effects that result when the quantitative properties are violated are documented and discussed. Only one methodology—a linking coefficient approach known as the “optimized linking algorithm”—is consistent with all of the properties.
Journal: Financial Analysts Journal
Pages: 76-91
Issue: 4
Volume: 60
Year: 2004
Month: 7
X-DOI: 10.2469/faj.v60.n4.2638
File-URL: http://hdl.handle.net/10.2469/faj.v60.n4.2638
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Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Firms' Investment and Financing Decisions: Theory and Empirical Methodology (a review)
Abstract: 
 The presentations and discussions at this May 2002 conference sponsored by the National Bank of Belgium form the contents of this book. Presenting and discussing the results of their empirical research, economists from the central bank and international scholars focused on the effect of capital market imperfections and tax policy on the investment and financing decisions of companies in general and start-up companies in particular. 
Journal: Financial Analysts Journal
Pages: 92-93
Issue: 4
Volume: 60
Year: 2004
Month: 7
X-DOI: 10.2469/faj.v60.n4.2639
File-URL: http://hdl.handle.net/10.2469/faj.v60.n4.2639
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:4:p:92-93




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Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Trading and Exchanges: Market Microstructure for Practitioners (a review)
Abstract: 
 Part of the series developed by the Financial Management Association to survey and synthesize current thinking, this book melds ideas on modeling market mechanics with discussion of the existing institutional frameworks. This comprehensive (and long overdue) book on the mechanics and structure of trading activity and exchanges is uniquely organized by a taxonomy of “trading types” and there motivations. 
Journal: Financial Analysts Journal
Pages: 93-95
Issue: 4
Volume: 60
Year: 2004
Month: 7
X-DOI: 10.2469/faj.v60.n4.2640
File-URL: http://hdl.handle.net/10.2469/faj.v60.n4.2640
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issues. 
Journal: Financial Analysts Journal
Pages: 96-96
Issue: 4
Volume: 60
Year: 2004
Month: 7
X-DOI: 10.2469/faj.v60.n4.2641
File-URL: http://hdl.handle.net/10.2469/faj.v60.n4.2641
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# input file: UFAJ_A_12047513_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “Predictability in Hedge Fund Returns” (September/October 2003) by Noel Amenc, Sina El Bied, and Lionel Martellini. 
Journal: Financial Analysts Journal
Pages: 13-13
Issue: 5
Volume: 60
Year: 2004
Month: 9
X-DOI: 10.2469/faj.v60.n5.2643
File-URL: http://hdl.handle.net/10.2469/faj.v60.n5.2643
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# input file: UFAJ_A_12047514_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In The Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issues.
Journal: Financial Analysts Journal
Pages: 96-96
Issue: 5
Volume: 60
Year: 2004
Month: 9
X-DOI: 10.2469/faj.v60.n5.2644
File-URL: http://hdl.handle.net/10.2469/faj.v60.n5.2644
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# input file: UFAJ_A_12047515_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Sustainable Spending in a Lower-Return World
Abstract: 
 Investors—whether corporate pensions, public pensions, foundations, endowments, or individuals—need to focus on “sustainable spending,” which is key to effective strategic planning. To assess sustainable spending, planners must start with the three building blocks of return for most assets—income, growth, and revaluation (changes in the yield offered by that investment). Analysis based on these components of historical equity and bond returns shows that the long-term investor cannot expect to receive in the future the commonly assumed 8–9 percent returns. With stock yields below 2 percent and bond yields of 5 percent, even a 5 percent spending rate may not be sustainable without future contributions from the investor. 
Journal: Financial Analysts Journal
Pages: 6-9
Issue: 5
Volume: 60
Year: 2004
Month: 9
X-DOI: 10.2469/faj.v60.n5.2645
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# input file: UFAJ_A_12047516_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Tom Arnold
Author-X-Name-First: Tom
Author-X-Name-Last: Arnold
Title: Insider Trading: More Comments
Abstract: 
 This material comments on “Insider Trading: Two Comments”.
Journal: Financial Analysts Journal
Pages: 11-11
Issue: 5
Volume: 60
Year: 2004
Month: 9
X-DOI: 10.2469/faj.v60.n5.2646
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# input file: UFAJ_A_12047518_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Dean LeBaron
Author-X-Name-First: Dean
Author-X-Name-Last: LeBaron
Title: Insider Trading: LeBaron Response
Abstract: 
 This material comments on “Insider Trading: Two Comments”.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 5
Volume: 60
Year: 2004
Month: 9
X-DOI: 10.2469/faj.v60.n5.2648
File-URL: http://hdl.handle.net/10.2469/faj.v60.n5.2648
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# input file: UFAJ_A_12047522_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Charles D. Ellis
Author-X-Name-First: Charles D.
Author-X-Name-Last: Ellis
Title: Tommy Armour on Investing
Abstract: 
 Golf, like life, has complexities and challenges comparable to investing, and the secret to success in each is self-discipline. We have been wisely advised to learn models of thinking in one area and apply them to problem solving in others. From Scotland came the origins of golf and investing, and from Scotland came a fine player and great teacher, Tommy Armour. His lessons are universal. We have been wisely advised to learn models of thinking in one area and apply them to problem solving in others. Thus, we can take some lessons from golf and apply them to the investment game. Scotland gave us the game of golf, and Scotland gave us a fine player and great teacher, Tommy Armour. I discuss his lessons as they apply to investment management, but indeed, his lessons are universal.Tommy Armour was, during his era, the greatest teaching pro in golf. After turning pro in 1925, he won every major golf championship. Then, starting in 1929, he taught golf. His 1953 book—still in print—is one of the very best books on playing golf and has the best, most encouraging title: How to Play Your Best Golf All the Time.Investors would benefit greatly from being able to study with a teacher like Armour and learn his “golf” lessons-which are so applicable to investing. A primary lesson would be to learn to play within the limits of our capabilities.Armour summarized his advice as follows: “Simplicity, concentration, and economy of effort have been the distinguishing features of every great player's methods.” Armour would want us to understand that the shrewd way to go forward is to take more time, have more knowledge and understanding, play to our strengths, invest in the ways we do best, and make investment decisions that make the next decision (or our long-term investing) easy. Some of the ways we can follow this advice are keep portfolio turnover low,index when appropriate,think more and take less action,before acting, focus more attention on reducing the “bad” stocks,recognize that success is relative to that of others and that in today's market, as in golf, we have little margin for error.
Journal: Financial Analysts Journal
Pages: 15-16
Issue: 5
Volume: 60
Year: 2004
Month: 9
X-DOI: 10.2469/faj.v60.n5.2652
File-URL: http://hdl.handle.net/10.2469/faj.v60.n5.2652
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:5:p:15-16




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Author-Name: Ronald N. Kahn
Author-X-Name-First: Ronald N.
Author-X-Name-Last: Kahn
Title: What Investors Can Learn from a Very Alternative Market
Abstract: 
 From the perspective of an active manager, the promise of behavioral finance is that an understanding of behavior will lead to new exploitable inefficiencies. So far, however, behavioral finance has mainly explained previously known inefficiencies. This article describes a very alternative market in which behavioral ideas have been successfully developed by science and applied in practice. The market is professional baseball, and the active manager is Billy Beane, the general manager of the Oakland Athletics. Behavioral finance has identified several common types of irrational human behavior that may contribute to market anomalies. Among the behaviors are social interactions that lead to following the crowd, oversimplification, and self-deception that produces overconfidence. From the perspective of an active investment manager, the promise of behavioral finance is that an understanding of behavior will lead to new exploitable inefficiencies. Behavioral finance has not yet, however, delivered on that promise. It has helped explain known market anomalies, but it has not led to the discovery of new ones.A very alternative market exists, however, in which the same foibles exist but at least one professional has been able to make use of them to beat “the market.” This market is the world of professional baseball, and it may offer insights into how we can identify exploitable behavior in the financial markets ex ante and apply that knowledge.The “professional investor” of note in this alternative market is Billy Beane, the general manager of the Oakland Athletics. How has Beane led one of the poorest teams in baseball to consistently outperform much wealthier teams—when the prevailing belief is that money buys baseball success? The answer is that quantitative analysis by outsiders of the game identified the characteristics that were truly important to success in baseball; then, Beane observed contradictory behavior (the same foibles discussed in behavioral finance) and exploited those market inefficiencies.Baseball and the financial markets are analogous, but they are not the same. The forces for market efficiency operate much more quickly to eliminate unsuccessful participants in the financial markets. The baseball market is relatively small; the forces imposing efficiency in baseball operate much more slowly—because of the relatively few players, games, teams, and trades, and baseball's protected marketplace. Predicting baseball success is also fundamentally much easier than predicting investment success.Nevertheless, we need to learn a lesson from Beane's approach—namely, the importance of rigorous scientific analysis to successful investing. Irrational behavior may provide opportunities, but clear, rational analysis of market data identifies those opportunities. If exploiting the large behavioral anomalies in baseball required rigorous scientific analysis, imagine how much more important such analysis is for investment management, where anomalies are more subtle and fleeting.
Journal: Financial Analysts Journal
Pages: 17-20
Issue: 5
Volume: 60
Year: 2004
Month: 9
X-DOI: 10.2469/faj.v60.n5.2653
File-URL: http://hdl.handle.net/10.2469/faj.v60.n5.2653
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# input file: UFAJ_A_12047524_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Manuel Ammann
Author-X-Name-First: Manuel
Author-X-Name-Last: Ammann
Author-Name: Ralf Seiz
Author-X-Name-First: Ralf
Author-X-Name-Last: Seiz
Title: Valuing Employee Stock Options: Does the Model Matter?
Abstract: 
 In this numerical analysis of models for valuing employee stock options, the focus is on the impact of a model on the resulting option prices and the sensitivity of pricing differences between models with respect to changes in the parameters. For most models, the price reduction relative to standard options is uniquely determined by the expected life of the option. In fact, with the exception of the Financial Accounting Standards Board 123 model, pricing differences are negligible if the models are calibrated to the same expected life of the option. Consequently, the application of models with several hard-to-estimate parameters, such as the utility-maximizing model, can be greatly simplified by calibration, because expected life is easier to estimate than utility parameters. Employee stock options differ from standard options in significant ways, and several researchers have noted the shortcomings of using traditional option formulas to value employee stock options. Although several pricing models for employee stock options have been proposed, no standard model has yet been accepted. As a contribution to the ongoing model discussion, we present a comparative analysis of current models for valuing employee stock options and propose a new model that accounts for suboptimal exercise because of nontradability by a simple adjustment of the exercise price. We analyze the impact of each model on the resulting option prices and investigate the sensitivity of pricing differences between models with respect to changes in the parameters.In particular, we investigate a utility-maximizing model, a recent Hull-White model, the model proposed by the Financial Accounting Standards Board (called “FASB 123”), and our model, which we call the “Enhanced American” model because of its similarity to modeling the price of a standard American option. In addition, we compare all the models with a standard Black-Scholes option-pricing model and the model for valuing American-style options.We show that, with the exception of the FASB 123 model and the standard Black-Scholes and American models, the models produce virtually identical option prices (differences in the range of −0.4 percent to +0.4 percent) if they are calibrated to the same expected life of the option. (The expected life of a set of employee stock options is defined as the length of time that options remain unexercised, on average, given that they vest.) In fact, for most models, after premature exercise of the option is accounted for, the expected life is a sufficient parameter to determine the price of an employee stock option relative to a standard option. In other words, even though the models tested derive their exercise policies in completely different approaches, the pricing effect of the exercise schemes is negligible as long as the expected life of the option is the same. As a consequence, dependence on unobservable and hard-to-estimate parameters, such as risk aversion, expected return, and nonoption wealth in the utility-maximizing model, can be overcome by using expected life, which is much easier to estimate, to calibrate the model. Expected life can replace the utility parameters because any combination of utility parameters implying the same expected life for the option produces the same option price.Furthermore, we show that modeling a time-varying employee exit rate can increase the value of the option if one assumes that the exit rate decreases during the vesting period for an option that is in the money. Hence, valuation models that use constant exit rates tend to underestimate the value of employee stock options.
Journal: Financial Analysts Journal
Pages: 21-37
Issue: 5
Volume: 60
Year: 2004
Month: 9
X-DOI: 10.2469/faj.v60.n5.2654
File-URL: http://hdl.handle.net/10.2469/faj.v60.n5.2654
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# input file: UFAJ_A_12047525_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Michael Stutzer
Author-X-Name-First: Michael
Author-X-Name-Last: Stutzer
Title: Asset Allocation without Unobservable Parameters
Abstract: 
 Some asset allocation advice for long-term investors is based on maximization of expected utility. Most commonly used investor utilities require measurement of a risk-aversion parameter appropriate to the particular investor. But accurate assessment of this parameter is problematic at best. Maximization of expected utility is thus not only conceptually difficult for clients to understand but also difficult to implement. Other asset allocation advice is based on minimizing the probability of falling short of a particular investor's long-term return target or of an investable benchmark. This approach is easier to explain and implement, but it has been criticized by advocates of expected utility. These seemingly disparate criteria can be reconciled by measuring portfolio returns relative to the target (or benchmark) and then eliminating the usual assumption that the utility's risk-aversion parameter is not also determined by maximization of expected utility. Financial advisors should not be persuaded by advocates of the usual expected-utility approach. Asset allocation advice for long-term investors is based on a variety of criteria. Some advice is based on maximization of expected utility. The most commonly used utility functions are (1) quadratic or exponential, which yield the ubiquitous mean-variance utility underlying modern portfolio theory, and (2) the constant relative risk-aversion (CRRA) power utility. Both utilities require measurement of a risk-aversion parameter appropriate to a particular investor. But no validated procedures exist for reliably assessing an individual's risk-aversion parameter, and some investigators have suggested that all such procedures are doomed to failure because the risk aversion of an individual can depend on the scale of risks encountered.Other asset allocation advice for long-term investors is based on a different criterion: minimizing the probability of falling short of a particular investor's targeted long-term return or an investable benchmark. This approach is grounded in the findings of behavioral finance, may be easier to explain to investors than maximization of expected utility, and obviates the need to assess a risk-aversion parameter.The article presents a description of the two criteria and illustrates specifically how to implement each in the three-step asset-allocation process: (1) choosing a criterion function to maximize, (2) using historical time-series (or some other) data on asset class returns to estimate optimal asset allocations consistent with the chosen criterion function, and (3) using specific investor information to select the asset allocation appropriate for the particular investor. Then, I argue that the CRRA-utility and shortfall-probability analyses can be reconciled. Surprisingly, the seemingly disparate conventional CRRA-utility-maximization and shortfall-probability-minimization methods can be reconciled by completely maximizing the expected CRRA utility of the ratio of the portfolio's return to the investor's target return. This maximization requires unconventionally maximizing the expected utility by selection of both the portfolio's asset allocation weights and the utility's risk-aversion parameter (as opposed to conventional maximization over the weights alone with the use of some fixed value of the risk-aversion parameter). This unconventional formulation of minimizing long-run target shortfall probability retains the framework of expected-utility maximization while eliminating the conventional but problematic requirement that the advisor fix a value of the risk-aversion parameter that is most appropriate for the investor. Instead, in an interactive feedback process, the advisor and the investor mutually determine the most appropriate target rate of return.I use a simple two-asset allocation problem to illustrate this approach. The results are quite sensible and lead to a reexamination of the arguments put forth by advocates of the conventional use of expected utility and of the arguments against the minimization of shortfall probability.Criticisms of the use of shortfall probability are either overstated or not applicable to target-shortfall minimization (target-outperformance maximization) as described in this article. Theorists who believe that this criterion is inferior to risk aversion parameter-dependent expected utility need to reevaluate that position in light of the implementation and the risk-scaling problems highlighted in this article.
Journal: Financial Analysts Journal
Pages: 38-51
Issue: 5
Volume: 60
Year: 2004
Month: 9
X-DOI: 10.2469/faj.v60.n5.2655
File-URL: http://hdl.handle.net/10.2469/faj.v60.n5.2655
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# input file: UFAJ_A_12047526_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Laurence B. Siegel
Author-X-Name-First: Laurence B.
Author-X-Name-Last: Siegel
Author-Name: M. Barton Waring
Author-X-Name-First: M. Barton
Author-X-Name-Last: Waring
Title: TIPS, the Dual Duration, and the Pension Plan
Abstract: 
 By defining “duration” as the sensitivity of an asset's price to changes in some other variable, one may characterize any asset as having an inflation duration, D i , and a real-interest-rate duration, D r . Unlike nominal bonds, for which D i  = D r , inflation-linked bonds, such as Treasury Inflation-Indexed Securities (commonly called TIPS), have different values for D i  and D r . Defined-benefit pension liabilities also have different values for D i  and D r . Such liabilities can be modeled as bonds (or portfolios of bonds and equities or other assets) held short. Thus, by appropriately combining TIPS and nominal bonds, a manager can build a portfolio that has the same inflation duration and real-interest-rate duration as the liability stream. Equities also have different values for D i  and D r , so the interaction of equities with TIPS and nominal bonds can be exploited in forming efficient pension portfolios—particularly in defeasing various liability streams. Nominal bonds are generally considered to have one duration (the sensitivity of the bond's price to a change in its nominal yield or interest rate), but inflation-indexed bonds, such as Treasury Inflation-Indexed Securities (formerly, Treasury Inflation-Protected Securities, TIPS), may be regarded as having two durations: D i , the sensitivity of the bond's price to a change in inflation, and D r , the sensitivity of the bond's price to a change in real interest rates.For a nominal bond, whether a change in yield was caused by a change in inflation expectations or a change in the real interest rate does not matter; the effect on the bond's price is essentially the same either way. But for a TIPS bond, an increase in inflation does not affect the bond's price because the change in the cash flows in the numerator (of the equation for discounted cash flow analysis) is indexed to inflation and the discount rate in the denominator has also been increased by the same change in the expected inflation rate. Thus, the TIPS bond has an "inflation duration" of zero. A change in real interest rates, however, affects the price of a TIPS bond much as it does the price of a nominal bond, so a long-term TIPS bond has a long real-interest-rate duration—say, 15 years.The idea that an asset or stream of cash flows has two durations (an inflation duration and a real-interest-rate duration) can be extended to pension liabilities, equities, and so on. Defined-benefit pension liabilities also have this dual-duration characteristic; for liabilities with a full cost of living adjustment (COLA), the inflation duration is zero and the real-interest-rate duration is long. Thus, a portfolio of TIPS can be used to fund such a pension plan with almost no residual risk. The plan would be hedged in both inflation duration and real-interest-rate duration.Most pension plans do not have a full COLA, and many have no formal COLA provision, yet they are exposed to inflation risk (that is, they have a nonzero inflation duration) because their benefit formulas are based on final salary, which for active employees is determined by wage inflation between the present time and the date of retirement. For example, we found that a stylized one-participant plan with no COLA and with the participant expecting to retire in 10 years has an inflation duration of about 7.6 "years" and a real-interest-rate duration of 17.5 "years." The inflation and real-interest-rate risks of such a plan can be eliminated with a portfolio of nominal U.S. T-bonds and TIPS that is engineered to have the same inflation and real-interest-rate durations as the pension liability. A portfolio of purely nominal bonds cannot accomplish this result.Typical pension managers find, however, that a mix of nominal bonds and TIPS does not have a high enough expected return to be attractive. They seek to increase expected return by moving farther out on the efficient frontier—adding equities and other risky assets. Dual-duration matching can nevertheless be preserved in this context if one has an estimate of the inflation and real-interest-rate durations of equities. Like TIPS and pension liabilities, equities have a relatively short inflation duration (because companies try to pass price increases on to consumers) and a long real-interest-rate duration. Thus, equities are, like TIPS, a natural hedge of these risks in the pension plan and, as one moves out on the efficient frontier, tend to displace TIPS (more than they displace nominal bonds) in efficient asset/liability portfolios.
Journal: Financial Analysts Journal
Pages: 52-64
Issue: 5
Volume: 60
Year: 2004
Month: 9
X-DOI: 10.2469/faj.v60.n5.2656
File-URL: http://hdl.handle.net/10.2469/faj.v60.n5.2656
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# input file: UFAJ_A_12047527_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: William Fung
Author-X-Name-First: William
Author-X-Name-Last: Fung
Author-Name: David A. Hsieh
Author-X-Name-First: David A.
Author-X-Name-Last: Hsieh
Title: Hedge Fund Benchmarks: A Risk-Based Approach
Abstract: 
 Following a review of the data and methodological difficulties in applying conventional models used for traditional asset class indexes to hedge funds, this article argues against the conventional approach. Instead, in an extension of previous work on asset-based style (ABS) factors, the article proposes a model of hedge fund returns that is similar to models based on arbitrage pricing theory, with dynamic risk-factor coefficients. For diversified hedge fund portfolios (as proxied by indexes of hedge funds and funds of hedge funds), the seven ABS factors can explain up to 80 percent of monthly return variations. Because ABS factors are directly observable from market prices, this model provides a standardized framework for identifying differences among major hedge fund indexes that is free of the biases inherent in hedge fund databases. Conventional models for constructing asset class indexes rest on the assumptions that the underlying assets have homogeneous performance characteristics and that the dominant investment strategy is to buy and hold assets. In contrast, the performance characteristics of hedge funds are diverse, the investment styles are dynamic, and bets may be highly levered. These hedge fund characteristics, together with the lack of standardized reporting of historical hedge fund performance, greatly limit the information content of hedge fund indexes that are constructed by using conventional methods. At times, using such indexes can even produce misleading results.In the study reported here, we used a method to create hedge fund benchmarks that captures the common risk factors in hedge funds by using asset-based style (ABS) factors. Model construction began by extracting common sources of risk from hedge fund returns. These sources of risk were identified by directly linking them to various market risk factors. These ABS factors were then used to construct a hedge fund risk-factor model similar to the approach in arbitrage pricing theory, in which the factor loadings (betas) are permitted to vary over time.Thus far, researchers have identified seven risk factors. Equity long-short hedge funds are exposed to two equity risk factors—market risk (as proxied by the S&P 500 Index) and the spread between small-capitalization stock returns and large-capitalization stock returns. Fixed-income hedge funds are exposed to two interest-rate-related risk factors—the change in 10-year U.S. Treasury yields and the change in the yield spread between 10-year T-bonds and Moody's Investors Service Baa bonds. Trend-following funds are exposed to the same risk factors as three portfolios of “lookback” options—on bond futures, on currency futures, and on commodity futures. Empirical evidence shows that these seven risk factors can jointly explain a major portion of return movements in diversified hedge fund portfolios, as proxied by a fund-of-funds index.Applying the risk-factor model to hedge fund indexes, we show that the model can identify risk differences inherent in these indexes, which in turn, helps explain anomalous return differences among them. An out-of-sample check on the usefulness of the risk-factor model with 2003 data indicates that the model explains a significant amount of the return differences among major hedge fund indexes.The ABS risk-factor model can be applied to circumvent the lack of transparency in hedge fund investments. It helps investors relate hedge fund strategies to a set of common risk factors, which can be key inputs for portfolio construction, risk management, and performance evaluation. Because ABS factors are measured in market prices, investors can frequently approximate the performance of their hedge fund investments to match the changing conditions of global markets without having to rely on normal net-asset-value reporting as the only input.Hedge fund managers can also use ABS factors to communicate the systematic risk inherent in a strategy to investors in a format that is consistent with the qualitative description of the strategy's style. Thus, risk disclosure and transparency can be brought to a satisfactory aggregated level without having to analyze the huge volume of individual hedge fund transactions.The same framework can be used by regulators to monitor aggregate exposures to systematic risks. This use would provide important input to the management of stressful events, such as the bond market decline of 1994.
Journal: Financial Analysts Journal
Pages: 65-80
Issue: 5
Volume: 60
Year: 2004
Month: 9
X-DOI: 10.2469/faj.v60.n5.2657
File-URL: http://hdl.handle.net/10.2469/faj.v60.n5.2657
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# input file: UFAJ_A_12047528_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: W. Brian Barrett
Author-X-Name-First: W. Brian
Author-X-Name-Last: Barrett
Author-Name: Thomas F. Gosnell
Author-X-Name-First: Thomas F.
Author-X-Name-Last: Gosnell
Author-Name: Andrea J. Heuson
Author-X-Name-First: Andrea J.
Author-X-Name-Last: Heuson
Title: Term-Structure Factor Shifts and Economic News
Abstract: 
 For this article, daily changes in pure discount yields on U.S. risk-free securities were fit to a theoretically robust term-structure model to derive a set of orthogonal factors measuring the level, slope, and curvature of the yield curve. Changes in these factors at the release of unexpected economic news are reported. This methodology explicitly allows for commonalities in responses in the universe of spot rates, thus painting a rich picture of interest rate reactions to new information. The results have important implications for hedging volatility risk or seeking to profit from predicting volatility in bond prices. The argument that efficient markets respond quickly and completely to new information has been a cornerstone of empirical financial research for decades. Given the depth, breadth, and liquidity of the market for U.S. Treasury debt, Treasury yields react to the release of unexpected macroeconomic news in regularly scheduled announcements. Our research shows that reactions occur in a systematic way across the term structure and that an understanding of this phenomenon can enhance portfolio management strategies that are designed to hedge or profit from this predictable volatility.We studied adjustments in a set of orthogonal factors that represent shifts in the level, slope, and curvature of the term structure. The factors were estimated from daily zero-coupon yield changes and allowed for commonalities in responses across the universe of spot rates. Announcements for the following economic series were incorporated: the U.S. Consumer Price Index and Producer Price Index, nonfarm payroll, unemployment, retail sales, durable goods orders, housing starts, and industrial production. The generality of the analysis is important because it distinguished announcements that move the entire term structure in a parallel fashion from those that have incremental effects in the short range. Of the eight releases studied, the four that had the strongest systematic impact were announcements made at the beginning of each month—nonfarm payroll, industrial production, producer prices, and retail sales. Surprises in these four had a consistent, measurable impact on the term structure of zero-coupon yields that was felt equally across the entire maturity spectrum in most interest rate environments. Some announcements—most notably, nonfarm payroll—had incremental effects on the slope component as well as the level component.The underlying data were drawn from Treasury yields for 1982–2002—a long series that contains regimes of rising, falling, and neutral interest rates. This segmentation allowed us to discover that the responses to some surprises (specifically, nonfarm payroll and retail sales) occur later in the maturity structure in a falling-interest-rate environment than in a rising or neutral environment. Furthermore, in periods when the level of Treasury yields was adjusting to a new short-term equilibrium, we found that the market was sensitive to more types of announcements and that reactions to some announcements (notably, retail sales and housing starts) were significantly more pronounced.Taken as a whole, our findings indicate that traders believe increased demand from the producer sector initiates economic expansions, with a corresponding increase in the level of interest rates, whereas developments in the consumer sector sustain yield rallies. In addition, we suggest that announcement risk should be a systematic component of multifactor bond-pricing models and that it should be incorporated into trading strategies that seek to hedge against or profit from daily volatility in U.S. Treasury markets.
Journal: Financial Analysts Journal
Pages: 81-94
Issue: 5
Volume: 60
Year: 2004
Month: 9
X-DOI: 10.2469/faj.v60.n5.2658
File-URL: http://hdl.handle.net/10.2469/faj.v60.n5.2658
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:5:p:81-94




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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Pension Challenge: Risk Transfers and Retirement Income Security (a review)
Abstract: 
 Essays from a wide range of academic writers provide practitioners with a comprehensive, up-to-date analysis, written in language accessible to the nonspecialist, of the essential issues in the valuation of corporate pension commitments. 
Journal: Financial Analysts Journal
Pages: 95-95
Issue: 5
Volume: 60
Year: 2004
Month: 9
X-DOI: 10.2469/faj.v60.n5.2659
File-URL: http://hdl.handle.net/10.2469/faj.v60.n5.2659
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:5:p:95-95




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# input file: UFAJ_A_12047530_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Tom Arnold
Author-X-Name-First: Tom
Author-X-Name-Last: Arnold
Author-Name: Timothy Falcon Crack
Author-X-Name-First: Timothy Falcon
Author-X-Name-Last: Crack
Title: Using the WACC to Value Real Options
Abstract: 
 Use of the weighted-average cost of capital (WACC) in real-option valuation is an alternative to using risk-neutral real-option valuation. Using the WACC involves a marginal increase in mathematical complexity, but the method is easy to implement in a spreadsheet and easy to present to company managers, clients, and colleagues. Because real-option valuation is immune to choices of admissible discount rates, however, the critical issue is correct estimation of volatility, not choice of discount rate. We also point out that the natural and conservative tendency to overestimate risk is anything but conservative in a real-option valuation. Two problems obstruct the wider use of real-option analysis: a lack of understanding of risk-neutral valuation and an inability to question a given constant discount rate for a project. We demonstrate how to overcome these problems by using the weighted-average cost of capital (WACC) to perform real-option valuation. Our argument relies on the immunity of option valuation to choice of admissible discount rates; that is, different admissible discount rates must lead to identical option valuations. The WACC valuation is marginally more mathematically complex than risk-neutral valuation, but it is easy to implement in a spreadsheet.We begin by deriving the generalized one-period option-pricing (GOPOP) model as a generalized risk-adjusted version of the Cox–Ross–Rubinstein (CRR) one-period binomial tree model. The GOPOP model allows any admissible risk-adjusted discount rate for the underlying asset to be used in option valuation. Admissibility is determined by arbitrage or equilibrium considerations.We use the GOPOP model to value a simple real option with the WACC as the discount rate for the underlying asset. We show that the valuation is identical to that obtained using CRR risk-neutral valuation. We then distinguish between the discount rate on the underlying asset and the discount rate on the real-option project itself. The discount rate on the real-option project changes as one steps through a multiperiod tree; the discount rate on the underlying asset does not. The WACC, however, applies properly to the real-option project, not the underlying asset. We show that using the WACC for option pricing is feasible and produces a final result identical to the results of the two earlier option value calculations. We argue, however, that forcing the underlying discount rate to change from period to period so as to maintain a constant project WACC is unduly artificial.We then ask: If real-option valuation is immune to assumptions about the discount rate—in which case, questions about the legitimacy of risk-neutral valuation are irrelevant—what is the critical parameter for real-option valuation?To answer this question, we show that even if one knows the payoffs to the option one period ahead and the real-world probabilities with which they will occur, one cannot value the option without an estimate of volatility. Thus, volatility estimation is the critical ingredient of real-option valuation. If one is using risk-neutral valuation (CRR), one still needs the risk-neutral probabilities before discounting, and one cannot find these probabilities without an estimate of volatility; if one is using non-risk-neutral valuation (GOPOP), then even if one has the non-risk-neutral probabilities, one still needs the discount rate, which is a function of volatility.Finally, we note that an overestimate of risk can make one too conservative in net present value (NPV) analysis but an overestimate of risk can make one very daring in real-option analysis because option values increase with volatility. A sensitivity analysis with regard to volatility is thus crucial in making project decisions in real-option analysis.
Journal: Financial Analysts Journal
Pages: 78-82
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.1909
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.1909
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:6:p:78-82




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# input file: UFAJ_A_12047531_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Michael A. Martorelli
Author-X-Name-First: Michael A.
Author-X-Name-Last: Martorelli
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Enron: Corporate Fiascos and Their Implications (a review)
Abstract: 
 This compilation of essays by specialists in a number of disciplines highlights the fatal near-sightedness on the part of Enron's directors, auditors, bankers, lawyers, and analysts. The editors provide a great service to those trying to absorb some lesson from that tragedy, and they put out a call for a holistic approach by corporate gatekeepers. 
Journal: Financial Analysts Journal
Pages: 83-83
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.1910
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.1910
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:6:p:83-83




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Author-Name: Ronald L. Moy
Author-X-Name-First: Ronald L.
Author-X-Name-Last: Moy
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Seeing What's Next: Using the Theories of Innovation to Predict Industry Change (a review)
Abstract: 
 In this good approximation of a crystal ball, the authors describe sustaining innovation (usually improvements in existing product lines made by established companies) and disruptive innovation (exploitations of market gaps usually made by small companies). The approach outlined in the book may enable investors to profit from the next disruptive innovation. 
Journal: Financial Analysts Journal
Pages: 83-84
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.1911
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.1911
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Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Investment Management: Portfolio Diversification, Risk, and Timing—Fact and Fiction (a review)
Abstract: 
 Drawing on research and his practitioner experience, the author of this informative book separates what seems to work in investing from what clearly does not and thereby educates the uninformed investor on avoiding the blunders that lead to subpar performance. 
Journal: Financial Analysts Journal
Pages: 85-86
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.1912
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.1912
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:6:p:85-86




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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In The Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issues.
Journal: Financial Analysts Journal
Pages: 88-88
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.1913
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.1913
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:6:p:88-88




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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Can We Keep Our Promises?
Abstract: 
 We cannot pursue returns sensibly without measuring our risks sensibly. For pension funds, three risks—not classic standard deviation alone—must be the focus: (1) falling short of our peers, (2) losing money, and (3) underperforming our liabilities (or, for endowments and foundations, failing to meet the obligations that the assets serve). Investment committees and consultant should measure results against all three metrics. If they do, they should welcome a goal of exceeding any two goals in most years. The result would be to unshackle investment professionals from their peer groups. 
Journal: Financial Analysts Journal
Pages: 6-10
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.2660
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.2660
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Author-Name:  An Interested Reader
Author-X-Name-First: 
Author-X-Name-Last: An Interested Reader
Title: “The Diversification Puzzle”: A Comment
Abstract: 
 This material comments on “The Diversification Puzzle”.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.2661
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.2661
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Author-Name: Clifford S. Asness
Author-X-Name-First: Clifford S.
Author-X-Name-Last: Asness
Title: “Stock Options and the Lying Liars Who Don't Want to Expense Them”: Author's Response
Abstract: 
 This material comments on “Stock Options and the Lying Liars Who Don't Want to Expense Them”.
Journal: Financial Analysts Journal
Pages: 14-14
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.2663
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.2663
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Author-Name: Kathryn M. Welling
Author-X-Name-First: Kathryn M.
Author-X-Name-Last: Welling
Title: “Stock Options and the Lying Liars Who Don't Want to Expense Them”: A Comment
Abstract: 
 This material comments on “Stock Options and the Lying Liars Who Don't Want to Expense Them”.
Journal: Financial Analysts Journal
Pages: 14-15
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.2666
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.2666
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Author-Name: Robert F. Richards
Author-X-Name-First: Robert F.
Author-X-Name-Last: Richards
Title: “Are Professional Traders Too Slow to Realize Their Losses?”: A Comment
Abstract: 
 This material comments on “Are Professional Traders Too Slow to Realize Their Losses?”.
Journal: Financial Analysts Journal
Pages: 15-15
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.2667
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.2667
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Author-Name: Glyn A. Holton
Author-X-Name-First: Glyn A.
Author-X-Name-Last: Holton
Title: Defining Risk
Abstract: 
 The financial literature frequently mentions risk, but it lacks a widely accepted definition of risk. This omission is no coincidence. Risk is an intuitive notion that resists formal definition. Adopting a largely historical perspective, this article draws on ideas that emerged during the 20th century and uses them to formalize specific limits to our ability to ever define the notion of risk. In doing so, it offers insights into the nature of risk. The financial literature frequently mentions risk, but it lacks a widely accepted definition of risk. Applications—such as risk limits, trader performance-based compensation, portfolio optimization, and capital calculations—increasingly depend on metrics of risk, but do these metrics reflect true risk? With financial decisions and compensation hanging in the balance, debates flare.Adopting a largely historical perspective, I draw on ideas that emerged during the 20th century to analyze the nature of risk. These include subjective probability and the philosophy of operationalism, both of which have origins in the empiricism of David Hume.Frank Knight's famous definition of risk is problematic for being unrelated to common usage. It depends upon an objectivist interpretation of probability and is somewhat parochial, being more useful in certain fields than in others. Harry Markowitz was careful to not define risk in his groundbreaking work on portfolio theory. This may have been due to his subjectivist perception of probabilities.Risk, as that notion is commonly understood, comprises two components: exposure and uncertainty. According to Percy Bridgman's philosophy of operationalism, only that which can be perceived can be defined. At best, we may define perceived exposure or perceived uncertainty. Accordingly, we can only hope to define perceived risk. There is no such thing as true risk.As practitioners of finance, we use subjective probabilities to operationally define perceived uncertainty. We use utility or state preferences to operationally define perceived exposure. Because perceived risk takes so many forms, it is not easy to operationally define. To simplify this task, we may operationally define some aspects of perceived risk. We adopt risk metrics—such as variance of return or maximum likely credit exposure—to identify specific aspects of perceived risk.What is risk? How can we quantify risks that cannot be perceived? If a trader or business manager has knowledge not reflected in a risk metric, does the risk metric misrepresent risk? In the absence of true risk, these questions are empty. A more practical question is whether a risk metric is useful. Used in a given application, will it promote behavior that management considers desirable?
Journal: Financial Analysts Journal
Pages: 19-25
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.2669
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.2669
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:6:p:19-25




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Author-Name: Peter L. Bernstein
Author-X-Name-First: Peter L.
Author-X-Name-Last: Bernstein
Title: A Do-It-Yourself Forecasting Kit Updated
Abstract: 
 Forecasters who make predictions without regard to past experience have no benchmarks to distinguish between what is radically different about their expectations and what experience has already taught us. Although the future will never replicate the past, analysis of long historical periods is the basic tool for forecasters. In this article, comparison of a set of major U.S. macroeconomic variables and capital market returns over a sequence of 20-year periods (beginning with 1873–1893) highlights that inflation is critical. Real, inflation-adjusted data often bear only a vague resemblance to the nominal data from which they were derived. Forecasting the long-run future is an inherently perilous activity. Forecasts based on an extrapolation of the past are at the outside limits of peril. We all know that. But forecasters who make predictions without regard to past experience are simply playing games. Without any reference points, they have no benchmarks to distinguish between what is radically different about their expectations and what experience has already taught us. Those insights are the essential building blocks of a rational forecast.In this article, I compare a set of major U.S. macroeconomic variables and capital market returns over a sequence of 20-year periods beginning with 1873–1893 and ending with 1983–2003—which provides a total of 23 eras, of which 22 contain a 15-year overlap with their predecessors. This sequence of periods spans big differences in both fundamental economic data and capital market data.The starting point of analysis is to remember that the data that matter the most are the real data. When you think about the future, you have to think about inflation before anything else. The real data often bear only a vague resemblance to the nominal data from which they were derived.In the data, variability in real bond yields, with the standard deviation about double the mean, is startling. But the biggest surprise is in the long-run relationship between inflation and equity returns. Stocks have done better when inflation was high than when it was low. Stocks really have been a hedge against inflation—over the long run. The three periods with the highest rates of inflation were those beginning with 1963, with 1968, and with 1973. In those periods, inflation ran higher than 6 percent but the stock market averaged 9.2 percent nominal return a year. Furthermore, the coefficient of variation for equity returns over 20-year spans, real as well as nominal, is no greater than it is for real GDP. The primary reason is that the average return on equities over the long run has been such a big absolute number.The intimate link between money growth and inflation is clearly as expected: The directional movements in money and inflation have been almost precisely in step over periods as long as 20 years. It follows that money growth and stock returns have also tended to move in the same direction, although the relationship has been less consistent than with bonds.Two interrelated dangers await investors who are excessively fond of evoking the long run as a basis for projecting the future. First, the long run smoothes the data by averaging out the wild volatility we experience in the short run. One can be mesmerized by the smoothing (or “soothing”) process of the long run. Second, a powerful feature of past experience has recently disappeared from the scene: An average dividend yield of 5.1 percent with a standard deviation of only 1.3 percent throughout the period from 1872 right through to 1996 overshadows the 9.2 percent mean return of the 20-year periods.How should one use these statistics in framing a long-term forecast? Very gently. Few observations actually fall close to the averages. Nominal return on equity for only two periods are within 100 bps of the average. Average or below-average returns over the next 20 years are not in any way beyond normal expectations—but so are spectacular results.Perhaps the most important advice for considering the future is to remember that 20 years is a long time. Those who last that long into the future will get there one year at a time, one month at a time, one moment at a time. Keeping the 20-year outlook in view will be difficult, except perhaps during those brief quiet moments that come our way on widely separated occasions or, perhaps more often, in the middle of the night.
Journal: Financial Analysts Journal
Pages: 27-32
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.2670
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.2670
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:6:p:27-32




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# input file: UFAJ_A_12047546_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: Fairness Outside the Cocoon
Abstract: 
 Investment bankers, security analysts, traders, and other finance professionals often behave as if they lived in a cocoon. They need to recognize that they live under the community's rules of fairness as well as the market's rules. Through anecdotes, quotations, and survey reports, this article discusses how internal and external obstacles keep finance professionals from perceiving the community's rules of fairness—rules that often make their way into the law. Ultimately, those who fail to understand and follow the community rules of fairness are taking risks they would be wise to avoid. Investment bankers, security analysts, traders, and other finance professionals often behave as if they lived in a cocoon, insulated from the fairness norms of the community. Finance professionals can take pride in the contributions they make to society by analyzing the value of companies and stocks, linking entrepreneurs with investors, and operating markets that provide liquidity and optimal sharing of risk. In their profession, however, although they favor regulations that promote fairness, they often hold the naive belief that their own perceptions of fairness are shared by all. They are not.Social norms, including rules of fairness, are rules of behavior enforced by the community. They often make their way into the law. People who violate rules of fairness that are enshrined in the law are punished according to the law, but people who violate rules of fairness that are not enshrined in the law do not escape punishment. Their punishment ranges from injury to their reputation to loss of career and social shunning. I discuss community rules of fairness and the perils of violating them through examples, including examples of those engaged in “spinning” (allocating lucrative shares in initial public offerings to executives one is courting) and market timing (in-and-out trading) and the Enron traders who crossed the line between arbitrage and theft.Sometimes, people violate rules of fairness—even those they understand—when the benefits they expect to derive from the violations exceed the expected costs. The benefits can be substantial profits; the potential costs are fines, loss of career, and jail time. For example, the tax partners of KPMG concluded that the profit from each tax shelter they sold would be $360,000 whereas the fine, if the shelter was discovered by the U.S. IRS, would be only $31,000. What about loss of career and/or jail time?At other times, people violate community rules of fairness because they fail to understand them. For example, one investment banker apparently did not understand that spinning shares worth hundreds of thousands of dollars to executives whose business she courted was perceived as different from paying for clients' golf games or dinners.Finance professionals often ask that society make the legal line clear and keep it constant. But such requests are naive. Society has often changed the rules of business after the fact and enforced the law unpredictably. Finance professionals must manage the risks of changing rules of fairness as they manage the risks of volatile markets. They must begin by knowing the risks.The kinds of surveys that have been used to elicit community views on subjects as diverse as the fair punishment for murder and the fair price of snow shovels are useful also in eliciting community rules of fairness in financial markets. Such surveys show, for example, that people judge well-off executives who trade on inside information more harshly than they judge summer interns who trade on the same information.Some might feel distaste for following rules of fairness uncovered by surveys of the entire community. Shouldn't we follow rules of fairness that are based on fundamental rights? Unfortunately, some rights conflict with other rights, and not all agree on which rights are fundamental. Moreover, following rules of fairness that are based on our own notions of fundamental rights is fine if these rules are stricter than the rules set by the community. But rights-based rules of fairness are of no help when, for example, they permit spinning just because the individual thinks it is fair or permit accounting fictions because the individual believes the effects are modest.Finance professionals who misperceive community rules of fairness put themselves at risk, just as they do if they misperceive the risks of bonds. A finance professional must know the community rules of fairness to judge the risk of violating them.Finance professionals who fail to understand and follow community rules of fairness are taking unnecessary risks they would be wise to avoid.
Journal: Financial Analysts Journal
Pages: 34-39
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.2671
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Author-Name: Stéphanie Desrosiers
Author-X-Name-First: Stéphanie
Author-X-Name-Last: Desrosiers
Author-Name: Jean-François L'Her
Author-X-Name-First: Jean-François
Author-X-Name-Last: L'Her
Author-Name: Jean-François Plante
Author-X-Name-First: Jean-François
Author-X-Name-Last: Plante
Title: Style Management in Equity Country Allocation
Abstract: 
 Strategies that entailed country selection based on relative strength (momentum) posted significant market risk–adjusted returns over the past 30 years, but relative-value strategies based on book value of equity to market value of equity did not. Because these two fixed-style strategies are negatively correlated, using them for style diversification and for style timing (rotation) is potentially rewarding. In the study described here, style diversification enhanced return and lowered risk but style timing provided consistent risk-adjusted performance that was superior to the performance of fixed-style strategies or style diversification. Many practitioners exhibit a consistent and strong value or momentum bias. This phenomenon is true irrespective of whether the point of view is security selection, sector selection, or country allocation. Both a value strategy and a momentum strategy can provide good average performance over a long period of time (in fact, they have done so over the past 30 years), but the strategies suffer from relatively long, nonoverlapping periods of underperformance. These periods can prove fatal for many portfolio managers.The correlation between value and momentum strategies is negative and fairly strong, so diversification (combining the uncorrelated strategies to reduce the risk involved in picking only one) and style timing (rotating between the two strategies) are two approaches that come to mind as useful for portfolio managers trying to avoid the fatal periods. A timing strategy is based on a criterion supported by psychological evidence that prior gains and losses affect subsequent risk-taking behavior. Timing is an attempt to switch portfolio exposure toward the potentially more rewarding strategy. A combination of the diversification and timing strategies can be thought of as “style management.” It would allow managers to maintain an exposure to both styles while alternately tilting toward the potentially more rewarding one.We studied the implementation and performance of these three strategies on a global basis through the use of country indexes. The countries included in the study are the 18 largest markets in the world; the sample period is January 1975 through August 2003, for a total of 344 months. The relative-value signal was based on country price-to-book ratios, and the relative-strength signal was based on country one-year previous prices.Compared with the fixed-style strategies, style diversification, based on an equally weighted combination of the relative-value signal and the relative-strength signal, enhanced return and lowered risk in the period studied. The timing strategy, however, provided consistent risk-adjusted performance superior to the performance of the diversification strategy and of the fixed-style strategies alone. In turn, the style management strategy posted even better risk-adjusted returns than the fixed-style strategies, the diversification strategy, and the timing strategy.In robustness tests, we found that transaction costs do not appear to undermine the statistical significance of reported results. We also examined how exposure to risk factors would alter the performance of the three strategies. To do so, we used a four-factor pricing model, with the risk factors being the equally weighted world market benchmark excess return over the U.S. risk-free rate, a size (liquidity) factor, the relative-value factor, and the relative-strength factor. After controlling for these four risk factors, we found that both the timing and management strategies can provide positive and significant risk-adjusted returns.In further tests, we measured how good each model was at selecting good countries (rather than timing the right style at a given time) and how good it was at using the right style at the right time. The performance attribution was carried out through the addition of a squared term for each previously mentioned factor in the model. As expected, we found that the abnormal performance from the timing model derives exclusively from its timing ability whereas the diversification model provides significant selection ability. The management model provides balance in terms of timing and selection.The models in this study seem promising for implementing stylediversification and timing strategies in country allocation. Further research could examine sector allocation as well as other conditional criteria. Managing the style bias in country allocation appears to be an important source of alpha for global portfolio managers. Furthermore, our study somewhat confirms the assumption advanced by behavioralists that after prior losses, people tend to adopt a more defensive (value-oriented) decision-making process whereas after prior gains, they tend to be less risk averse and open to the influence of momentum.
Journal: Financial Analysts Journal
Pages: 40-54
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.2672
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.2672
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Handle: RePEc:taf:ufajxx:v:60:y:2004:i:6:p:40-54




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Author-Name: John A. Doukas
Author-X-Name-First: John A.
Author-X-Name-Last: Doukas
Author-Name: Chansog (Francis) Kim
Author-X-Name-First: Chansog (Francis)
Author-X-Name-Last: Kim
Author-Name: Christos Pantzalis
Author-X-Name-First: Christos
Author-X-Name-Last: Pantzalis
Title: Divergent Opinions and the Performance of Value Stocks
Abstract: 
 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. Proponents of rational asset pricing and advocates of behavioral finance are engaged in an ongoing debate about the exact interpretation of the “value premium.” Rationalists argue that because value stocks are fundamentally riskier than growth (or “glamour”) stocks, the value premium is compensation for bearing risk. Behaviorists claim that value stocks produce superior returns because investors consistently overestimate the future earnings of growth stocks relative to value stocks. The essence of this argument is that investors are excessively pessimistic (optimistic) about value (growth) stocks because they tie their expectations for the future to past earnings. That is, investors make systematic errors in predicting future growth in earnings for value stocks, and investors' excessive pessimism about these stocks causes the superior performance of value stocks relative to growth stocks. This non-risk-based (behavioral) explanation of the value premium is known as the “extrapolation” or “errors-in-expectations” explanation, and it has been supported by several researchers.Recently, some researchers, using U.S. analyst earnings forecasts as a proxy for the market's expectations of future earnings, provided evidence against the errors-in-expectations view. Therefore, the observed abnormal return of value stocks on earnings announcement days is apparently not caused by surprise in the level of earnings but by some different mechanism. This mechanism—disagreement about future payoffs—is the focus of our article.Proponents of the rational explanation of the value premium have overlooked differences of opinion as a possible source of risk that could explain the value premium. Disagreement among investors is widely recognized, however, as a potential determinant of asset prices. The concept of heterogeneous beliefs about future stock payoffs has been introduced into a standard capital asset pricing model and shown to be a positively associated with future stock returns.In this framework, the superior future performance of certain stocks arises because not all investors possess completely accurate probability beliefs; heterogeneous expectations among investors matter in asset pricing because the opportunity set is partially unknown. When investors are uncertain about the true probability structure of stock return payoffs, they tend to hold different subjective opinions about the future of the stocks. When uncertainty about the future prospects of a stock is high, subjective beliefs will diverge, causing investors to demand high rates of return to invest in the stock.An alternative view is that the higher returns for stocks exposed to greater disagreement among investors arise because in imperfect capital markets, capital market equilibrium requires the simultaneous determination of asset prices and of the identity (that is, the opinions) of investors trading in each asset.Dispersion of opinion, then, may represent a unique source of risk, and its impact on prices should be compounded by the degree of disagreement. To examine this issue, we used dispersion in analysts' earnings forecasts as a proxy for investors' heterogeneous beliefs. We hypothesized that value (growth) stocks have greater (lower) exposure to dispersion in forecasts and, therefore, should earn a higher (lower) return.Our results are consistent with the investor disagreement explanation for the return differential between value and growth stocks. We found that the dispersion in analysts' earnings forecasts is considerably higher for portfolios composed of stocks with high book-to-market ratios (BV/MVs). We obtained similar results when we compared the extreme quintiles of stocks ranked on size. Small-capitalization stocks exhibited greater forecast dispersion than large-cap stocks. These results suggest that high-BV/MV stocks and small-cap stocks earn higher returns because there is greater disagreement among investors about the stocks' future payoffs.Our multifactor asset-pricing tests confirmed that investor disagreement, manifested in the dispersion of analysts' earnings forecasts, is a risk factor that is priced, together with other risk factors, in the determination of value stock and small-cap stock returns. These results are consistent with the view that investors require higher returns for stocks exposed to greater disagreement.
Journal: Financial Analysts Journal
Pages: 55-64
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.2673
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.2673
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Author-Name: Fenghua Wang
Author-X-Name-First: Fenghua
Author-X-Name-Last: Wang
Author-Name: Yexiao Xu
Author-X-Name-First: Yexiao
Author-X-Name-Last: Xu
Title: What Determines Chinese Stock Returns?
Abstract: 
 This study applied the three-factor model to A-shares in the Chinese equity market, one of the fastest growing markets ever. The sample period is July 1996 through June 2002. Size was found to explain the cross-sectional differences in returns, but contrary to findings for the U.S. market, the book-to-market ratio was not helpful. As in the U.S. experience, beta did not account for return differences among individual stocks. Because of the speculative nature of Chinese capital markets, the large proportion of government-owned shares, and the low quality of the companies' accounting information, the free float (that is, the ratio of shares in a public company that are freely available to the investing public to total company shares) was added to the study to serve as a proxy for company fundamentals. The three-factor model that included proxies for size and free float significantly increased the explanatory power of the market model—from 81 percent to 90 percent. The Chinese equity market is one of the fastest growing markets ever. Although the majority of stocks are those of small-cap companies by U.S. standards, the speed of these companies' growth is astonishing. Like many emerging markets, the Chinese markets suffer from unsatisfactory corporate governance, dubious accounting practices, market manipulation, and insider-trading problems. Not only are institutional investors lacking, but most investors trade speculatively with short holding periods.Our study concerned A-shares, which are available only to domestic investors, for nonfinancial companies. These stocks are traded on either the Shanghai Stock Exchange or the Shenzhen Stock Exchange. Because of restrictions on trading, about half of the A-shares in the study were not tradable.Indeed, the issue of nontradable shares is the paramount issue facing the Chinese stock markets. It has generated inefficiencies and problems of corporate governance.We set out to apply the Fama and French three-factor model to the Chinese market. The unique aspects of the Chinese equity market suggested, however, that alternatives to the three factors might be at work in China. In particular, investors in a speculative, emerging market may understand that book values are very inaccurate and thus it is difficult to evaluate future cash flows or growth opportunities by comparing a company's book value with its market value. Therefore, we sought a proxy that would signal a company's future success, and we argue that free float (that is, the ratio of shares in a public company that are freely available to the investing public to total company shares)serves that purpose.A large proportion of tradable shares should lead to better corporate governance by outsiders, which should lead to company growth and profitability.Using A-shares for theperiod July 1996, when price stabilization was implemented on the Chinese exchanges,through June 2002, we performed cross-sectional tests on the conventional three factors and the proposed free float factor. Then, we constructed our proxies for size (market cap or price times the number of tradable shares) and free float; we ranked all stocks in our sample by size and divided them into two groups (small size and big size). Independently of the size sorting, we also ranked stocks on the residual free float calculated from regressing free float on the log market cap of all stocks in June of each year. We divided the stocks into three groups (high, medium, and low) according to the free float sorting and formed six portfolios with equal weights from the intersection of the two size and three residual free float groups, which were then used to construct proxies—“small minus big” for size and “high residual FF minus low residual FF” for free float.In the cross-sectional study, size was found to explain the differences in returns among individual companies, but contrary to findings for the U.S. market, the book-to-market ratio was not helpful. As in the U.S. experience, beta did not account for return differences among individual stocks. Our primary finding is that free float is useful in understanding cross-sectional return differences for Chinese stocks.The time-series evidence from 25 size+float-sorted portfolios suggests that a three-factor model consisting of the market factor, size, and free float can explain 90 percent of the variation in portfolio returns, which is a 10 percentage point improvement over the result of using a simple market model.
Journal: Financial Analysts Journal
Pages: 65-77
Issue: 6
Volume: 60
Year: 2004
Month: 11
X-DOI: 10.2469/faj.v60.n6.2674
File-URL: http://hdl.handle.net/10.2469/faj.v60.n6.2674
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Author-Name: Jeffrey J. Diermeier
Author-X-Name-First: Jeffrey J.
Author-X-Name-Last: Diermeier
Title: Financial Analysts Journal: An Obligation to Lead
Abstract: 
 This piece provides information to FAJ readers from Jeffrey J. Diermeier, CFA.
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2675
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2675
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Author-Name: Thomas A. Bowman
Author-X-Name-First: Thomas A.
Author-X-Name-Last: Bowman
Title: Financial Analysts Journal: A Tradition of Public Service
Abstract: 
 This piece provides information to FAJ readers from Thomas A. Bowman, CFA.
Journal: Financial Analysts Journal
Pages: 10-11
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2676
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2676
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Whither Finance Theory?
Abstract: 
 The FAJ has played an important role in publishing some of the best thinking in the industry, positing new theories, and challenging established wisdom. “Reflections” pieces in this 60th anniversary year continue the tradition. Of several current accepted concepts that have fallen into question as a result of empirical observation, two discussed here are the capital asset pricing model and the capitalization-weighted market-clearing portfolio. 
Journal: Financial Analysts Journal
Pages: 12-14
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2677
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2677
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Author-Name: John C. Bogle
Author-X-Name-First: John C.
Author-X-Name-Last: Bogle
Title: The Mutual Fund Industry 60 Years Later: For Better or Worse?
Abstract: 
 The mutual fund industry has undergone tremendous change in the past 60 years. Total assets, number of funds, and fund costs have increased exponentially, whereas both the duration of the funds' portfolio holdings and the duration of their shareholders' holdings have tumbled. The industry's ownership of corporate stocks is at an all-time high, yet mutual fund managers have been noticeably absent from the corporate governance debate. This article details 10 fundamental changes that have taken place in the mutual fund industry since 1945 and finds that, in the aggregate, they have benefited mutual fund managers to the direct and commensurate detriment of mutual fund investors. The mutual fund industry has undergone tremendous change since 1945. Among the 10 major changes I identify and discuss are the following:The size and the number of funds available: What was a small industry (68, largely stock-oriented funds) with less than $1 billion in assets has become a giant, with assets now spread over a $7 trillion array of 8,000 stock, bond, and money market funds.Broadening of stock fund investment styles: Stock funds in 1945 were largely large-capitalization blend funds that offered broad diversification, and for the most part, they were suitable to be held as the sole component of an investor’s equity investment portfolio. Today, “style box” investing has become the name of the game. Investors are able to slice and dice their equity fund investments into any number of styles and sectors.Fund holding periods have declined dramatically: From the 1940s until the mid-1960s, equity mutual funds were long-term investors that turned their portfolios over at an annual rate of less than 20 percent. They have gradually become short-term speculators that now turn their portfolios over at an annual rate of more than 100 percent.The mutual fund industry’s ownership of Corporate America: In 1945, the mutual fund industry controlled barely more than 1 percent of all U.S. equities. Today, that figure is nearly 25 percent. The mutual fund industry has become the proverbial 800-pound gorilla. It could sit anywhere it wants at the corporate board table, but it rarely even attends the meetings.The costs of fund ownership have risen dramatically: Total mutual fund assets have increased 3,600-fold since 1945, but mutual fund fees and operating expenses have increased 6,600-fold in that same period—a stunning rise, particularly in an industry that is characterized by tremendous economies of scale.These changes in the industry raise a simple question: Have the changes benefited mutual fund investors? Extensive data confirm that they have not. The industry needs to go “back to the future” and return to its fiduciary roots.
Journal: Financial Analysts Journal
Pages: 15-24
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2678
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2678
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Author-Name: Dean LeBaron
Author-X-Name-First: Dean
Author-X-Name-Last: LeBaron
Title: Our Role in Corporate Malfeasance
Abstract: 
 Two classes of culprits contributed to the recent corporate scandals but have not been touched by the scandals or even mentioned in connection with misdoings. One group is us, the financial analysts; the other is the independent directors who are elected and paid by shareholders to represent the shareholders' interests. When we reform the performance we expect from these two groups—analysts and independent directors—we can say we are fixing the system. The numerous and large-scale corporate scandals uncovered in the past five years are not surprising; the end of a bull market has historically unearthed corporate hanky-panky. What is surprising this time is who we have selected for prosecution and who has escaped. Some corporate officers, accountants, and advisors have been brought to the bar of justice, but two types of culprits who contributed to the recent corporate scandals have not been touched by the scandals or even mentioned in connection with misdoings. One group is us, the financial analysts; the other is the independent directors who are elected and paid by shareholders to represent the shareholders’ interests. In several recent scandals, analysts were complicit in rather than preventive of corporate misbehavior. Our excuse is that “we did not know” or “we accepted the numbers.” Yet, we are supposed to ask the questions, to probe, and independently assess the job corporate managers are doing.Where was the second group—the independent directors—when malfeasance was going on under their noses? They are elected and paid by shareholders to represent shareholder interests; they have intimate access to company information. Yet, not one has been charged with not doing the job.  Both groups must be held to account. Only when we reform the performance we expect from these two groups—analysts and independent directors—can we say we are fixing the system.
Journal: Financial Analysts Journal
Pages: 25-26
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2679
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Author-Name: Charles D. Ellis
Author-X-Name-First: Charles D.
Author-X-Name-Last: Ellis
Title: Investing Success in Two Easy Lessons
Abstract: 
 Successful investing can be almost easy: Avoid harmful “accidents” and do what will achieve your own most important long-term objectives. The very human irony is that learning this lesson can take so many years that by the time we “get it,” it may be too late to use the lesson because the powers of compounding need time. Successful investing should be easy. Outcomes show that it is not. But after more than 40 years as an advisor to the leaders of major investment and securities firms, I find that two investment lessons stand out for me as particularly valuable and easy to use. Like career bookends for four decades of continuous learning about investing, one lesson came early and one came late.The late lesson came last summer while I was watching the end of a marathon being run in Munich, Germany. No matter what placement in the race each runner was achieving, each one—on entering the stadium, seeing the crowd, and hearing the scattered but friendly applause—reached high overhead with both arms in the traditional triumphal “Y” and held it for at least half a minute as, grinning in victory, they ran out the final lap. At first, I thought it strange that these runners were acting like victors when they weren’t, but then I realized that each had achieved his or her own realistic goal, so each was a true winner and fully entitled to make the big Y and run the victory lap. In investing, this lesson brings good news: Everyone can win. Everyone can be a winner. The secret is to plan your play and play your plan to win your game.The early lesson came when I was in a training program at a Wall Street firm. One day, the senior partner, Joseph K. Klingenstein, met with all the interns to discuss the Big Picture. We listened quietly—but not, I fear, conscientiously, and at the end of his talk, he asked if we had any questions. After a long silence, finally a voice spoke out: “Yeah, Mr. Klingenstein, I’ve got a question for you. You’re rich, Mr. Klingenstein. We all want to be rich too, Mr. Klingenstein. So, what can you tell us from all your experience, Mr. Klingenstein, about how to get rich like you, Mr. Klingenstein?” A long silence. At first, we feared that Joseph K. Klingenstein was angry, but to our great relief, we realized that he was silent because he was thinking. And finally, he spoke: “Don’t lose.” Indeed. Large losses are forever, and a 50 percent loss requires a double the next time up just to get even. Large losses are almost always caused by trying to get too much and taking too much risk. If you can learn to concentrate on wisely defining your own long-term objectives and learn to focus on not losing as the most important part of each specific decision, you can all be winners over the long term.
Journal: Financial Analysts Journal
Pages: 27-28
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2680
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2680
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Author-Name: Keith Ambachtsheer
Author-X-Name-First: Keith
Author-X-Name-Last: Ambachtsheer
Title: Beyond Portfolio Theory: The Next Frontier
Abstract: 
 Logically, investment theory's next frontier is to put into practice the rich set of tools that academia has bestowed on the investment community—starting with Harry Markowitz's seminal article on portfolio selection in 1952. Or is it? In fact, the next frontier lies beyond simply engineering the implementation of new investment decision tools. The time has come to integrate the powerful insights offered by information theory and principal–agent theory into a holistic, comprehensive theory of investing. Only such an expanded theory offers any material hope of improving the economic prospects of the millions of clients/beneficiaries of today's mutual funds, pension funds, endowments, and foundations. The broad consensus among finance and investment academics is that investment theory’s next frontier consists of putting into practice the rich set of tools that academia has bestowed on the investment community since 1952. Without doubt, the academic community can be proud of its intellectual achievements in proposing the concepts of modern portfolio theory and extending them to add:the consideration of multiple horizons,the use of long-term inflation-linked bonds as the natural reference point for assessing the reward and risk of alternative investment strategies,the integration of investment-related rewards and risks with other considerations, such as real property, andthe recognition that investment returns have time-variant predictive components, so strategic asset allocation must be dynamic.These four extensions of “old” portfolio theory are major advances in investment theory, but that reality does not logically make the “engineering of systems” to incorporate the extensions into practice the next frontier for investment theory.  Before we settle on what investment theory’s next frontier really is, we need to consider two additional (related) bodies of thought—information theory and principal–agent theory:Information theory addresses the question of whether economic actors (e.g., buyers and sellers of investment-related services) are in equivalent positions, from an information perspective, as they make decisions. Principal–agent theory addresses the question of whether or not the economic interests of principals (e.g., individuals) and agents making decisions on their behalf (e.g., investment managers) are aligned. The market for investment services is a classic illustration of informational asymmetry—with sellers having much information and buyers having little. The acute informational asymmetry of the financial services market leads logically to principal–agent considerations. In a world where the clients/beneficiaries of various financial service organizations (e.g., pension funds, mutual funds, endowment funds) are millions of remote, faceless individuals, will the boards and managers of the organizations and those they hire serve the interests of the beneficiaries, or will they use their power to serve their own interests?Because of these characteristics of today’s investment world, we need more than simply the reengineering of investment decision systems. We must integrate into our new models the profound issues raised by (1) information asymmetry and (2) the fact that millions of ultimate beneficiaries at the bottom of the financial food chain depend on a mosaic of intermediary (agent) organizations to provide products and services that truly serve the beneficiaries’ interests.This article explores what investment theory would look like if it integrated old portfolio theory not only with the post-1952 technical offerings of academia but also with the economic concepts of asymmetrical information and misalignment of economic interests—that is, integrative investment theory. It would recognize that Client/beneficiary value creation = f(A, G, R, IB, FE);that is, client/beneficiary value creation is a function of the successful integration of five value drivers: A = agency issues,G = governance,R = risk issues, IB = investment beliefs, and FE = financial engineering.  Despite evolutionary fits and starts over the past five decades, integrative investment theory is inevitable. Why? Because its broad adoption will produce better financial outcomes for millions of “ordinary” people. They will not be denied.
Journal: Financial Analysts Journal
Pages: 29-33
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2681
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2681
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# input file: UFAJ_A_12047557_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: John Y. Campbell
Author-X-Name-First: John Y.
Author-X-Name-Last: Campbell
Author-Name: Luis M. Viceira
Author-X-Name-First: Luis M.
Author-X-Name-Last: Viceira
Title: The Term Structure of the Risk–Return Trade-Off
Abstract: 
 Expected excess returns on bonds and stocks, real interest rates, and risk shift over time in predictable ways. Furthermore, these shifts tend to persist for long periods. Changes in investment opportunities can alter the risk–return trade-off of bonds, stocks, and cash across investment horizons, thus creating a “term structure” of the risk–return trade-off. This term structure can be extracted from a parsimonious model of return dynamics, as is illustrated with data from the U.S. stock and bond markets. Recent research in empirical finance has documented that expected excess returns on bonds and stocks, real interest rates, and risk shift over time in predictable ways. Furthermore, these shifts tend to persist over long periods of time. One important implication of time variation in expected returns is that investors, particularly aggressive investors, may want to engage in market-timing (or tactical asset allocation), based on the predictions of their return forecasting model, in order to maximize short-term return. There is considerable uncertainty, however, about the degree of asset return predictability, which makes it hard to identify the optimal market-timing strategy. A second, less obvious implication of asset return predictability is that risk—defined as the conditional variances and covariances per period of asset returns—may be significantly different for different investment horizons, thus creating a “term structure of the risk–return trade-off.” This article characterizes this trade-off and explores its implications for the asset allocation decisions of long-horizon investors.We present an empirical model that captures the complex dynamics of expected returns and risk but is simple to apply. Specifically, we model interest rates and returns as a vector autoregressive (VAR) model. We show how to extract the term structure of risk using this parsimonious model of return dynamics, and we illustrate our approach with the use of quarterly data from the U.S. stock, T-bond, and T-bill markets for the period since World War II. In our empirical application, we use variables that have been identified as return predictors by past empirical research, such as the short-term interest rate, the dividend–price ratio, and the yield spread between long-term and short-term bonds. These variables enable us to capture horizon effects on stock market risk, inflation risk, and real interest rate risk.Among our findings are the following: Mean reversion in stock returns decreases the volatility per period of real stock returns at long horizons, whereas reinvestment risk increases the volatility per period of real T-bill returns. Inflation risk increases the volatility per period of the real return on long-term nominal bonds held to maturity. Stocks and bonds exhibit relatively low positive correlation at both ends of the term structure of risk, but they are highly positively correlated at intermediate investment horizons. Inflation is negatively correlated with the real returns on bonds and stocks at short horizons but positively correlated at long horizons.These patterns have important implications for the efficient mean–variance frontiers that investors face at different horizons and suggest that asset allocation recommendations based on short-term risk and return may not be adequate for long-horizon investors. For example, the composition of the global minimum variance (GMV) portfolio changes dramatically for different horizons. We calculated the GMV portfolio when predictor variables are at their unconditional means—that is, when market conditions are average—and found that at short horizons, the GMV portfolio consists almost exclusively of T-bills but at long horizons, reinvestment risk makes T-bills risky. Thus, long-term investors can achieve lower risk with a portfolio that consists predominantly of long-term bonds and stocks.We also found that the composition of the tangency portfolio of bonds and stocks (calculated under the counterfactual assumption that a riskless long-term asset exists with a return equal to the average T-bill return) becomes increasingly biased toward stocks as the horizon increases. The reason is the increasing positive correlation between stocks and bonds at intermediate investment horizons and the decrease of the volatility per period of stock returns at long horizons.To concentrate on horizon effects, we bypass several other considerations that may be important in practice—for example, changes in volatility through time—and, ignoring the possibility that investors care about other properties of the return distribution, we consider only the first two moments of returns. In addition, our results depend on the particular model of asset returns that we estimated. We treated the parameters of our VAR(1) model as known, whereas these parameters are highly uncertain, and investors should take this uncertainty into account in their portfolio decisions. Fortunately, our main conclusions hold up well when the model is estimated over subsamples or is extended to allow higher-order lags.The technical details of this study are provided in “Long-Horizon Mean–Variance Analysis: User Guide,” which is available in the supplemental material.
Journal: Financial Analysts Journal
Pages: 34-44
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2682
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2682
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# input file: UFAJ_A_12047558_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ser-Huang Poon
Author-X-Name-First: Ser-Huang
Author-X-Name-Last: Poon
Author-Name: Clive Granger
Author-X-Name-First: Clive
Author-X-Name-Last: Granger
Title: Practical Issues in Forecasting Volatility
Abstract: 
 A comparison is presented of 93 studies that conducted tests of volatility-forecasting methods on a wide range of financial asset returns. The survey found that option-implied volatility provides more accurate forecasts than time-series models. Among the time-series models, no model is a clear winner, although a possible ranking is as follows: historical volatility, generalized autoregressive conditional heteroscedasticity, and stochastic volatility. The survey produced some practical suggestions for volatility forecasting. Volatility forecasting plays an important role in investment, option pricing, and risk management. In this article, we summarize our review of 93 papers devoted to comparing the forecasting power of various volatility models reported in the past 20 years. The definition of volatility is taken to be standard deviation of returns. The assets studied in these 93 papers included stock indexes, stocks, exchange rates, and interest rates from both developed and emerging financial markets. The forecast horizon ranged from one hour to one year (with a few exceptions that extended the forecast horizon to 30 months and to five years). The review covers three main categories of time-series model—historical volatility, autoregressive conditional heteroscedasticity (ARCH), and stochastic volatility (SV)—and the method of deriving implied volatility from option prices. We introduce the four models, discuss some characteristics of financial market volatility, and describe the common objectives of volatility forecasting that have a direct impact on choice of volatility model and the criteria for evaluating forecasts. Using recent research, we provide some insights into the effect of outliers, make some suggestions as to how they might be handled, and provide some practical advice for volatility forecasters. We also offer a broad-based ranking of the four volatility-forecasting models.Financial market volatility is clearly forecastable. Research has shown that the forecasting power for stock index volatility is 50–58 percent for horizons of 1 to 20 trading days. The one-day-ahead forecasting record for exchange rates is 10–15 percent, and it is likely to increase by about threefold if ex post volatility is measured more accurately. The one-week-ahead and one-month-ahead records for short-term interest rates have been documented as, respectively, 8 percent and 24 percent.  Based on the forecasting results reported in the studied papers, option-implied volatility dominates time-series models because the market option price fully incorporates current information and future volatility expectations. Between historical volatility and ARCH models, we found no clear winner, but they are both better than the stochastic volatility model. Despite the added flexibility and complexity of the SV model, we found no clear evidence that it provides superior volatility forecasts. Also, high-frequency data clearly provide more information and produce better volatility forecasts, particularly over short horizons. The conclusion that option-implied volatility forecasting provides the best forecast does not violate market efficiency because accurate volatility forecasting is not in conflict with underlying asset and option prices being correct. Options are not available for all assets, so using historical volatility must be considered. These models are not necessarily less sophisticated than ARCH models. For example, the realized-volatility model is classified as a historical volatility model. The important aspects of using historical models are (1) that actual volatility must be measured accurately and (2) that when high-frequency data are available, such information improves volatility estimation and forecasts.
Journal: Financial Analysts Journal
Pages: 45-56
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2683
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2683
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:1:p:45-56




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# input file: UFAJ_A_12047559_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bradford Cornell
Author-X-Name-First: Bradford
Author-X-Name-Last: Cornell
Author-Name: Richard Roll
Author-X-Name-First: Richard
Author-X-Name-Last: Roll
Title: A Delegated-Agent Asset-Pricing Model
Abstract: 
 Asset-pricing theory has traditionally made predictions about risk and return but has been silent on the actual process of investment. Today, most investors delegate major investment decisions to financial professionals. This suggests that the instructions given by investors to their delegated agents and the compensation of those agents might be important determinants of capital market equilibrium. In the extreme, when all investment decisions are delegated, the preferences and beliefs of individuals would be completely superseded by the objective functions of agent/managers. A provocative illustration of the difference between direct and delegated investing is provided based on active asset management relative to a benchmark index, a common objective function in practice. With the growing preponderance of delegated investing, future asset-pricing theory will not only have to describe risk and return but, to be complete, must also be able to explain the observed objective functions used by professional managers. Asset-pricing theory has traditionally made predictions about risk and return but has been silent on the actual process of investment. Many investors today delegate major investment decisions to professionals—investment managers or financial advisors. Thus, the instructions given by investors to their delegated agents and the compensation of those agents may be important determinants of capital market equilibrium. In the extreme case of all investment decisions being delegated, the preferences and beliefs of individuals would be completely superseded by the objective functions of agent/managers.In specifying an objective function for the agent, there is always a trade-off between (1) a complete reflection of the principal’s desires and (2) enough clarity and transparency that the principal’s objectives can be codified, monitored, and enforced at reasonable cost. To the extent that delegated agents are the predominant investors, it is their objective functions, not investor utility functions, that determine relative asset prices. In other words, the actual portfolios managed by investment professionals on behalf of their clients may differ in fundamental respects from the investment portfolios clients might have selected on their own.In the case of investment management, the objective functions can be empirically observed. To illustrate, we consider a hypothetical capital market where all investors partition their resources between active and passive managers. Passive managers run index funds. Active managers are compared with those passive benchmark indexes; their compensation depends on average excess return performance and (negatively) on the volatility of tracking error. This compensation arrangement is a common objective function in practice but has no grounding in traditional theory. Investors give half their funds to passive managers to manage because the investors are uncertain about the value added by active managers.Active managers respond to their compensation incentives by selecting portfolios that they believe will have higher average returns than their benchmarks but are also highly correlated with their benchmarks (to control tracking error). Usually, such portfolios will not be optimal in the mean–variance sense. Indeed, active managers are aware that other portfolios have higher expected returns and/or lower volatility than the portfolios they select, but they eschew such choices because of the tracking-error risk. Such suboptimal choices are the direct result of delegated investing and the concomitant divergence between manager objective functions and investor utility functions.The resulting capital market equilibrium differs materially from the standard mean–variance capital asset pricing model, even though investors acting alone would have produced the CAPM equilibrium. Delegated investing adds an extra term to the cross-sectional relationship between risk and return. In addition to the familiar beta, the return–risk trade-off depends on the fraction of all funds invested with active managers and the compensation schedules of those managers. Moreover, one of the central implications of the standard CAPM, that the market portfolio of all assets is mean–variance efficient, is no longer true when professional managers are dominant. The market portfolio’s composition is also influenced by agent/manager compensation schedules.With the growing preponderance of delegated investing, asset-pricing theory of the future will not only have to describe risk and return but also, to be complete, explain the observed objective functions and the compensation contracts of professional investment managers.
Journal: Financial Analysts Journal
Pages: 57-69
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2684
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2684
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:1:p:57-69




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# input file: UFAJ_A_12047560_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: C. Mitchell Conover
Author-X-Name-First: C. Mitchell
Author-X-Name-Last: Conover
Author-Name: Gerald R. Jensen
Author-X-Name-First: Gerald R.
Author-X-Name-Last: Jensen
Author-Name: Robert R. Johnson
Author-X-Name-First: Robert R.
Author-X-Name-Last: Johnson
Author-Name: Jeffrey M. Mercer
Author-X-Name-First: Jeffrey M.
Author-X-Name-Last: Mercer
Title: Is Fed Policy Still Relevant for Investors?
Abstract: 
 Thirty-eight years of U.S. data indicate that U.S. monetary policy continues to have a strong relationship with security returns. U.S. stock returns are consistently higher and less volatile when the Federal Reserve is following an expansive monetary policy. Furthermore, the monetary policy–related return patterns of companies considered to be most sensitive to changes in monetary conditions are much more pronounced than average patterns. Finally, the influence of U.S. monetary policy is global; international indexes have return patterns similar to those for the U.S. market. Overall, the evidence suggests that investment professionals should continue to consider monetary conditions when performing fundamental analysis of U.S. and international securities. Numerous studies have documented the relationship between monetary policy and security returns, but the relevance of monetary conditions in investment analysis is still debated. In particular, questions have been raised about the continued importance of U.S. monetary policy in recent periods.  To study this issue, we analyzed stock returns following changes in the U.S. Federal Reserve’s monetary policy in 21 separate monetary policy environments that occurred from the middle of July 1963 to early 2001. We considered U.S. stocks in general, U.S. stocks grouped according to size and along the value–growth dimension, U.S. stocks by industrial sector, and international stocks.  We identified a change in Fed monetary policy as a directional change in the Fed discount rate. We used daily returns (rather than monthly returns) to provide an accurate assessment of returns. To the cross-sectional study, we added an exploration of the time-series consistency of all the relationships.Our findings support the following claims: First, monetary conditions have had and continue to have a strong relationship with security returns. In particular, periods of expansive monetary policy are associated with strong stock performance (higher-than-average returns and lower-than-average risk), whereas periods of restrictive monetary policy generally coincide with weak stock performance (lower-than-average returns and higher-than-average risk). Second, a highly consistent relationship between monetary conditions and stock returns is evident over time. Although initial analysis suggests the relationship has diminished, a more thorough investigation indicates that a single monetary period that occurred in the mid-1990s is largely responsible for this conclusion. Third, small-cap companies are more sensitive than large-cap companies to changes in monetary conditions. Portfolios of small-cap stocks have economically and statistically significant monetary policy–related return patterns that are consistent over time. Fourth, cyclical stocks have a much higher sensitivity to changes in monetary conditions than defensive stocks. For example, stocks in the cyclical consumer goods, cyclical financial services, and information technology sectors had expansive-period returns that were more than 26 percentage points a year higher than the returns they earned during restrictive periods. Finally, U.S. monetary policy has an important influence on global markets. We found significant return patterns related to U.S. monetary policy for five international stock indexes. This evidence is consistent with the prominent role U.S. economic conditions play in the prospects of foreign companies.Overall, our evidence strongly suggests that practitioners should devote considerable attention to monetary conditions as part of a thorough economic analysis. Furthermore, because sensitivity to changes in monetary conditions deviates considerably among sectors, a rigorous industry analysis is also essential. Finally, investment professionals who are attempting a sector or industry rotation strategy should carefully monitor changes in Fed monetary policy.
Journal: Financial Analysts Journal
Pages: 70-79
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2685
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2685
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# input file: UFAJ_A_12047561_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Equity Markets in Action: The Fundamentals of Liquidity, Market Structure & Trading (a review)
Abstract: 
 A good candidate for required reading for aspiring traders and equity money managers, this book examines the means by which investment ideas are put into action—market structure, the trading process, costs, and the mechanics of price movements, both in the United States and in Europe. 
Journal: Financial Analysts Journal
Pages: 80-81
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2686
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2686
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# input file: UFAJ_A_12047562_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ronald L. Moy
Author-X-Name-First: Ronald L.
Author-X-Name-Last: Moy
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Financial Dynamics: A System for Valuing Technology Companies (a review)
Abstract: 
 A close reading of this book should enable the diligent analyst to view the valuing of technology companies from a fresh perspective, with a systematic, out-of-the-box approach to analysis and valuation. 
Journal: Financial Analysts Journal
Pages: 81-82
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2687
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2687
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# input file: UFAJ_A_12047563_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Hedge Fund Risk Fundamentals (a review)
Abstract: 
 Although this book may have been intended largely to be a marketing tool for the author's risk measurement model, it contains an abundance of helpful information, clearly explains the intricacies and risk dynamics that fund investors face, and provides a framework for measuring and evaluating the risks associated with hedge fund strategies. 
Journal: Financial Analysts Journal
Pages: 82-83
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2688
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2688
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# input file: UFAJ_A_12047564_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Emanuel Derman
Author-X-Name-First: Emanuel
Author-X-Name-Last: Derman
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Principles of Financial Engineering (a review)
Abstract: 
 This readable, wide-ranging, practical, and wise book introduces the entire field of financial engineering and covers it in a compulsively consistent fashion. 
Journal: Financial Analysts Journal
Pages: 84-85
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2689
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2689
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# input file: UFAJ_A_12047565_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: My Life as a Quant: Reflections on Physics and Finance (a review)
Abstract: 
 This invaluable first-hand account of the quantitative revolution in finance since the 1980s recaps the main intellectual challenges successively tackled by the quants—exotic options and the option volatility “smile.” 
Journal: Financial Analysts Journal
Pages: 85-85
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2690
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2690
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# input file: UFAJ_A_12047566_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In The Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issues.
Journal: Financial Analysts Journal
Pages: 88-88
Issue: 1
Volume: 61
Year: 2005
Month: 1
X-DOI: 10.2469/faj.v61.n1.2691
File-URL: http://hdl.handle.net/10.2469/faj.v61.n1.2691
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# input file: UFAJ_A_12047567_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In The Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issues.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2136
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2136
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# input file: UFAJ_A_12047568_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Irving Kahn
Author-X-Name-First: Irving
Author-X-Name-Last: Kahn
Title: Early Days at the Financial Analysts Journal
Abstract: 
 This piece provides information to FAJ readers from Irving Kahn, CFA.
Journal: Financial Analysts Journal
Pages: 6-7
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2705
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2705
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: What Cost “Noise”?
Abstract: 
 We have no way of knowing “true fair value” for any asset because we cannot see all future cash flows. But few would dispute that market prices differ wildly from the ultimate true fair value. The implications for capitalization-weighted indexes are profound. If market capitalization is equal to true fair value, plus or minus a large error term, then the largest-cap stocks will predominantly be those with a large true fair value and a positive error term. History supports this view: The largest-cap stocks underperform the average stock with some regularity—and by a startlingly large margin. 
Journal: Financial Analysts Journal
Pages: 10-14
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2706
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2706
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Author-Name: Larry J. Johnson
Author-X-Name-First: Larry J.
Author-X-Name-Last: Johnson
Title: “How to Value Employee Stock Options”: A Comment
Abstract: 
 This material comments on “How to Value Employee Stock Options”.
Journal: Financial Analysts Journal
Pages: 16-16
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2707
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2707
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Author-Name: John Hull
Author-X-Name-First: John
Author-X-Name-Last: Hull
Author-Name: Alan White
Author-X-Name-First: Alan
Author-X-Name-Last: White
Title: “How to Value Employee Stock Options”: Authors' Response
Abstract: 
 This material comments on “How to Value Employee Stock Options”.
Journal: Financial Analysts Journal
Pages: 17-17
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2708
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2708
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:2:p:17-17




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# input file: UFAJ_A_12047573_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: “Sustainable Spending in a Lower-Return World”: Author's Response
Abstract: 
 This material comments on “Sustainable Spending in a Lower-Return World”.
Journal: Financial Analysts Journal
Pages: 18-18
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2710
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2710
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:2:p:18-18




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# input file: UFAJ_A_12047574_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Paul McCulley
Author-X-Name-First: Paul
Author-X-Name-Last: McCulley
Title: History Lessons for 21st Century Investment Managers
Abstract: 
 The United States can be thought of as a strained marriage of democracy and capitalism, with the two often at odds with each other. Interestingly, history has shown that inflection points occur when there is a shift in dominance between democracy and capitalism within our economy. And although managers should not assume that history will repeat itself in exactly the same fashion, they would be wise to use history as a guide in interpreting the secular changes presently occurring within the U.S. economy. The United States can be thought of as a strained marriage of democracy and capitalism, with the two often at odds with each other. Democracy is founded on the principle of “one person, one vote,” which assures that each person (theoretically) has equal influence in the system. Capitalism is founded on the principle of “one dollar, one vote,” which is known as a “cumulative voting system.” Secular changes (or points of inflection) occur when the weights of these two factors in our economy shift. This article describes some recent macroeconomic inflection points as the weights tilted toward government in the 1960s and 1970s, moved back toward capitalism in the 1980s and 1990s, and moved back again toward the public sector as we entered the 21st century. The article also describes what sort of investment management makes sense as the balance of power shifts between democracy and capitalism.The 1960s and 1970s constituted an inflationary period—a bull market in government and a bear market in capitalism. This period ended because the bull market in government eventually created “stagflation,” following which, the electorate decided to shift the weight toward a market-based economy. Strong returns from financial assets in the 1980s and 1990s arose from a bull market in capitalism and falling inflation.Now, the United States is at another inflection point, with the power of government again on the rise. If history is any guide, an expanded role for government means that over the secular horizon, inflation will rise. More inflation holds many implications for investment portfolios. If investment managers take seriously their fiduciary mandate, they will need to realign their portfolios to a mix of public- and private-sector investments that matches the macroeconomic environment. The following are some important recommendations:Overweight tangible assets and TIPS in relation to nominal financial assets. If we are indeed entering a bull market in government and a period of secularly rising inflation, a successful portfolio will need more tangible assets. It will also need Treasury Inflation-Indexed Securities (originally “Treasury Inflation-Protected Securities,” commonly called “TIPS”), which did not even exist in the 1980s. TIPS are T-bonds whose principal value is adjusted to reflect actual inflation, a feature that makes them compare favorably with nominal bonds, whose yields reflect only the market's estimate of inflation. Although TIPS performed well in the past several years as real yields fell, they still offer relatively cheap insurance against inflation. TIPS valuations are supported by the fact that real rates have been lower during reflationary, government-oriented periods than during disinflationary, private sector-dominated times.Balance stocks and bonds. Unfortunately, both stocks and bonds are going to offer lousy returns in the years ahead because rising inflation is both a damper on P/E multiples and a corrosive for total returns on bonds. Stocks and bonds had their glorious two-decade run, but now they face a headwind. If I were forced to choose, I would overweight bonds in relation to stocks, partly because I consider stocks to be a call option on capitalism. And if capitalism checks into the Betty Ford Center for balance sheet rehabilitation, the call option is not worth much.Overweight value in relation to growth. The coming environment is not one in which growth stocks will perform well. They were strong performers in the late 1990s, but that rally was about the nation reembracing the U.S. enterprise as a going concern. Now, we must think in terms of normalized relative valuations and performance, which means a bias toward value.Overweight private-sector obligations. A bull market in government is actually a bull market in credit quality. Current valuations are rich in the corporate bond market, but secularly speaking, investors should shift from government debt to private debt.Overweight nondollar assets in relation to the dollar. In the United States, rising inflation and a more government-controlled economy will weigh heavily on the dollar's value over the secular horizon. What is more, the sheer size of the U.S. current account deficit—an inevitable consequence of “successful” reflation—implies a surplus of dollars globally relative to private global demand.
Journal: Financial Analysts Journal
Pages: 19-24
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2711
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2711
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:2:p:19-24




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# input file: UFAJ_A_12047575_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Peter L. Bernstein
Author-X-Name-First: Peter L.
Author-X-Name-Last: Bernstein
Title: Dividends and the Frozen Orange Juice Syndrome
Abstract: 
 The bonanza of a 15 percent top-bracket federal income tax on dividends has had little impact on values in the stock market or on management decisions about dividend payout ratios. The question is why. Dividends matter, yet investors have forgotten how to think about such factors. This article explains the phenomenon in the form of “the frozen orange juice syndrome” and describes through four chapters of history how the situation arose. Why has the bonanza of a 15 percent top-bracket federal income tax on dividends had so little impact on values in the stock market or on management decisions about dividend payout ratios? At 15 percent, this tax rate on dividends means that the after-tax income in your pocket from dividends is now worth as much as the after-tax dollars in your pocket from capital gains. This radical change should have ignited a big shift in investor preferences.Why has the response been minimal? To answer this question, I first make the positive case for dividends and then take a trip through history.Dividends matter, first, because earnings data, thus also P/E multiples, are inherently inaccurate—in many cases, purposely inaccurate. Dividends matter, second, because capital gains do not pay your bills. You must have cash to pay your bills. Therefore, for a rational investor, investments that never yield cash are extremely risky. Third, retaining earnings or buying back stock does not magically equal growth. Reliance on companies to use the cash to raise the price of their stock is reliance on the “greater fool" theory of investing. Companies cannot use cash to make the market raise their stock prices; no one can make the market do anything. Finally, the notion that growth companies need or use the money to continue growing and thus cannot afford to pay dividends is not true. For example, in the years before 1990, S&P 500 Index companies as a whole paid out dividends and still recorded high earnings growth rates. The payout ratio exceeded 50 percent in every year of the 1960s, the decade when growth became the dominant theme in equity investing.Yet, investors have forgotten how to think about these matters. I offer the unorthodox explanation of this phenomenon in the form of “the frozen orange juice syndrome." A generation that grows up drinking only frozen orange juice will forget that any other form of orange juice exists. Low payouts and low yields are frozen orange juice.I describe how this situation came about through four chapters of history: (1) From 1871 to the end of the 1950s, investors set dividend yields in a range of 4–6 percent. Payouts were in the 50 percent area. (2) For at least three decades after the market crash of 1929, veterans of that event dominated Wall Street. Most investors were still the wealthy individuals, and they lived off their incomes, not their capital. Institutional investing was in its infancy. (3) A paradigm shift occurred in the early 1960s with the rise of institutional investors, to whom dividends are not important. The miracle of compounding was forgotten; growth was what mattered. (4) By the technology bubble of the 1990s, the new market participants knew little about hard times and had no memory at all of the days when dividends mattered. The bursting of the bubble in 2000–2002 changed perceptions about the credibility of earnings announcements, but because nobody remembered much about dividends, dividends remained in the shadows. The new individual investors were not living off their incomes; moreover, none of the innovations in financial instruments of the 1990s—such as hedge funds—were focusing on income. Today, except in the area of high-yield bonds, income plays no role in portfolio strategy or in the formulation of investment objectives. All have forgotten any form of orange juice but frozen.Maybe one day soon, however, word will reach market participants that dividends have been enriched by an income tax of only 15 percent. If so, they will launch a new generation of investors who, at last, will disdain frozen orange juice.
Journal: Financial Analysts Journal
Pages: 25-30
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2712
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2712
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:2:p:25-30




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# input file: UFAJ_A_12047576_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: Normal Investors, Then and Now
Abstract: 
 Investors were “normal” in 1945 when the first issue of the Financial Analysts Journal was published, and they remain normal today, 60 years later. But in between was a long period, starting in the late 1950s, when investors were described as “rational.” The portrait of investors as rational is the first foundation block of standard finance. Other foundation blocks are market efficiency, mean–variance portfolio theory, and the capital asset pricing model. This article provides descriptions of normal investors as they were portrayed in the FAJ and other finance journals before standard finance was introduced and as they have emerged recently in behavioral finance. Investors were “normal” in 1945 when the first issue of the Financial Analysts Journal was published, and they remain normal today, 60 years later. But in between was a long period, starting in the late 1950s, when investors were described as “rational.”The portrayal of investors as rational is the first foundation block of standard finance. Other foundation blocks are market efficiency, mean–variance portfolio theory, and the capital asset pricing model (CAPM). In this article, I describe normal investors as they were portrayed in the FAJ and other finance journals before standard finance was introduced and as they have emerged recently in behavioral finance.Behavioral finance offers a replacement block for each block of standard finance. In behavioral finance, investors are described as normal, subject to cognitive biases and emotions. In behavioral finance, markets are not efficient in that price deviates from fundamental value, so behavioral capital asset pricing theory accounts for factors beyond fundamental value, such as sentiment. In behavioral finance, investors construct portfolios as layered pyramids, bonds in a low layer and stocks in a high one, by the rules of behavioral portfolio theory.In 1957, before the introduction of standard finance, the author of an FAJ article was trying to teach normal investors “how to take a loss and like it.” He noted that realizing losses increases wealth by reducing taxes. But he also noted that, human nature being what it is, normal investors are reluctant to realize losses. We tend to hang on in the hope that one day we will look at the asset and find it has not only recovered its value but risen. In contrast, the rational investors of standard finance realize their losses quickly and can hardly understand why any investor would procrastinate.The observed reluctance of normal investors to realize losses was reintroduced by early researchers in behavioral finance in the 1980s as the “disposition effect”—the disposition to sell winners too early and ride losers too long. In a behavioral framework, investors—normal investors—are affected by cognitive biases and emotions, consider their stocks one by one in mental accounts distinct from their overall portfolios, and distinguish paper losses from realized losses.Much of finance has changed since the FAJ was founded in 1945, but the drive to uncover facts and make sense of them remains. The facts of investor behavior indicate that investors are not the rational investors of standard finance. They are the normal investors of behavioral finance.
Journal: Financial Analysts Journal
Pages: 31-37
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2713
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2713
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:2:p:31-37




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Author-Name: Aswath Damodaran
Author-X-Name-First: Aswath
Author-X-Name-Last: Damodaran
Title: Value and Risk: Beyond Betas
Abstract: 
 Risk can be both a threat to a company’s financial health and an opportunity to get ahead of the competition. Most analysts, when referring to risk management, focus on the threat and emphasize protecting against that threat (i.e., risk hedging). The risk associated with an investment is generally reflected in the discount rate used in conventional discounted cash flow models, and because analysts also assume that only market risk affects discount rates, the firms that spend time and resources on hedging company-specific risk may well lose value. But risk management can increase firm value—by altering investment policy and creating competitive advantages, which can have consequences for expected growth rates and excess returns. Risk can be both a threat to a company's financial health and an opportunity to get ahead of the competition. Most analysts, when they refer to risk management, focus on the threat posed by risk and emphasize protecting against that threat (i.e., risk hedging). In keeping with this narrow definition, the risk associated with an investment is almost always reflected in the discount rate used in conventional discounted cash flow models.The article begins with analyzing the classic methods for judging the riskiness of a firm—discounted cash flow analysis and relative comparisons. Many corporate executives believe that conventional valuation models take too narrow a view of risk, however, so I then turn to ways in which the discussion of risk in valuation can be expanded—simulations, considering the specific effects of risk hedging and risk management on the inputs to DCF models and on whether the markets price riskiness in the relative firm valuation, and option-pricing models.Firms that expend time and resources on hedging firm-specific risk will lose value to the extent that this part of risk management is expensive. In contrast, risk management can increase firm value. Risk management affects expected cash flows by altering investment policy and creating competitive advantages, which in turn, can have consequences for expected growth rates and excess returns.Risk reduction is only a part of risk management. Risk management has to be defined far more broadly to include actions that are taken by firms to exploit uncertainty. While risk hedging is product based and financial (involving the use of options, futures, and insurance products), risk management is strategic.
Journal: Financial Analysts Journal
Pages: 38-43
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2714
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2714
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# input file: UFAJ_A_12047578_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Marcelle Arak
Author-X-Name-First: Marcelle
Author-X-Name-Last: Arak
Author-Name: L. Ann Martin
Author-X-Name-First: L. Ann
Author-X-Name-Last: Martin
Title: Convertible Bonds: How Much Equity, How Much Debt?
Abstract: 
 Financial analysts need accurate estimates of debt, equity, leverage, and EPS. The method proposed here, based on the probability of conversion, yields new estimates of the debt and equity in a convertible bond issue. When this method is used, the value of the equity component in a hypothetical issue is found to be substantial—larger than the value of the options and clearly larger than zero, which is assigned under current accounting rules. The estimate of the debt component is smaller than recorded under current accounting rules. Thus, the leverage of convertible bond issuers is substantially lower when this method is used. Convertible bonds, which can be converted into shares of the issuer's stock, have some probability of remaining bonds and some probability of being converted into stock. Although, on the face of it, these bonds seem to be part debt and part equity, under current accounting rules, convertibles are counted entirely as debt until converted or paid off.We discuss a new approach for determining the debt and equity portions of a convertible bond that is consistent with modern finance theory and grounded in economic reality. In this approach, we view convertible bonds as part equity, part debt, with the proportions depending on the probability of conversion, and show how that treatment affects the analyst's picture of the company's financial structure.Using a typical convertible bond structure, we illustrate our method of estimating the embedded equity and contrast the results with those found by following current accounting guidance and those based on the straight bond/option decomposition. Our measure of the equity component of the convertible bond is substantial—larger than the value of the embedded stock options and also larger than zero, which is the amount of equity assigned to a convertible issue under current accounting rules. The debt component, measured by our method, is much smaller than the total value of the convertible and also much smaller than the value of the straight bond (the value of the convertible bond minus the options). As a consequence, the leverage calculated with our method is substantially lower than that based on the two other methods.Over time, of course, the probability of conversion changes, and so do the debt, equity, and leverage of the issuer derived from our approach.The probability of conversion can also be applied to estimate dilution. According to our method, the shares attached to the convertible issue during the bond's life are many fewer than the total potential shares, the measure used under current accounting rules to calculate EPS. Consequently, EPS is higher under our method until the bond is converted.Financial analysts need estimates of leverage and EPS that reflect economic reality. As we show, the difference between the numbers derived from our method and the numbers resulting from the current accounting rules is too large to ignore. The current accounting rules create a distorted, highly negative view of the capital structure and EPS of convertible bond issuers at the time of issue. Unless the accounting profession embarks on a dramatic rethinking of equity embedded in convertible issues, financial analysts will need to do their own calculations; we provide a method for doing so.
Journal: Financial Analysts Journal
Pages: 44-50
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2715
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2715
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# input file: UFAJ_A_12047579_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jeroen Derwall
Author-X-Name-First: Jeroen
Author-X-Name-Last: Derwall
Author-Name: Nadja Guenster
Author-X-Name-First: Nadja
Author-X-Name-Last: Guenster
Author-Name: Rob Bauer
Author-X-Name-First: Rob
Author-X-Name-Last: Bauer
Author-Name: Kees Koedijk
Author-X-Name-First: Kees
Author-X-Name-Last: Koedijk
Title: The Eco-Efficiency Premium Puzzle
Abstract: 
 Does socially responsible investing (SRI) lead to inferior or superior portfolio performance? This study focused on the concept of “eco-efficiency,” which can be thought of as the economic value a company creates relative to the waste it generates, and found that SRI produced superior performance. Based on Innovest Strategic Value Advisors' corporate eco-efficiency scores, the study constructed and evaluated two equity portfolios that differed in eco-efficiency. The high-ranked portfolio provided substantially higher average returns than its low-ranked counterpart over the 1995–2003 period. This performance differential could not be explained by differences in market sensitivity, investment style, or industry-specific factors. Moreover, the results remained significant for all levels of transaction costs, suggesting that the incremental benefits of SRI can be substantial. In recent decades, a large number of investors have embraced the concept of socially responsible investing (SRI). Currently, nearly 12 percent of assets under management are invested according to ethical criteria. Despite the increasing popularity of SRI, however, debate continues over whether adding an ethical dimension to the stock selection process adds value.Our study focused on a concept called “eco-efficiency,” which can be thought of as the economic value a company produces relative to the waste it generates. Using corporate eco-efficiency scores from Innovest Strategic Value Advisors, we evaluated self-composed equity SRI portfolios. Focusing exclusively on the environmental element of social responsibility, we investigated whether a long-run premium or penalty exists for holding environmentally responsible companies.In the first part of the research, we constructed two mutually exclusive portfolios with distinctive eco-efficiency scores. We applied performance attribution models to test whether any performance differential between the portfolios was significant and attributable to the environmental component. This method allowed us to examine the long-term benefits of including environmental criteria in the investment process. We demonstrate that a stock portfolio composed of U.S. companies with high eco-efficiency scores sizably outperformed stocks with low scores over the 1995–2003 period. Using single-factor and multifactor attribution models, we also show that this performance differential cannot be explained by differences in market risk, investment style, or industry exposure.Obtaining evidence by adjusting returns after the fact may not be very useful, however, from an investor's perspective. Therefore, we also outline the economic implications of our findings by demonstrating how one can construct an environmentally responsible investment portfolio under practical conditions. For this part of the study, we constructed industry-balanced SRI portfolios based on “best-in-class” analysis, in which all stocks were allocated into specific industries and, subsequently, ranked relative to their industry peers. Stocks with high (low) eco-efficiency scores were allocated into the best-in-class (worst-in-class) portfolio. In the absence of transaction costs, the best-in-class portfolio outperformed the worst-in-class portfolio by approximately 6 percentage points on a risk- and style-adjusted basis. Even in the presence of transaction costs, the differential return between the portfolios remained large.Our evidence suggests that the incremental benefits of SRI can be substantial. Our results are puzzling because it is difficult to reconcile the observed performance differential with the well-established return–risk paradigm. The fact that common risk factors fail to account fully for the observed results raises the possibility of a mispricing story.
Journal: Financial Analysts Journal
Pages: 51-63
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2716
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2716
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# input file: UFAJ_A_12047580_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Alan Scowcroft
Author-X-Name-First: Alan
Author-X-Name-Last: Scowcroft
Author-Name: James Sefton
Author-X-Name-First: James
Author-X-Name-Last: Sefton
Title: Understanding Momentum
Abstract: 
 The extensive literature on price momentum effects is a potential source of confusion for portfolio managers because conflicting explanations give rise to different implications for portfolio strategy. Analysis of the value-weighted large-capitalization universe represented by the MSCI World Index indicates that price momentum is driven largely by industry momentum, not individual-stock momentum, and that it is not a result of cross-sectional dispersion in industry mean returns or varying industry exposure to systematic risk. In a small-cap universe, stock-specific effects assume greater importance. For sample periods 1992–2003 and 1980–2003, value investors would have reduced risk by imposing sector neutrality on their portfolios whereas growth managers could have profited by relaxing sector constraints. The extensive literature on price momentum effects is a potential source of confusion for portfolio managers because conflicting explanations give rise to different implications for portfolio strategy. Is momentum a stock-level phenomenon, or is it subsumed by industry or style effects? What are the performance implications of imposing sector or style neutrality on portfolio strategies? How does price momentum affect estimates of tracking error or Sharpe ratios?We found that in a value-weighted large-capitalization universe, such as the MSCI World Index, price return momentum is driven largely by industry momentum; it does not appear to be explained either by country or individual-stock momentum. Furthermore, return continuation in this universe is not a result of either cross-sectional dispersion in industry mean returns or of varying industry exposures to systematic risk. In broad universes, such as the Dow Jones Global Index universe, stock-specific effects assume greater importance. We demonstrate that these results are broadly consistent with previous research if that research is differentiated by the breadth of the authors' data sample and by whether they value-weighted or equally weighted their momentum portfolios.We used two approaches to decompose momentum returns. The first approach was to compare the average return to long–short momentum portfolios constructed at the stock level with the average return to such portfolios constructed at either the sector or country level. We show that in a value-weighted large-cap universe, the sector momentum strategies can generate a magnitude of return that is similar to the return of stock-level momentum strategies. The second approach was to decompose the returns to the stock-level momentum strategies by using the “random coefficient" approach. We demonstrate that a significant proportion of the returns to these strategies can be attributed to the sector and country factors.Over both our sample periods, January 1992 through March 2003 and January 1980 through March 2003, value investors would have reduced risk by imposing sector neutrality whereas growth managers could have profited from both a growth strategy and a momentum strategy by relaxing sector constraints, although the effects would have been stronger for the more recent past. In practice, any group of companies sharing a common characteristic has the potential to exhibit price momentum. Such a characteristic could be as simple as industry or country—or any characteristic that investors expect to affect performance. Controlling the risk in any portfolio, therefore, requires monitoring style exposure.
Journal: Financial Analysts Journal
Pages: 64-82
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2717
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2717
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# input file: UFAJ_A_12047581_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Author-Name: Jason Hsu
Author-X-Name-First: Jason
Author-X-Name-Last: Hsu
Author-Name: Philip Moore
Author-X-Name-First: Philip
Author-X-Name-Last: Moore
Title: Fundamental Indexation
Abstract: 
 A trillion-dollar industry is based on investing in or benchmarking to capitalization-weighted indexes, even though the finance literature rejects the mean–variance efficiency of such indexes. This study investigates whether stock market indexes based on an array of cap-indifferent measures of company size are more mean–variance efficient than those based on market cap. These “Fundamental” indexes were found to deliver consistent, significant benefits relative to standard cap-weighted indexes. The true importance of the difference may have been best noted by Benjamin Graham: In the short run, the market is a voting machine, but in the long run, it is a weighing machine. The insights from the celebrated capital asset pricing model (CAPM) have led many to champion capitalization-weighted equity market portfolios as mean–variance optimal. In response, investment managers and consultants have created a trillion-dollar industry based on investing in passive cap-weighted indexes, such as the S&P 500 Index and other indexes constructed by commercial providers. Trillions more dollars are actively managed and benchmarked against these same cap-weighted indexes, but the CAPM literature already rejects the mean–variance efficiency of cap-weighted equity market indexes. It should be possible, therefore, to construct stock market indexes that are more mean–variance efficient than those based on market capitalization.In pursuing this possibility, we describe a series of equity market indexes weighted by fundamental metrics of size other than market capitalization: book value, trailing five-year average cash flow, trailing five-year average revenues, trailing five-year average sales, trailing five-year average gross dividends, and total employment. We chose these metrics because if capitalization is a “Wall Street” definition of the size of an enterprise, these characteristics are clearly “Main Street” measures. When a merger is announced, the Wall Street Journal may cite the combined capitalization but the New York Post will focus on the combined sales or total employment.We selected companies and their weights in the indexes on the basis of these simple measures using data from the Compustat and CRSP databases. In addition to the individual indexes, we constructed a composite index that equally weights the metrics of book value, cash flow, sales, and dividends. For comparisons, we use the S&P 500 and a “Reference” portfolio constructed as a cap-weighted index of the 1,000 largest stocks by market capitalization.In comparisons, we found that the Fundamental indexes delivered consistent and significant benefits relative to standard cap-weighted market indexes in our sample period, 1962–2004. The Fundamental indexes exhibited beta, liquidity, and capacity that are similar to those of the cap-weighted equity market indexes and had very low turnover. They produced annual returns for the sample period that were, on average, 215 bps higher than equivalent cap-weighted index returns. They contained most of the same stocks found in the traditional indexes, but the weights of the stocks in these new indexes differed materially from their weights in cap-weighted indexes.Although price inefficiency could lead to the observed alpha because capitalization weighting overweights the overvalued stocks and underweights undervalued stocks, the superior performance of Fundamental Indexation may be attributable to superior mean–variance portfolio construction or to hidden risk factors, none of which violates the assumption of price efficiency. Regardless of the exact reason, these Fundamental indexes appear to provide long-term performance superior to that of comparable cap-weighted equity indexes.We find it refreshing that Main Street indexing outperforms Wall Street indexing. The true significance of the difference between these two forms of viewing the stock market may have been best noted by Benjamin Graham: In the short run, the market is a voting machine, but in the long run, it is a weighing machine.
Journal: Financial Analysts Journal
Pages: 83-99
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2718
File-URL: http://hdl.handle.net/10.2469/faj.v61.n2.2718
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# input file: UFAJ_A_12047582_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Investment Manager Analysis: A Comprehensive Guide to Portfolio Selection, Monitoring, and Optimization (a review)
Abstract: 
 An exhaustive narrative of the manager search process, this book provides a practical, real-life method of analyzing investment managers. Its tone straddles the fence between academic and conversational, so newcomers to the search process should find the book informative and interesting. 
Journal: Financial Analysts Journal
Pages: 100-101
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2719
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Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Paul Volcker: The Making of a Financial Legend (a review)
Abstract: 
 The accomplishments of Paul Volcker are well worth noting. He successfully led the United States in perhaps the most tumultuous period in its history, when interest rates and inflation reached levels not seen before or since. His unique role as an arbiter of corporate and professional ethics since that time, however, may turn out to be more significant than anything else he did in 30 years of public service. 
Journal: Financial Analysts Journal
Pages: 101-102
Issue: 2
Volume: 61
Year: 2005
Month: 3
X-DOI: 10.2469/faj.v61.n2.2734
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# input file: UFAJ_A_12047584_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Edmund A. Mennis
Author-X-Name-First: Edmund A.
Author-X-Name-Last: Mennis
Title: Financial Analysts Journal: Marrying the Academic and Practitioner Worlds
Abstract: 
 This piece provides information to FAJ readers from Ed Mennis, CFA.
Journal: Financial Analysts Journal
Pages: 6-7
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2720
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# input file: UFAJ_A_12047585_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: A Provocative Year: Guest Editorial
Abstract: 
 This overview highlights several of the themes that have been developed in the Reflections articles written for the FAJ in its 60th anniversary year: the ethical responsibilities of various market participants, agency theory, rules individuals need to succeed in making their own investment decisions, understanding the rapid development of what we call “modern finance theory,” and putting to use the lessons we can learn from the past. 
Journal: Financial Analysts Journal
Pages: 12-17
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2721
File-URL: http://hdl.handle.net/10.2469/faj.v61.n3.2721
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# input file: UFAJ_A_12047586_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Erik Benrud
Author-X-Name-First: Erik
Author-X-Name-Last: Benrud
Title: “Is Fed Policy Still Relevant for Investors?”: A Comment
Abstract: 
 This material comments on “Is Fed Policy Still Relevant for Investors?” (January/February 2005). 
Journal: Financial Analysts Journal
Pages: 18-18
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2722
File-URL: http://hdl.handle.net/10.2469/faj.v61.n3.2722
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:3:p:18-18




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# input file: UFAJ_A_12047587_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: C. Mitchell Conover
Author-X-Name-First: C. Mitchell
Author-X-Name-Last: Conover
Author-Name: Gerald R. Jensen
Author-X-Name-First: Gerald R.
Author-X-Name-Last: Jensen
Author-Name: Robert R. Johnson
Author-X-Name-First: Robert R.
Author-X-Name-Last: Johnson
Author-Name: Jeffrey M. Mercer
Author-X-Name-First: Jeffrey M.
Author-X-Name-Last: Mercer
Title: “Is Fed Policy Still Relevant for Investors?”: Authors' Response
Abstract: 
 This material comments on “Is Fed Policy Still Relevant for Investors?”.
Journal: Financial Analysts Journal
Pages: 18-20
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2723
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:3:p:18-20




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# input file: UFAJ_A_12047588_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jack Treynor
Author-X-Name-First: Jack
Author-X-Name-Last: Treynor
Title: The Investment Value of an Idea
Abstract: 
 The value of an idea derives from its ability to solve our problems. It ends when a fully developed better idea arrives. No one knows how long development will take, but the probability that the challenger will arrive in a given year is the “mortality rate” for the old champion. We can calculate the present value of the old idea by adding the mortality rate to the market discount rate. The addition of the mortality rate increases the sensitivity of the discounted value to shortterm prospects for the economy. The value of an idea derives from its ability to solve our problems. It ends when better solutions arrive. Fortunately for the old idea, the better one does not arrive until its development is complete—until human ingenuity has removed the last obstacle to its practical application. But no one knows how long that process will take.The probability that the challenger will arrive in a given year is, of course, the “mortality rate” for the old champion. And as it turns out, we can calculate the present value of the old idea by simply adding the mortality rate to the market discount rate.Adding the extra term has two curious effects:Until the challenger arrives, the old idea rewards its owner with a rate of return that includes the mortality rate as well as the market discount rate.Sensitivity of the discounted value to short-term prospects for the economy increases.The equity in a publicly owned corporation or real estate is a rough measure of the value in the asset that is available to lenders. Leverage is an indication that the risk in an asset is low in relation to its value and that the remaining value can be freed up to bear risks that are high in relation to their value. One source of such risk—the main source—is the ideas being developed by entrepreneurs.The level of risk in ideas can be so high that, especially in the early stages of research and development, lenders will resist attempts at incorporation, which would limit the assets subject to their claim. But if they must forgo the protections afforded by incorporation, “entrepreneurs” will scrimp on expenses—even working, when possible, in their own basements or garages, most of which are attached to houses with mortgages.We can express our ignorance of the actuarial risk posed to a current champion by a challenger with a probability that development will be completed in a given year. When we do so, we find thatthe risk of sudden death can be incorporated into estimates of investment value by simply adding the appropriate mortality rate to the market discount rate;ideas for which the Damoclean sword has not yet fallen will reward investors with rates of return higher than the market rate. Shares of their corporate owners will behave like growth stocks;an idea will exhibit more systematic risk than conventional investment assets with the same value. Because it cannot be diversified away, this risk places special burdens on the owner's capacity for risk bearing.
Journal: Financial Analysts Journal
Pages: 21-25
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2724
File-URL: http://hdl.handle.net/10.2469/faj.v61.n3.2724
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:3:p:21-25




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# input file: UFAJ_A_12047589_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Frank J. Fabozzi
Author-X-Name-First: Frank J.
Author-X-Name-Last: Fabozzi
Title: The Structured Finance Market: An Investor's Perspective
Abstract: 
 The largest sector of the U.S. investment-grade fixed-income market is structured products—mortgage-backed securities and asset-backed securities. Issues and challenges currently facing investors who participate in this market sector include legal issues (e.g., consumer lending legislation), market structure (e.g., the role of the government-sponsored enterprises), and analytical methods (e.g., prepayment modeling). An important current concern is the need for education and training in the structured products area—particularly for investment policy compliance staff and for equity analysts. Asset-backed securities (ABS) are an alternative to traditional bond financing. In contrast to a traditional secured bond, with an ABS, the burden for repayment shifts from the cash flow of the issuer to the cash flow of the pool of loans or receivables and/or a third party that guarantees the debt payments if the pool of assets does not generate sufficient cash flow. The largest type of asset that has been securitized is mortgage loans (residential and commercial), which are referred to as mortgage-backed securities (MBS). Collectively, ABS and MBS are referred to as “structured products,” and as of the end of 2004, these securities represented about 40 percent of a broad-based investment-grade U.S. bond index and slightly more than half of the investment-grade products in the same index.Starting with a brief discussion of why asset securitization has been a major financial innovation, the article discusses current issues and challenges investors who participate in this market sector face-legal issues, questions of market structure, and analytical issues. Legal risk is a major concern to investors in the structured products market and represents the greatest threat to the growth of this sector of the bond market. The most critical issue is the long-standing view that investors in a structured product are protected from the creditors of the seller of the collateral because of the so-called bankruptcy remote trust/true sale opinion. In this concept, when the seller of the collateral transfers it to the trust (a special-purpose vehicle), the transfer represents a “true sale”; therefore, in the case of the seller's bankruptcy, the bankruptcy court cannot penetrate the trust to recover the collateral or cash flow from the collateral. The bankruptcy remote trust/true sale opinion has never, however, been fully tested.Issues related to the market's structure are the role of the Government National Mortgage Association and two government-sponsored enterprises, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation; the survival of the “to be announced” market (an important market innovation that works like a forward contract and has fostered the development of the fixed-rate agency pass-through security market); corporate issues masquerading as securitizations; the role of the servicer/trustee; and the increased use of derivatives (including credit default swaps and the relatively new prepayment derivatives). These issues all have an impact on valuation and trading strategies in the structured finance market.The analytical issues and challenges facing today's investors are valuation (including prepayment modeling and credit-risk modeling), risk measurement, and the management of structured products. Prepayment modeling is an ongoing analytical challenge in the MBS area. MBS valuation and the measurement of MBS interest rate risk (duration, convexity, and key-rate duration) require the projection of the collateral's cash flow, and the cash flow itself depends on the prepayment forecast. Projecting cash flows for structured products typically requires projections of the default rate, the timing of defaults, and the recovery rate. Default modeling for structured products is in its infancy. Portfolio managers whose mandate is to outperform a broad-based bond index face the problem of constructing a portfolio that has the desired tracking error vis-à-vis the agency pass-through sector of a bond index. Unlike replicating the U.S. Treasury, agency, and credit sectors of a bond index, replicating the pass-through sector is fraught with difficulties.Finally, the article addresses two groups of investment professionals who are badly in need of education and training in structured finance—compliance staff and equity analysts.
Journal: Financial Analysts Journal
Pages: 27-40
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2725
File-URL: http://hdl.handle.net/10.2469/faj.v61.n3.2725
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Author-Name: J. Parker Hall
Author-X-Name-First: J. Parker
Author-X-Name-Last: Hall
Title: Good News!
Abstract: 
 We are continuously bombarded by bad news—war, terrorism, recession, deficits, malfeasance, speculation. These events, coming at a mindnumbing frequency, cause us to hunker down and invest more cautiously. In fact, this continuous stream of distressing news, many examples of which are cited in this article, and the related roiled security markets, offer fresh investment opportunities. The good news is that an investor with a diversified benchmark can have confidence in the stability of the U.S. economy, the concept of reversion, and the profitability of a program of portfolio rebalancing. During nearly 50 years in the institutional investment management business, one comes across some useful insights. One such insight is how intense and bleak our feelings are during, and for a while after, a bear market. But then, looking back at the resolution of the crisis, we realize it was not so bad after all. From this first insight comes a second insight related to portfolio strategy: The good sense of rebalancing is affirmed.We are continuously bombarded by bad news—war, terrorism, recession, deficits, malfeasance, speculation. These events, coming at a mind-numbing frequency, cause investors to hunker down and invest more cautiously. Happily, the U.S. economy has demonstrated extraordinary resilience under this constant barrage of bad news. This resilience reflects, among other attributes, the large, productive, and diverse nature of our economy and fruitful monetary initiatives that have been pursued.These fundamental economic strengths can reassure us with respect to investment policy formation. In a diversified investment portfolio, the opportunity to benefit through portfolio rebalancing from others' misplaced fears and related (mostly futile) “timing“ has obvious merit. By rebalancing I mean a policy of systematically (quarterly?) trimming winning segments (asset classes) and supplementing losing segments to maintain a portfolio's normal strategic proportions.The good news is that an investor with a diversified portfolio can have confidence in the stability of our economy, the concept of reversion, and the related profitability of a program of portfolio rebalancing.
Journal: Financial Analysts Journal
Pages: 42-44
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2726
File-URL: http://hdl.handle.net/10.2469/faj.v61.n3.2726
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# input file: UFAJ_A_12047591_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Marianne M. Jennings
Author-X-Name-First: Marianne M.
Author-X-Name-Last: Jennings
Title: Ethics and Investment Management: True Reform
Abstract: 
 What happened to ethical behavior in the era of the dot-com, the bubble, Enron, and WorldCom? We were not involved in close ethical calls in these cases. The lapses were great, the conflicts many, and the cost, in terms of investor trust, nearly unspeakable. Each time scandals occur, market reforms result, but the pattern is that, despite their extensive nature, the reforms do not bring us an insurance policy against misconduct. True reform lies not in statutory or codified detail. Rather, true reform comes from a strong moral compass that is applied by leaders who demonstrate ethical courage. True reform requires a focus on doing more than the law requires and less than the law allows. As we look to the future, the events of the past and their lessons cannot go unheeded. Focusing on those events and learning from them is the beginning of true reform.The interaction of analysts with the markets in the era of the dot-coms, telecoms, and 1990s bubble contains three lessons. The first lesson is that the missteps were not ethical close calls. The lapses were great, the conflicts many, and the cost, in terms of investor trust, nearly unspeakable. The ethical misdeeds involved, first, conflicts of interest as research gave way to deal making, as analysts and other investment professionals used their positions (and research) for personal gain, and as the use of soft dollars was falsely justified and became a way of life. Second, analysts accepted and used false impressions, falsehoods, and frauds as they transformed into cheerleaders rather than objective examiners. The result of the conflicts was that the role of analysts became muddled.A second lesson comes from the recognition that we have been down the road of market abuses and reforms before. This latest round of scandals is the third since the mid-1980s. The first was the savings and loan disaster, and the second was the insider trading/junk bond debacle. In each case, individuals go down a path of ethical shortcuts and an unwillingness to question, and following each scandal, the result is extensive, expensive, and often ineffective regulation. The Sarbanes–Oxley Act and all the related organizational and professional mandates are only the latest attempt at regulation.In such times, we turn to the law to establish standards and reforms, but statutory and codified reforms are minimum standards for behavior. Despite their extensive nature, the reforms can deal only with the lapses uncovered. They can give us laws and regulations, but they do not bring us an insurance policy against future misconduct. We cannot possibly legislate, regulate, or codify every conflict of interest and every ethical dilemma or question. The result of efforts to do so is oppressive regulation that often finds those affected seeking the very loopholes ethical behavior condemns.True reform comes from three characteristics we need in our leaders and in ourselves. First is a strong, meaningful moral compass in individuals—self-imposed control governing individual action. Second, ethical issues need to be analyzed properly. We must deal with each basic issue—for example, the conflict of interest inherent in an industry—rather than letting it slide and trying to deal with the inevitable moral questions spawned by the initial misstep. Retention of moral absolutes requires constant introspection, discussion of practices, and exploration of those practices from the perspective of clients and the market, not from industry practice. Finally, the moral compass and ethical analysis need to be applied by leaders who demonstrate ethical courage. True reform requires a focus on doing more than the law requires and less than the law allows.
Journal: Financial Analysts Journal
Pages: 45-58
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2727
File-URL: http://hdl.handle.net/10.2469/faj.v61.n3.2727
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:3:p:45-58




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# input file: UFAJ_A_12047592_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: John Dobson
Author-X-Name-First: John
Author-X-Name-Last: Dobson
Title: Monkey Business: A Neo-Darwinist Approach to Ethics Codes
Abstract: 
 Contrary to the dictates of homo economicus, to be guided by a code of ethics does not entail sacrificing one's self-interest; rather, it entails correctly defining one's self-interest as a professional. A genuine concern for others, which is the theme of any sound code of ethics, is a natural human drive. An organizational culture that recognizes and nurtures this drive through the active implementation of an ethics code—from top management on down—is a successful one. If the code is grounded in the correct definition of professionalism as commitment to the profession and to the community, those guided by the code will be successful professionals. In the business jungle, as in the primeval jungle, the keys to success are honesty, fair dealing, and cooperation. Man is a social animal. Ethics codes are now ubiquitous in financial organizations. But a central question remains unanswered: To what extent do the codes and training achieve their desired objective? This article addresses major reasons why codes of conduct are generally ineffective in shaping behavior and how the problem can be fixed.A primary reason for people's skepticism about ethics codes is the widespread belief that the behavior espoused in ethics codes is, in a fundamental sense, unnatural and irrational. People are the rational wealth maximizers of classical economics and game theory—homo economicus. Recent developments in biology, psychology, and neuroscience, however, indicate that the motivations ascribed to people by these theories are too narrow. Research shows, for example, that many humans place some intrinsic value on fairness or fair distribution. Moreover, this trait is not unique to humans; studies of nonhuman primate behavior have found a similar tendency. The evidence from biology and psychology is that in advocating virtuous behavior, such as honesty and empathy, ethics codes are advocating natural behavior.Therefore, contrary to the dictates of homo economicus, to be guided by a code of ethics does not entail sacrificing one's self-interest; rather, it entails correctly defining one's self-interest as a professional. A genuine concern for others, which is the theme of any sound code of ethics, is a natural human drive. An organizational culture that recognizes and nurtures this drive through the active implementation of an ethics code—from top management on down—is a successful one. If the code is grounded in the correct definition of professionalism as commitment to the profession and to the community, those guided by the code will be successful professionals. In the business jungle, as in the primeval jungle, the keys to success are honesty, fair dealing, and cooperation. Man is a social animal.
Journal: Financial Analysts Journal
Pages: 59-64
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2728
File-URL: http://hdl.handle.net/10.2469/faj.v61.n3.2728
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:3:p:59-64




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# input file: UFAJ_A_12047593_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Alfred Rappaport
Author-X-Name-First: Alfred
Author-X-Name-Last: Rappaport
Title: The Economics of Short-Term Performance Obsession
Abstract: 
 In theory, discounted cash flows (DCFs) set prices in well-functioning capital markets. In practice, investment managers attach substantial weight in stock selection to short-term performance, particularly earnings and tracking error. Corporate executives blame this behavior for their own obsession with short-term earnings. Are stock prices likely to allocate financial resources efficiently when short-term earnings dominate investment decisions? Can investment managers who identify stocks as mispriced on a DCF basis earn excess returns? This article explains why maximizing long-term cash flow is the most effective way to create value for shareholders and charts a course for alleviating the obsession with short-term performance. According to economic theory, discounted cash flows (DCFs) set prices in all well-functioning capital markets. A company's value depends on its long-term ability to generate cash to fund value-creating growth and pay dividends to its shareholders. To select stocks in practice, however, investment managers attach substantial weight to short-term performance, particularly earnings and tracking error. Corporate executives blame the behavior of the investment community for their own obsession with short-term accounting earnings. ‘Short-termism’ is the disease; earnings and tracking error are the carriers.The gap between theory and practice prompts four basic questions:Why do investment managers focus on quarterly earnings? The fascination of investment managers with quarterly earnings is not terribly puzzling. In fact, it is perfectly rational in a market dominated by agents responsible for other people's money but also looking out for their own interests. The problem is that earnings data are not well suited to use in valuation.Can stock prices be allocatively efficient when short-term earnings, tracking error, and a host of non-DCF criteria dominate investment decisions? The most basic function of capital markets is to allocate scarce resources to enterprises with the most promising long-term prospects. Perfect resource allocation assumes flawless foresight. Allocative efficiency, or how well market prices allocate resources, depends on the skills of informed buyers and sellers with competing estimates of DCF values.Can investment managers earn excess returns if they buy and sell stocks they believe the market has mispriced on a DCF basis? Only individuals with brains, resources, a long investment horizon, and no agency conflicts are promising candidates for exploiting mispricings. If managers' chances of success are to improve, the market's fascination with the short term and its obsession with earnings will have to change.Is corporate management's focus on short-term earnings self-serving, or is it also in the best interests of its shareholders? Managers with career concerns and short-term incentive compensation arrangements are predictably obsessed with earnings, but a focus on short-term earnings compromises shareholder value. Maximizing long-term cash flows rather than managing for short-term earnings, even in an earnings-dominated market, is the most effective means of creating value for continuing shareholders.After addressing these questions, I present a three-pronged program for reducing short-term performance obsession. The first step is to improve corporate performance reporting. A “Corporate Performance Statement” is suggested that separates cash flows and accruals, classifies accruals by levels of uncertainty, provides a range and the most likely estimate for each accrual, excludes arbitrary, value-irrelevant accruals, and details assumptions and risks for each line item.The second step is to change the incentives for corporate managers. The current standard incentive stock-option plan has performance targets that are too low, sets holding periods that are too short, and can induce too little or too much risk taking. To overcome the shortcomings, I recommend a system of extended time horizons and indexing options to a peer-group index or, alternatively, a discounted equity-risk options plan.The third step is to change the incentive scheme for investment managers. Earnings obsession will persist as long as investment managers have inadequate incentives to focus on companies' long-term prospects. To change the focus, the closed-end fund needs to be revived. For this purpose, investment firms need to make total compensation at closed-end funds competitive with the amount managers could earn if they moved to an open-end fund, extend the performance evaluation period to three to five years, pay annual bonuses on the basis of rolling three-year to five-year performance, motivate long-term value creation by deferring some payouts and placing them “at risk” against future performance, and finally, require portfolio managers to make meaningful investments in the fund.
Journal: Financial Analysts Journal
Pages: 65-79
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2729
File-URL: http://hdl.handle.net/10.2469/faj.v61.n3.2729
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Author-Name: Philip McBride Johnson
Author-X-Name-First: Philip McBride
Author-X-Name-Last: Johnson
Title: Solving the Mystery of Stock Futures
Abstract: 
 From 1981 until 2000, futures contracts on single stocks and on small-stock indexes were prohibited under a U.S. federal law known popularly as the “Shad–Johnson Accord.” After 2002, trading was conducted on two newly formed markets; one has already closed, but the other battles on. In this article, one of the Accord's namesakes discusses why these products were banned and why they have struggled since being launched. Futures contracts on single stocks and on small-stock indexes were banned by U.S. federal law in 1981 because the Commodity Futures Trading Commission (CFTC), which enjoyed exclusive regulatory jurisdiction over all futures trading (regardless of the underlying asset), refused to cede any co-regulatory role to the SEC. The commission feared that this step would embolden other federal and state regulators to demand equal rights with respect to futures on “their” industries' assets (such as co-regulation of crude oil futures by the Federal Energy Regulatory Commission).In 2000, the CFTC changed its mind and the U.S. Congress created a system of co-regulation with the SEC of futures on single stocks and on small-stock indexes. In late 2002, two newly formed markets (joint ventures of other markets) launched the products. One market has already closed its doors; the other struggles on under new management.Some causes for the disappointing performance of these products can be readily identified. The CFTC/SEC regulatory regime is a harsh one, with margins, taxes, and transaction costs much higher than for other futures contracts and with severe restrictions on what stocks qualify. Most of these impediments are avoidable by many investors, however, especially institutional investors, which are free to bypass the regulated exchanges and to negotiate among themselves on whatever terms they wish. Even so, little evidence exists that this alternative is being used to trade these stock futures. Why? I pose several possibilities while recognizing that more study is needed.
Journal: Financial Analysts Journal
Pages: 80-82
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2730
File-URL: http://hdl.handle.net/10.2469/faj.v61.n3.2730
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:3:p:80-82




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Author-Name: Sumon C. Mazumdar
Author-X-Name-First: Sumon C.
Author-X-Name-Last: Mazumdar
Author-Name: Partha Sengupta
Author-X-Name-First: Partha
Author-X-Name-Last: Sengupta
Title: Disclosure and the Loan Spread on Private Debt
Abstract: 
 Companies that consistently make detailed, timely, and informative disclosures face lower costs of public equity and debt capital. The study reported here investigated whether such companies also face lower interest costs on private debt contracts. Examination of a sample of 173 new private debt issues during the 1989–93 period suggests that, after company- and loan-specific factors and market conditions have been controlled for, loan spreads are negatively associated with a measure of companies' overall disclosure quality. That is, companies with consistently high ratings for voluntary disclosures pay lower interest on their private debt (bank loan) contracts. Companies that consistently make detailed, timely, and informative disclosures face lower costs of public equity and debt capital. The study reported here investigated whether such companies also face lower interest costs on private debt (bank loan) contracts.We examined a sample of 173 new private debt issues during the 1989–93 period. The loan spread was the reported spread over LIBOR, the U.S. Federal Reserve prime rate, or CD rates obtained from the DealScan database compiled by the Loan Pricing Corporation. Our proxy for the overall disclosure quality of companies was obtained from volumes of the Corporate Information Committee Report (CIC Report) published annually from 1976 through 1996 by the Association for Investment Management and Research (now CFA Institute).Our findings suggest that, after company- and loan-specific factors and market conditions have been controlled for, loan spreads are negatively associated with a measure of companies' overall disclosure quality. That is, companies with consistently high ratings from analysts for the quality of the companies' voluntary disclosure pay lower interest on their private debt contracts. The negative relationship between loan spreads and the aggregate disclosure metric was quite large—a 1 point increase in the composite disclosure score was related to a 1.62 bp lower loan spread. Thus, holding all other factors constant, the benefit of disclosure can be crudely approximated.The highest and lowest composite disclosure scores (out of a possible 100) observed in our sample were 95.85 and 38.30, respectively, for a disclosure score differential of 57.55. Such a differential would result in annual interest cost savings of 0.93 percentage point annually. Assuming that the company with the highest disclosure score held an average-sized loan for this period ($624.67 million) and with other factors that affect loan pricing held constant, the company would have saved, on average, approximately $5.8 million annually compared with the company with the lowest disclosure score.Overall disclosure scores were broken into three categories—the quality of the company's disclosure (voluntary and required disclosures) in annual reports and other required published material, the quality of the company's disclosure provided in quarterly reports and other nonrequired published material (such as proxy statements), and the quality of the company's disclosures made to financial analysts. The loan spread was negatively associated with all disclosure subcategory scores, but the result was strongest for voluntary disclosures in required annual reports.Our findings suggest that financial intermediaries, which one can argue have better monitoring abilities than public debtholders have and have access to private information about companies they lend to, nevertheless rely on the quality of a company's disclosures and incorporate this information in their default-risk estimates. Companies that are rated favorably on the basis of their disclosure quality enjoy a lower interest on their private loans, possibly because banks believe these companies are unlikely to be withholding adverse financial information. This study also extends prior research on the effects of disclosure quality on the cost of equity capital and on the interest cost of public debt issues.Our analysis is relevant from a company perspective for corporate governance and capital structure decisions because private debt constitutes the bulk of corporate credit. Our results also shed empirical light on the nature of private loan contracting and pricing, which is an important area of academic research.
Journal: Financial Analysts Journal
Pages: 83-95
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2731
File-URL: http://hdl.handle.net/10.2469/faj.v61.n3.2731
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:3:p:83-95




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Author-Name: Denise Dickins
Author-X-Name-First: Denise
Author-X-Name-Last: Dickins
Author-Name: Julia Higgs
Author-X-Name-First: Julia
Author-X-Name-Last: Higgs
Title: Interpretation and Use of Auditor Fee Disclosures
Abstract: 
 Publicly available fee disclosures have been used by investors and regulators to assess various matters, including the quality of a company's audit, financial reporting, and corporate governance. We find that many companies' disclosures are insufficient, standardized, or inconsistently prepared. This finding has implications for the usefulness of the data because disclosures are informative only to the extent that analysts fully understand their composition, the possibility of varying interpretations, and the potential for bias. Beginning in 2001, publicly traded companies have been required to disclose the amount and nature of fees paid to their external auditors. Fees are classified into four categories (audit, audit related, tax, and other). These disclosures are used by analysts and investors, among others, in their assessments of various matters of corporate governance, including the quality of financial reporting and the level of auditor independence.From analyzing a sample of 194 companies' fee disclosures, we found that significant variations exist in companies' individual fee disclosures. We found that only 3 of 24 services provided by external auditors were consistently classified among companies. Audit fees were consistently reported in the “audit” category; quarterly reviews, in the “audit” category; and tax studies, in the “tax” category. Many services were classified consistently less than 75 percent of the time, and several services were classified in all four categories. The most inconsistently classified services were registration statements, SEC matters, compliance audits, transaction consulting, review of tax accruals, internal control reviews, acquisition audits, statutory filings, benefit plan tax services, and attendance at board/annual meetings. Because the fees associated with several of these services can be significant, differences can create inconsistencies when comparisons are based on ratios. Findings that fee disclosures are not consistent among companies or among their auditors significantly reduce the usefulness of the disclosures.The observed inconsistencies in fee disclosures—whether from random variations or conscious or subconscious bias—result, in part, because various interpretations of the disclosure rules are allowed.In addition, we found that many companies' disclosures are insufficient or are standardized, which also potentially diminishes their usefulness.Our analysis is intended to be both informative and cautionary. In particular, our results suggest that before attempting to draw conclusions about auditor independence, financial reporting quality, or corporate governance, users of fee disclosure information must be aware of the potential for incomplete or standardized disclosures and disclosure inconsistencies among companies. Fee disclosures are informative only to the extent that analysts fully understand their composition, the possibility of varying interpretations, and the potential for bias.
Journal: Financial Analysts Journal
Pages: 96-102
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2732
File-URL: http://hdl.handle.net/10.2469/faj.v61.n3.2732
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:3:p:96-102




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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In The Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issues.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 3
Volume: 61
Year: 2005
Month: 5
X-DOI: 10.2469/faj.v61.n3.2733
File-URL: http://hdl.handle.net/10.2469/faj.v61.n3.2733
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:3:p:104-104




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Author-Name: Jack Treynor
Author-X-Name-First: Jack
Author-X-Name-Last: Treynor
Title: Ideas for the People Who Make the Decisions
Abstract: 
 This piece provides information to FAJ readers from Jack Treynor.
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 4
Volume: 61
Year: 2005
Month: 7
X-DOI: 10.2469/faj.v61.n4.2735
File-URL: http://hdl.handle.net/10.2469/faj.v61.n4.2735
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Performance Fees: The Good, the Bad, and the (Occasionally) Ugly
Abstract: 
 The topic of performance-based fees is one of the many governance issues that arise in the management of investment assets, the investment process, and the investment enterprise. Performance-based fees are not inherently better or worse than asset-based fees—for sponsor or manager. Performance fees can be a fair and useful tool to align the interests of a manager with those of the clients, a way for clients to cut their overall fee burden, or a way for an investment manager to expropriate large chunks of client wealth. This column explores the subtleties of this fascinating element of the investment business. 
Journal: Financial Analysts Journal
Pages: 10-13
Issue: 4
Volume: 61
Year: 2005
Month: 7
X-DOI: 10.2469/faj.v61.n4.2736
File-URL: http://hdl.handle.net/10.2469/faj.v61.n4.2736
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Author-Name: Clive W.J. Granger
Author-X-Name-First: Clive W.J.
Author-X-Name-Last: Granger
Title: The Present and Future of Empirical Finance
Abstract: 
 More and more data, greatly increased computing power, a rising number of research enthusiasts, an increased number of finance journals, and sophisticated techniques have been the characteristics of empirical finance in the past 30 years. Topics of current interest relate to conditional means, conditional variances, and conditional distributions. These topics will remain in the forefront for years to come and perhaps be joined by questions that will shake the foundations of finance theory. For example, will we find that market data are characterized by jump diffusions—that is, diffusions with breaks—rather than standard diffusions? In the third of a century since my first investigations into finance theory, empirical finance has changed dramatically—from only a few active workers to hundreds, maybe thousands, of researchers. The number of finance journals has grown from one to dozens, and the techniques have become considerably more advanced. The availability of much more data and greatly increased computer power have produced impressive research publications. Many of these publications have relatively little practical usefulness, however, and in fact, the purpose of much of the work is unclear.I avoid the most popular procedures that have developed (which are covered by several excellent textbooks on financial econometrics) and survey the work that is going on and the work that needs to be done with conditional means, conditional variances, and conditional distributions.For the future, I see, first, continued investigation of topics already under scrutiny. In particular, conditional distributions will continue to be a major subject as finance learns how to generate more of its fundamental theories in distributional forms: arbitrage and portfolio theory, efficient market theory and its consequences, the Black-Scholes formula, and so forth.Structural breaks are also likely, however, in the present framework. In particular, I foresee renewed study of the “facts” researchers found through using basically a linear foundation for studying prices, returns, and volatility. An example of these facts is the conclusion that returns are nearly white noise; that is, they have no serial or autocorrelation.I see problems in the new field of continuous-time finance theory. The mistake that I see is starting with the assumption that a price or a return can be written in terms of a standard diffusion, which is based on a Gaussian distribution. The approach served well in the early days of econometrics but only for mathematical convenience; it was not tested. The assumption in continuous-time theory is dangerous because we have no way to test it. We have no continuous-time data.Finally, I find interesting the recent results indicating that our market data behave in a way that is more consistent with jump diffusions—that is, diffusions with breaks—than with standard diffusions. If this finding holds, the majority of current financial theory will probably have to be rewritten with “jump diffusion” replacing “diffusion” and with some consequent changes in theorems and results. As with all radical new ideas, this change will certainly be opposed by some.
Journal: Financial Analysts Journal
Pages: 15-18
Issue: 4
Volume: 61
Year: 2005
Month: 7
X-DOI: 10.2469/faj.v61.n4.2737
File-URL: http://hdl.handle.net/10.2469/faj.v61.n4.2737
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:4:p:15-18




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Author-Name: David I. Fisher
Author-X-Name-First: David I.
Author-X-Name-Last: Fisher
Title: A Step Backward Might Be a Good Thing
Abstract: 
 The investment management profession has strayed from its primary mission; instead of being the best managers we can be, too many people and firms are focused on gathering more and more assets. We need to reinstate what was good about the past, including fundamental valuation and the search for positive tracking error. And marry those concepts and methods to what's good about today, including the high caliber of people coming into the business. Finally, we should use our skills and resources to give something back to the world. Some aspects of what I have recently seen in our profession are discouraging. I have watched a growing focus on the profit side of our business—for example, in the increasing consolidation—and a waning focus on creative ways to make money for clients. Money is being managed by people whose passions are more about the business than the investment management process. The business has increasing short-term pressures. And people have begun to complain that our business just isn't as much fun as it used to be.At such a point, what happens is that people in the business begin to reinvent themselves in newly formed boutiques and begin to spread the virtues of independence, small size, a focused organization, and equity participation for all the principals. This turning point may already have been reached.This article looks at what was good about the Old Days and what is good about the New Days. In the Good Old Days, we focused on getting to know companies and trying to come to grips with their future prospects, on valuation of the companies, and on making sure that our analysis of future prospects was correct. I am distressed and somewhat depressed by the notion that the rest of the world would prefer to talk more about the trading characteristics of the stock certificates in the portfolio than about the underlying fundamentals of the companies in the portfolio. I have seen the rise of backward-looking measures such as beta and tracking error, the emergence of mediocrity as an objective for money managers, too much reliance on the computer's answer, and the definition of risk as deviation from the benchmark rather than what it is—the risk of losing money.While I mourn the passing of some aspects of the Good Old Days, I also celebrate many of the changes in the profession. In the Good New Days, the market is global and the people and organizational culture of our organizations have become global. The quality of the young people who are attracted to this business is tremendously high. They understand modern portfolio theory, but they don't pray at its altar; they are passionate about analyzing companies and the impact people can have on companies. They love thinking about the future and are comfortable with uncertainty and risk. They automatically put things in a global perspective.Finally, when I think of all this business has given us and all the fun we've had, I realize that we need to give something back—through the training and opportunities we give to others in the business and by allowing them to donate their time and energy to making the world a better place. There is more to life than managing portfolios, and we don't want to miss the chance to give something back.
Journal: Financial Analysts Journal
Pages: 20-23
Issue: 4
Volume: 61
Year: 2005
Month: 7
X-DOI: 10.2469/faj.v61.n4.2738
File-URL: http://hdl.handle.net/10.2469/faj.v61.n4.2738
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:4:p:20-23




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Author-Name: Gary P. Brinson
Author-X-Name-First: Gary P.
Author-X-Name-Last: Brinson
Title: The Future of Investment Management
Abstract: 
 Looking at the present and at 35 years in the investment management field has produced the six observations and conjectures in this article: The correct portfolio for any investor is global (with a distinction between currency exposure and asset exposure), and global asset trading will eventually be continuous, 24 hours; “momentum investing” is an oxymoron; the model inputs reflecting our fundamental expectations are often irrational; investment management fees must drop significantly; the lumpiness and discontinuities in the market provide opportunities but frighten most investors; and past investment results are largely random noise with no predictive value. The reflections and conjectures shared in this article are grounded in 35 years of experience in the field of investment management. These thoughts cover roughly six—sometimes related, sometimes not—topics:Globalization of financial markets. Portfolios that span the asset allocation array across all of the global markets have a return–risk relationship that dominates any individual asset class. Globalization raises the need to separate the idea of currency exposure from decisions about a portfolio's asset holdings. Because of globalization, asset markets in the future will transact over 24-hour periods without defined opening and closing prices.The distinction between trading and investing. Trading is focused on short-term price changes that occur for any variety of reasons. Investing is a process focused on future economic cash flows from business activities that ultimately determine the value of an investment.Fundamental expectations. Decision-making models have evolved nicely during the past 35 years, but unfortunately, inputs to the models have not. Careless assumptions have led investors to erroneous conclusions from model outputs. Therefore, in the future, investment analysis needs to become more rigorously grounded.Fees. Measuring the aggregate fees paid by investors as a group against the aggregate value added by their investment managers shows clearly that something is greatly amiss. Therefore, investors will alter their acceptance of fees in the coming years.Lumpiness and discontinuities. Successful investment management that seeks to provide value above appropriate benchmarks is a lumpy and discontinuous process. Managers and clients need to do a much better job in the future of recognizing this characteristic of markets.Random noise. Because investment results are largely random noise with no predictive information, the investment management field should ultimately evolve away from using past performance for anything other than its historical accounting value.In offering these observations to the reader, I am mindful of Oscar Wilde's warning: “Experience is the name everyone gives to their mistakes.” I leave it up to the reader to judge whether my “experience” adds any value.
Journal: Financial Analysts Journal
Pages: 24-28
Issue: 4
Volume: 61
Year: 2005
Month: 7
X-DOI: 10.2469/faj.v61.n4.2739
File-URL: http://hdl.handle.net/10.2469/faj.v61.n4.2739
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:4:p:24-28




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Author-Name: Abby Joseph Cohen
Author-X-Name-First: Abby Joseph
Author-X-Name-Last: Cohen
Title: Aristotle on Investment Decision Making
Abstract: 
 In this age of inexpensive and abundant data, investors must remain mindful of the limitations of the data they are using for their investment decisions. Despite widespread problems with the quality, timeliness, and relevance of financial and economic data, many investors accept and react to these data at face value. Often, further analysis of the data and an understanding of the factors that drive the data will lead to increased uncertainty—and may change the analyst's conclusions. Most modern people acknowledge that Aristotle was a bright and insightful man, but most do not recognize that his wisdom can be applied to investment decision making. Aristotle warned, “It is the mark of an educated person to look for precision only as far as the nature of the subject allows.” Investors would do well to apply that wisdom to the data and models used in their analyses and forecasts.Investors commonly presume greater precision than is warranted in data and quantitative techniques. This article examines the limitations, quality, timeliness, and relevance of some of the financial and economic data that are so extensively and inexpensively available today. Indeed, the power of today's computational techniques can magnify the consequences of bad data and poorly constructed models.The first area of concern is the quality of the data used as inputs to analysis. Investors must acknowledge the shortcomings of many of the commonly used variables. Consider that company analysts tend to emphasize reported EPS, often to the exclusion of other factors—such as revenues and cash flow—and despite the volatility in earnings data related to unevenly applied accounting standards.Second, users must be cognizant of the inherent weaknesses in the models themselves. Too often, investors rely on inexact rules of thumb rather than more disciplined theoretical approaches. A prime example is the use, when measuring and estimating fair value, of the historical “average” P/E multiple rather than more complex approaches that also consider trend growth in earnings or cash flows and adjust for inflation, interest rates, and sustainable return on investment.Third, financial markets respond almost instantaneously to the public release of economic and financial data and investors rarely look back to readjust their response when more complete or accurate information becomes available. For example, share prices respond more notably to the release of pro forma company results than to the more precise information later filed with the U.S. SEC. Similarly, sharp market reactions often occur to initial economic data releases, although the data are of notoriously poor quality. Many of the series of government data are based on small samples and are repeatedly revised when more raw information becomes available to government statisticians. Even so, few investors review their earlier conclusions. The initial data releases can lead to misinterpretations, and those mistakes can be compounded when users fail to recognize the interrelationships between economic indicators. Examples include the links between GDP (which can be revised for years following the initial announcement), labor productivity, and employment costs. Furthermore, initial trade data are incomplete, yet investors often fail to review subsequent revisions when considering their views on trade deficits, currencies, and global flows of funds.Some investors, especially those with very short horizons, quickly respond to data announcements, of whatever quality, and then move on. Those with longer-term horizons, however, would be well advised to become better acquainted with the construction of economic and financial information. Doing so, and monitoring later revisions, may provide exceptional insights into the true condition of the economy or the company being analyzed. Revised conclusions may be quite different from those that were developed by the earlier “instant analysis” approach and may reveal notable anomalies and distinctive opportunities.
Journal: Financial Analysts Journal
Pages: 29-41
Issue: 4
Volume: 61
Year: 2005
Month: 7
X-DOI: 10.2469/faj.v61.n4.2740
File-URL: http://hdl.handle.net/10.2469/faj.v61.n4.2740
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Author-Name: John J. Nagorniak
Author-X-Name-First: John J.
Author-X-Name-Last: Nagorniak
Title: From Theory to Practice
Abstract: 
 The investment profession has experienced major changes in the short time since 1970—primarily because of advances in technology. We regularly use quantitative models, we have masses of data, and the world is our market. New financial paradigms have not, however, eliminated the challenges of investing. And in the future, we will need to deal with new as well as old issues. The investment profession has experienced major changes since 1970—primarily because of advances in technology. Theoretical work on various aspects of finance had been going on since 1900, but these early ideas did not gain traction until Markowitz wrote his dissertation examining the mathematics of portfolio risk in 1952.Until the arrival of the computer, no one had a means for testing or applying the theoretical ideas. The large advances in computer technology during the 1960s and 1970s made testing practical and fostered a growth in the quantitative content of economics and finance.In the nonacademic world, practice was often far removed from the textbooks. In the early 1970s, investors did not regularly calculate their performance and the performance numbers they did compute were simple estimates. Moreover, investments were usually not viewed as a portfolio.Today, we regularly use quantitative approaches; they have inspired new markets, and the models have changed how we look at finance and risk. Performance is measured frequently and carefully. We view the aggregate characteristics of portfolios with relative ease. We understand the diversification merits of global investing, indexing has become commonplace, the financial markets have become more efficient since 1970, trading is becoming automated, short-term performance has taken on too much importance, defined-benefit plans have peaked, and individual-directed investments are on the rise.New financial paradigms have not eliminated the challenges of investing. Booms and busts still occur. Throughout all the trends, investing remains a task that rewards merit and punishes the lack of merit. We need to efficiently use the masses of data we now have in combining investment information and using this information to build portfolios.In the future, new technologies will arise, old and new issues will challenge us. I hope for the following:Capital markets will increase everyone's overall welfare.Participation in the capital markets will be broad and thoughtful.The costs of investing will continue to fall.Information for all investors will be plentiful and of high quality.The average investing result of all investors, while remaining average, will be higher than ever before, and less risk will be involved in obtaining it.Access to capital markets will be fair, and ethical, high-quality advice will be available to all who need it.
Journal: Financial Analysts Journal
Pages: 42-46
Issue: 4
Volume: 61
Year: 2005
Month: 7
X-DOI: 10.2469/faj.v61.n4.2741
File-URL: http://hdl.handle.net/10.2469/faj.v61.n4.2741
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Author-Name: Xinge Zhao
Author-X-Name-First: Xinge
Author-X-Name-Last: Zhao
Title: Determinants of Flows into Retail Bond Funds
Abstract: 
 Despite the growth of investments by individuals in bond funds, no research has investigated the determinants of these money flows into the funds. This study examined such determinants and the behavior of bond fund investors in the 1992–2001 period. Bond fund investors chase risk-adjusted performance leaders instead of raw return leaders. Bond fund investors, particularly investors in municipal bond funds and government security funds, are sensitive to expenses, such as operating expenses and sales loads. Poor long-term equity market returns tend to increase investors' investments in government security funds, Ginnie Mae funds, and high-quality bond funds. This study addressed the determinants of net flows into retail bond funds as a whole and by investment objective. The study used a new dataset of all retail bond funds and covered the period 1992 to 2001.Bond funds have become an increasingly important investment vehicle for individual investors, but despite the growth of investments into bond funds, no research has been done on the determinants of flows into the funds or the behavior of bond fund investors. A large literature has been devoted to the determinants of flows into equity funds, but these findings may not apply to bond funds because of differences in the characteristics of holdings and the profiles of investors. As a result, the behavior of bond fund investors needs to be studied in a separate investigation, which is the primary contribution of this article.In addition to studying the determinants of flows into bond funds as a whole, this research studied the determinants of flows for the funds disaggregated according to their investment objectives: municipal bond, government security, Ginnie Mae (Government National Mortgage Association, GNMA), high-quality bond, high-yield bond, and global bond. The fixed-income instruments in the groups have different risk and return characteristics and may appeal to different investors. As a result, investors may exhibit different behavior toward the different types of funds.The study found the following:Bond fund investors chase the funds that are the performance leaders on a risk-adjusted basis rather than on the basis of raw returns.Most bond fund investors—in particular, municipal bond fund and government security fund investors—are sensitive to expenses; they avoid funds with high operating expenses and funds that charge sales loads.Poor long-term equity market returns tend to increase investors' investments in government security funds, Ginnie Mae funds, and high-quality bond funds.Except among the high-quality bond funds, small bond funds receive higher net dollar flows than large funds.Bond funds from fund families with larger assets tend to receive higher flows.Investors in high-yield bond funds do not chase absolute performance and are more likely to rely on the assistance of brokers and financial advisors.As the first comprehensive study of the determinants of flows into bond funds, this article sheds light on the behavior of bond fund investors with various investment objectives. These results enhance bond fund portfolio managers' and financial advisors' understanding of what drives the decisions of bond fund investors. These findings can also help senior executives and boards of directors of mutual fund families formulate their policies regarding fees and distribution channels.
Journal: Financial Analysts Journal
Pages: 47-59
Issue: 4
Volume: 61
Year: 2005
Month: 7
X-DOI: 10.2469/faj.v61.n4.2742
File-URL: http://hdl.handle.net/10.2469/faj.v61.n4.2742
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:4:p:47-59




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Author-Name: Jose Menchero
Author-X-Name-First: Jose
Author-X-Name-Last: Menchero
Title: Optimized Geometric Attribution
Abstract: 
 To address the problem of geometric performance attribution in a recently proposed framework of qualitative characteristics and quantitative properties, the approach reported here is to solve the problem in a two-step fashion. The first step is to define a set of attribution effects in their “pure” geometric form. Because these pure effects will not aggregate in a residual-free manner, however, the second step is to perturb the geometric attribution effects in such a way that they deviate as little as possible, subject to the constraint that there be no residual, from their pure values. The resulting optimized attribution effects represent the most accurate formulation of geometric attribution. Performance attribution analysis is a widely used tool for quantifying the impact of active management decisions on active return. The active return is decomposed into a set of attribution effects that are themselves directly related to active management decisions. The attribution effects, when aggregated, fully account for the active return.Broadly, two formulations of performance attribution—arithmetic and geometric—are in use. The arithmetic approach defines active return as a difference, whereas the geometric approach defines it as a ratio. This article shows that these definitions present unique, yet related, challenges. Arithmetically, defining the attribution effects for a single period is simple but linking them over multiple periods is challenging. Geometrically, the situation is reversed: Linking attribution effects over multiple periods is simple, but defining them for a single period is challenging.A recent article identified a set of qualitative characteristics and quantitative properties for the case of arithmetic attribution. Qualitatively, the attribution methodology should be intuitive, transparent, and robust. Quantitatively, it should be residual free, fully linkable, commutative, and metric preserving. This article applies these characteristics and properties to the case of geometric attribution.I develop a geometric attribution methodology consistent with this framework via a two-step procedure. In the first step, I define the geometric attribution effects in their “pure” metric-preserving form. The attribution effects so constructed exhibit all of the desirable characteristics and properties, except that they do not aggregate in a strictly residual-free fashion. The second step, therefore, is to eliminate the residual. I meet this challenge by applying an optimization procedure that, subject to the constraint that there be no residual, minimizes the perturbation from the pure values. I compare this algorithm with others that have been proposed and argue that the algorithm resulting from my process represents the most accurate formulation of geometric attribution. Several examples illustrate the spurious effects that can arise with alternative approaches to geometric attribution.
Journal: Financial Analysts Journal
Pages: 60-69
Issue: 4
Volume: 61
Year: 2005
Month: 7
X-DOI: 10.2469/faj.v61.n4.2743
File-URL: http://hdl.handle.net/10.2469/faj.v61.n4.2743
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Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Author-Name: Anthony Bova
Author-X-Name-First: Anthony
Author-X-Name-Last: Bova
Title: Allocation Betas
Abstract: 
 The complexities of standard optimization can obscure the intuitive decision process that should play a major role in asset allocation. The use of allocation alphas and betas—with U.S. equity as the beta source—facilitates an intuitive approach and greatly simplifies the decision process. A portfolio's assets are separated into two groups: “Swing assets” are the traditional liquid asset classes, such as U.S. bonds and equity; the “alpha core” is all other assets, which are subject to more stringent limits. After the nontraditional assets are combined to form an alpha core, the result is a three-part efficient frontier: (1) a cash-to-core segment, (2) a fixed-core segment, and (3) an equity extension. The boundaries lead to a “sweet spot” on the efficient frontier where most U.S. institutional portfolios are clustered. The market assumptions behind standard asset allocation studies embed a set of expected returns and covariance relationships among the relevant assets. These assumed relationships are often not consistent with either equilibrium conditions or an efficient market view. This article deconstructs the relationships in an illustrative set of market assumptions into “beta” components that are correlated with U.S. equity and “alpha” components that are independent of U.S. equity. The term “allocation beta” is used to underscore that these values are derived from a covariance matrix intended as the starting point for an allocation study.The selection of U.S. equity as the beta source is motivated by its role as the dominant risk factor in U.S. institutional portfolios. In addition, the beta measure relative to a U.S. equity index is a familiar and intuitive concept (even though it is not typically used in an allocation context).When this asset-based analysis is applied to representative U.S. institutional portfolios, roughly 90 percent or more of their volatility is explained by their beta sensitivity to U.S. equities. Moreover, for a wide range of U.S. institutional portfolios, the beta values (and the overall volatilities) tend to be surprisingly tightly clustered around a beta of 0.60 and a volatility of 10 percent.This framework provides a simplified approach to the allocation process. A portfolio's assets can be decomposed into two groups—“swing assets” and an “alpha core.” Swing assets are the traditional liquid assets—U.S. equities, U.S. bonds, and cash—whereas the alpha core consists of all other assets—non-U.S. equity, real estate, hedge funds, private equities, and so on—that are potential alpha sources but are generally subject to relatively tight portfolio constraints. Although the alpha core is often viewed as serving to diversify the volatility of the swing assets, its real benefit tends to be return enhancement.The allocation process in this approach can then be viewed as a three-step process. First, maximum acceptable limits are determined for each “nontraditional” asset class. Second, these alternative assets are combined into a “subportfolio”—the alpha core. The composition of the alpha core will generally involve both intuitive and qualitative considerations that go well beyond the explicit quantitative characteristics embedded in the return-covariance matrix. The fund will try to include this alpha core within the final portfolio at its maximum allowed percentage. The third step is to adjust the composition of the swing assets to achieve the desired risk level for the overall fund. (In essence, this process “reverses” the usual path, whereby a portfolio of traditional assets is deployed into alternatives on an incremental basis.)The assumption of a fixed percentage weight devoted to the alpha core leads to a three-part efficient frontier: (1) a cash-to-core segment, (2) a fixed-core segment, and (3) an equity extension to 100 percent equity. The first and third segments are tied to the fixed points of, respectively, 100 percent cash and 100 percent equity.Not surprisingly, when four illustrative portfolios are examined in depth, most allocations fall—rather tightly—within the fixed-core segment. Long-term funds apparently have an incentive to move beyond the cash-to-core segment and an incentive to not pursue the equity extension. The fixed-core segment thus forms a “sweet spot” on the efficient frontier, a spot where most real-life portfolios are likely to cluster.
Journal: Financial Analysts Journal
Pages: 70-82
Issue: 4
Volume: 61
Year: 2005
Month: 7
X-DOI: 10.2469/faj.v61.n4.2744
File-URL: http://hdl.handle.net/10.2469/faj.v61.n4.2744
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Author-Name: J. Benson Durham
Author-X-Name-First: J. Benson
Author-X-Name-Last: Durham
Title: More on Monetary Policy and Stock Price Returns
Abstract: 
 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. No one would argue that Federal Reserve policy is irrelevant to financial markets. A more focused question is whether past data on the prevailing stance of monetary policy and stock prices imply that there is an anomaly that investors can exploit to realize excess returns. A cursory read of recent research that reports an empirical link between monetary policy cycles and stock returns since the mid-1980s might prompt one to question the efficient market hypothesis (EMH) and accept the existence of such an anomaly. At least three issues prevent me from drawing such a conclusion from the data.First, the findings seem to be highly sensitive to sample selection. For example, exclusion of a single data point—the 19 October 1987 stock market crash—vitiates the findings. Also, the results vanish if the pre-1994 period (before the Federal Reserve began announcing its policy decisions) is excluded or the most recent easing cycle from 2001 through June 2004 is included. Of course, one can assail any seemingly robust statistical result with changes in the sample and torture the data until they confess. But these sample considerations, especially the increase in observations to include data past early 2001, should produce a more rigorous test of the hypothesis. At any rate, one might wish to know the effects of outliers and additional information before accepting the inference that the relationship between returns and monetary policy remains strong in recent periods.Second, this recent research does not identify an anomaly that investors can exploit today, because the dichotomous measure of monetary policy that its authors use does not distinguish new from old information, which is absolutely necessary to detect an anomaly. In research reported in this article, I used federal funds futures to separate the two components and show that if monetary policy matters for stocks, it is new, not old, information that is potentially important. In other words, unanticipated rather than anticipated monetary policy is relevant, and the last 15 years of data suggest that an anomaly never existed, even within or between investment styles and sectors. Moreover, the impact of unanticipated policy actions is, on average, of only moderate magnitude in the context of overall stock market volatility.Third, the recent research does not acknowledge that stock returns and monetary policy are probably determined simultaneously because stock prices contain information about investors' expectations for the economy and, in turn, Federal Reserve policy. Therefore, analysis based on the assumption that policy is exogenous should be viewed with suspicion.So, is Federal Reserve policy still relevant for investors? No and yes. Old information does not move stock prices. New information seems to affect equity returns, but the effect is not substantial in the context of overall stock market volatility. If the data are any guide, portfolio managers are unlikely to profit from trading strategies based on past or anticipated Federal Reserve policy decisions.
Journal: Financial Analysts Journal
Pages: 83-90
Issue: 4
Volume: 61
Year: 2005
Month: 7
X-DOI: 10.2469/faj.v61.n4.2745
File-URL: http://hdl.handle.net/10.2469/faj.v61.n4.2745
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Equity Culture: The Story of the Global Stock Market (a review)
Abstract: 
 This well-researched, readable, and engaging book traces the stock market's evolution all the way from trading in shares of investor-owned contractors in the Roman republic to the exploits of the Taiwanese stock operators of the 1980s and beyond. In addition, the author tackles several key theoretical issues involving the equity market. 
Journal: Financial Analysts Journal
Pages: 92-93
Issue: 4
Volume: 61
Year: 2005
Month: 7
X-DOI: 10.2469/faj.v61.n4.2746
File-URL: http://hdl.handle.net/10.2469/faj.v61.n4.2746
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In The Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issues.
Journal: Financial Analysts Journal
Pages: 96-96
Issue: 4
Volume: 61
Year: 2005
Month: 7
X-DOI: 10.2469/faj.v61.n4.2747
File-URL: http://hdl.handle.net/10.2469/faj.v61.n4.2747
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Author-Name: Randolph L. Hood
Author-X-Name-First: Randolph L.
Author-X-Name-Last: Hood
Title: Determinants of Portfolio Performance—20 Years Later
Abstract: 
 This piece provides information to FAJ readers from L. Randolph Hood, CFA.
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 5
Volume: 61
Year: 2005
Month: 9
X-DOI: 10.2469/faj.v61.n5.2750
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Disentangling Size and Value
Abstract: 
 The finance community has published thousands of articles about the size effect, the value effect, and other “Fama-French factors.” But size is typically defined by market capitalization, which is a product of the size multiplied by some measure of growth, such as P/E. So, capitalization is a tangled combination of size and growth. Moreover, when the analysis of other market anomalies are cap weighted and partitioned by value versus growth, size and style become interconnected in ways that undermine the measurement of the anomalies. When the size effect is separated from the value-versus-growth effect, size as measured by market cap is seen to be far less powerful than is generally believed and the value effect becomes more powerful and more consistent than generally believed. 
Journal: Financial Analysts Journal
Pages: 12-15
Issue: 5
Volume: 61
Year: 2005
Month: 9
X-DOI: 10.2469/faj.v61.n5.2751
File-URL: http://hdl.handle.net/10.2469/faj.v61.n5.2751
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Author-Name: Harry M. Markowitz
Author-X-Name-First: Harry M.
Author-X-Name-Last: Markowitz
Title: Market Efficiency: A Theoretical Distinction and So What?
Abstract: 
 With the aid of some simplifying assumptions, the capital asset pricing model comes to dramatic conclusions about practical matters, such as how to choose an investment portfolio and how to value financial assets. As illustrated in this article, when one particular, clearly unrealistic CAPM assumption is replaced by a more real-world version, some of the dramatic, practical conclusions of CAPM no longer follow. This result has implications for financial practice, research, and pedagogy. The capital asset pricing model is an elegant theory. With the aid of some simplifying assumptions, the CAPM comes to dramatic conclusions about such practical matters as how to choose an investment portfolio, how to forecast expected returns, and how to value financial assets with suitable adjustments for risk. These practical implications of the CAPM follow from two basic CAPM conclusions: (1) that the market portfolio—that is, a portfolio that holds securities in proportion to their market capitalization—is an efficient portfolio and (2) that an asset's expected return has a simple (linear) relationship to its beta.One of the simplifying assumptions of the original CAPM is that any investor can borrow without limit at the risk-free rate. As this article illustrates, the two basic CAPM conclusions no longer follow if this assumption of unlimited borrowing is replaced with that of limited or no borrowing. When borrowing is restricted, the market portfolio can be quite inefficient. Also, expected returns are not linearly related to betas.An alternate CAPM replaces the assumption of unlimited borrowing with the assumption that the investor can sell short and use the proceeds of the sale to buy long positions, without limit. In effect, it assumes that the investor can deposit $1,000 with a broker, short $1,000,000 worth of Security A, and use the proceeds of the short plus the deposit to buy $1,001,000 worth of Security B. This assumption is no more realistic than the assumption of unlimited borrowing.This alternate CAPM, like the original CAPM, implies that the market portfolio is an efficient portfolio and that expected returns are linearly related to betas. As I explain in this article, if the assumption that short proceeds can be used to buy long positions is replaced by a more real-world description of what is permitted in long-short portfolios, again, the two basic CAPM conclusions do not follow. In other words, the market portfolio may be substantially inefficient and expected returns are not linearly related to betas. These market inefficiencies would not be arbitraged away if some investors could borrow without limit, or short and use the proceeds to buy long positions without limit, while other investors could not.Thus, some of the “well-known” “conclusions” of “modern financial theory” disappear when the other assumptions of the theory are combined with more realistic descriptions of investor constraints. In particular, commonly used rules for risk adjustment and asset valuation are called into question.
Journal: Financial Analysts Journal
Pages: 17-30
Issue: 5
Volume: 61
Year: 2005
Month: 9
X-DOI: 10.2469/faj.v61.n5.2752
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Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Title: Alpha Hunters and Beta Grazers
Abstract: 
 The search for incremental returns—“alphas” in current parlance—has become the holy grail of active investment. This article begins by drawing a distinction between two broad classes of alphas: (1) “allocation alphas” that are broadly available, on a non-zero-sum basis, by moving the strategic portfolio toward a more balanced return–risk structure and (2) truly active-skill-based return enhancements derived from opportunistic inefficiencies. Inefficiencies can be hard to discern and even harder to exploit, which may help explain both why some investors are able to consistently produce positive alpha and also why they are so few in number. The search for incremental returns—“alphas” in current parlance—has become the holy grail of active investment. This article begins by drawing a distinction between two broad classes of alphas: (1) “allocation alphas” that are widely available, on a non-zero-sum basis, by moving the strategic portfolio toward a balanced return-risk structure and (2) truly active-skill-based return enhancements derived from opportunistic inefficiencies. A number of potential sources of such inefficiencies are discussed, including an excessive focus on outcomes versus process, “convoy” or herding behavior, concentration on either very short term or annual evaluation periods, Bayesian rigidity, price-target revisionism, highly channeled investment flows, implicitly inconsistent rebalancing procedures, clustering in portfolio volatilities, risk structures that are overwhelmingly dominated by the home-equity exposure, and an overly compulsive focus on maintaining a pre-established policy portfolio.One source of market inefficiencies is the rebalancing behavior of four typical categories of investors: holders, rebalancers, valuators, and shifters. Holders are individuals who tend to leave their positions unchanged as markets deteriorate. In contrast, institutions tend to be formulaic rebalancers; when the market pushes an institutional fund away from the policy portfolio allocation, they usually quickly rebalance back to the original percentage weights. Valuators take positions based on the belief that the market is either cheap or rich or based on the belief that it will continue or reverse its recent direction. Valuators can thus be contrarians or momentum followers. Shifting occurs when a fundamental change in asset allocation is required because of a fund's or an individual's situation rather than because of an assessment of the market. At times, these behaviors may overly exacerbate or overly moderate market movements, thereby creating some level of market inefficiency.Moreover, one can argue that the standard practice of rapid rebalancing back to a preset policy portfolio is theoretically inconsistent with either a purely efficient market or a (discernibly) inefficient market. One can also speculate whether the remarkable clustering of U.S. institutional portfolios on volatility in the 10–11 percent range reflects a concern with avoiding a potential triggering event so adverse that it could force a fundamental downshift in the policy portfolio.Behavioral biases of individuals and institutions create opportunities and, at the same time, stand in the way of their successful exploitation, which may help explain both why most investors fail to bring home a steady supply of positive alphas and why some few great investors do seem to develop winning records over a span of many years.
Journal: Financial Analysts Journal
Pages: 32-39
Issue: 5
Volume: 61
Year: 2005
Month: 9
X-DOI: 10.2469/faj.v61.n5.2753
File-URL: http://hdl.handle.net/10.2469/faj.v61.n5.2753
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Author-Name: William H. Gross
Author-X-Name-First: William H.
Author-X-Name-Last: Gross
Title: Consistent Alpha Generation through Structure
Abstract: 
 Successful money management over long periods of time rests on two foundations. The first is “a secular outlook”—that is, a three- to five-year forecast that forces one to think long term. The second is the “structural” composition of portfolio management—the portfolio's genetic makeup, how it is constructed without regard to short-term strategic decisions, principles that are longer than secular. Duration, curve, credit, volatility, and other tilts to a portfolio's steady-state status are a portfolio's inherent structure. Recognizing the structural elements of the investment equation will allow the investor to be the one walking away with a pile of chips. Successful money management over long periods of time rests on two, somewhat disparate, foundations. The first is “a secular outlook”—that is, a three-year to five-year forecast that forces one to think long term and to avoid the destructive bile arising from the emotional whipsaws of fear and greed. The second is what might be called the “structural” composition of portfolio management. A portfolio's structure is akin to its genetic makeup: It is how it is constructed without regard to short-term strategic decisions. Structure incorporates principles that are longer than secular; for example, duration, curve, credit, volatility, and other less obvious tilts to a portfolio's steady-state status are a portfolio's inherent structure. Those who fail to recognize the structural elements of the investment equation will leave far more chips on the table than they could ever imagine.An example of successful investment structure is banks, which have a formidable investment structure: Borrow short near the risk-free rate; lend longer and riskier. Another example is the successful Berkshire Hathaway structure, which depends on “float” combined with bottom-up, secular stock picks and has produced one of the world's greatest investment success stories. And a third example is PIMCO's BondsPLUS and related approaches. This structure involves the use of financial futures or future-related investments and the successful placement of the residual cash into higher-yielding, slightly longer-dated investments.In addition to their profit-generating elements, these structures share the common element of longevity, near permanence. They span time periods beyond the secular segments of three to five years, which define typical forecasting periods, and secular stretches of inflation/disinflation that have endured for several decades.An inherent part of the structure of the markets is the price involved in the buying/selling of volatility. The “noise” content of volatility allows for overpricing, and other features of volatility-based option prices lead to structural overvaluation and thus to profitable structural sales. For example, because the U.S. government and U.S. homeowners are systematic buyers of volatility (with little recognition of the price they are paying), others can profit structurally by taking the other side of the bet. Long-term performance numbers for mortgages versus straight agency notes, for instance, favor mortgages over almost any five-year (or longer) period. Moreover, the mispricing/overpricing of the prepayment option by U.S. homeowners leads to continuing profit opportunities. No amount of buying in the past decade seems to have “arbitraged” away the overpricing of this option.The essence of my structural investment thesis is that applying the appropriate structure to an investment portfolio over long periods of time can add value and alpha before any strategizing—short-term or secular—takes place. Individuals as well as institutional money managers can apply this structural philosophy. It can be done via the futures and options markets. Investors should do it but not overdo it. And they should pick the structures in concert with their long-term secular view of the economy.
Journal: Financial Analysts Journal
Pages: 40-43
Issue: 5
Volume: 61
Year: 2005
Month: 9
X-DOI: 10.2469/faj.v61.n5.2754
File-URL: http://hdl.handle.net/10.2469/faj.v61.n5.2754
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: Are Active Management Fees Too High?
Abstract: 
 The potential payoff from active management has waned over the past 60 years, but the price of active management is at or near its all-time high. What does this seeming paradox imply for the future of investment management? Markets appear to have become steadily more efficient during the past several decades. Nevertheless, and notwithstanding evidence that active management fees are, on balance, wasted, the price of active management has risen steadily over the same period. The most likely explanation for the rising price of asset management appears to be the phenomenal growth of investable assets that occurred during the extraordinary era of the 1980s and 1990s. Investable assets increased by more than 1,100 percent between 1980 and 2004—from $7.5 trillion to $87.2 trillion—making this quarter-century the Great Era of Asset Gathering for the investment industry.Are investment management fees “too high”? Using a model that relates the likelihood of investor success to manager skill for various levels of fees charged, I conclude that, for a large swath of the investment management business, fees are implausibly high. In the absence of a continuation of the extraordinary growth of “assets-to-be-managed” seen during the past 25 years, I offer this forecast of the future: Active management will continue to lose market share to indexing.Downward pressure on investment management fees will be evident for the first time in history, and many investors will shift from high-priced active products to lower-priced ones as they come to recognize that high fees sap the performance potential of even skillful managers.A new market segment of investment management will develop. Although it will have many of the operational features of hedge funds, it will be characterized by greater transparency than is characteristic of hedge funds and pricing in this segment will be more like that of traditional institutional investment management.
Journal: Financial Analysts Journal
Pages: 44-51
Issue: 5
Volume: 61
Year: 2005
Month: 9
X-DOI: 10.2469/faj.v61.n5.2755
File-URL: http://hdl.handle.net/10.2469/faj.v61.n5.2755
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:5:p:44-51




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Author-Name: Richard Grinold
Author-X-Name-First: Richard
Author-X-Name-Last: Grinold
Title: Implementation Efficiency
Abstract: 
 An analysis of risk, covariance, and correlation is used to measure the implementation losses that arise as a result of transaction costs and investment constraints. Losses are measured relative to an ideal, costless, and unconstrained implementation. The figure of merit is mean-variance expected utility expressed as portfolio alpha minus penalties for active variance and transaction costs. In a general setting, before-cost results are found that define the opportunity loss and identify its sources. In a specific case, after-cost results are found that enable prediction of how expected utility and information ratios are influenced by the investment process, information turnover, risk aversion, and transaction costs. The efficient management of investment portfolios requires an ability to understand, measure, forecast, and manage risk, return, and costs. In this article, I demonstrate how the tools of portfolio analysis—namely, analysis of risk, covariance, and correlation—can be used to understand, measure, and forecast the implementation losses that arise because of transaction costs and investment restrictions.An ideal, costless and unconstrained, implementation strategy is established as a benchmark; then, any actual implementation is measured relative to that ideal. The figure of merit is mean-variance expected utility expressed as portfolio alpha minus penalties for active variance and transaction costs. The difference between where we would like to be (the ideal) and where we are is called the “backlog.” The backlog is the basket trade that would move us to an ideal holding. The loss in expected utility for any implementation is equal to the variance penalty for that backlog position. The correlation of the actual and ideal implementations is the transfer coefficient; the information ratio of any implementation is equal to the information ratio of the ideal implementation multiplied by the transfer coefficient. Moreover, the ratio of the objective values (before costs) for the actual and ideal implementations is bounded above by the transfer coefficient squared. Thus, a transfer coefficient of 0.7 indicates that we are getting less than 50 percent of the potential utility. This analysis lets me demonstrate, through an example, a general procedure for allocating the utility loss to constraints and costs.I consider a specific model that provides after-cost results in a simple analytic form. This model has four drivers: the power of our information, the half-life (shelf life) of our information, our risk aversion, and a model of transaction costs. These four factors determine, in a relatively simple way, the resulting nature of the investment in terms of active risk level, expected alpha, and expected transaction costs per year. The model is used to demonstrate the sensitivity of after-cost investment performance to changes in the half-life of the investment insights and to various levels of transaction costs.
Journal: Financial Analysts Journal
Pages: 52-64
Issue: 5
Volume: 61
Year: 2005
Month: 9
X-DOI: 10.2469/faj.v61.n5.2756
File-URL: http://hdl.handle.net/10.2469/faj.v61.n5.2756
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# input file: UFAJ_A_12047618_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jack Treynor
Author-X-Name-First: Jack
Author-X-Name-Last: Treynor
Title: Why Market-Valuation-Indifferent Indexing Works
Abstract: 
 Using market values for indexing gives more portfolio weight to the stocks with positive price errors and less portfolio weight to the stocks with negative price errors. Market-valuation-indifferent indexing—such as equal weighting or weighting by number of employees, number of customers, or sales—relies on averaging over hundreds of stocks to give equal weight to the two groups. Stock markets price stocks imperfectly, but the mispricings are always relative. Because overpriced stocks are counterbalanced by underpriced stocks, the distribution of error at any point in time is symmetrical. One can picture this distribution as a bell-shaped curve with “error” on the horizontal axis and some measure of “frequency” on the vertical axis. Because it reflects both the number of companies in the market and their size, aggregate value is the appropriate measure of frequency, but which measure of aggregate value—true value or market value?Large positive errors increase the market value of the stocks with those errors, and large negative errors reduce the market value of stocks with those errors. Unlike a distribution of the pricing error based on true value, the error distribution for market values will be skewed to the right. This lack of symmetry is the problem with capitalization weighting: By using market values to determine its weights, a cap-weighted index fund will invest more money in overpriced stocks than in underpriced stocks.Market-value-indifferent (MVI) indexing avoids this problem. An example is an equally weighted (or constant-weight) portfolio. The problem with equal weighting is that it will have a strong small-cap bias. Other weighting schemes reduce or even reverse the bias.
Journal: Financial Analysts Journal
Pages: 65-69
Issue: 5
Volume: 61
Year: 2005
Month: 9
X-DOI: 10.2469/faj.v61.n5.2757
File-URL: http://hdl.handle.net/10.2469/faj.v61.n5.2757
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:5:p:65-69




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# input file: UFAJ_A_12047619_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Roger Clarke
Author-X-Name-First: Roger
Author-X-Name-Last: Clarke
Author-Name: Harindra de Silva
Author-X-Name-First: Harindra
Author-X-Name-Last: de Silva
Author-Name: Steven Thorley
Author-X-Name-First: Steven
Author-X-Name-Last: Thorley
Title: Performance Attribution and the Fundamental Law
Abstract: 
 The reported study operationalized the “fundamental law of active management” in the context of a factor-based performance attribution system. The system incorporates factor payoffs in the linear regression framework that many portfolio managers and external reviewers use to judge what is being rewarded in the market. The study indicates that parameters of the fundamental law can be used to approximate and interpret the results of the regression-based performance attribution system. The procedure is illustrated by the use of security holdings, returns, and factor exposure data for two portfolios benchmarked to the S&P 500 Index for April 1995 to March 2004. The study reported here operationalized the “fundamental law of active management” by using a factor-based performance attribution system that identifies the sources of benchmark-relative returns in actively managed portfolios. Some of the relative return can be ascribed to marketwide factor exposures that differ from the benchmark, such as beta, company size, and company sector membership, and the realized payoffs to those factors. Relative performance not captured by these marketwide factors is generally attributed to security selection. In practice, the information content of the security-ranking system is often measured by an information coefficient or the performance of stocks grouped within quantile rankings, with little attempt to relate the success of the security-ranking system to its actual basis point contribution to performance. In this article, we show how a regression-based attribution system can be extended to decompose the active return associated with stock selection into the information content of the rankings and constraint-induced noise.The fundamental law of active management shows that, in addition to the forecasting power of the ranking system, performance is also influenced by how well the manager is able to structure the portfolio to capture the most attractive securities. The relationship between the security rankings and actual over- and underweight positions in the portfolio is measured by the transfer coefficient. A previous extension of the fundamental law demonstrated that the lower the transfer coefficient, the more noise in the active return. The procedures we discuss here allow the contribution from the security rankings to be separated from the noise component and give the manager insight into the determinants of portfolio performance.To illustrate the attribution procedure and test the accuracy of the fundamental law, we collected data on two portfolios benchmarked to the S&P 500 Index for the 108 months of April 1995 to March 2004. We examined performance attribution results for both a long-only portfolio and a long-short portfolio constructed on the basis of the same signal. The results illustrate the advantages in implementation efficiency of long-short strategies. Despite the simplifying assumptions used in the fundamental law mathematics, our estimates of signal and noise contributions were within a basis point per month of the contributions from regression analysis. We next used the 108 monthly time-series observations to test two key predictions of the fundamental law: an ex ante or expectational relationship for the information ratio and an ex post relationship describing the sources of realized variance in active returns.The fundamental law yields predictions about the expected value and variance of active returns under the assumption of fixed parameter values. Thus, the perfect empirical test of the fundamental law predictions requires repeated observations of the same month (or a time series without any structural changes in the market). In practice, covariance matrices and the underlying effectiveness of security-ranking procedures change over time, so our nine years of monthly observations provided only a rough check on the fundamental law predictions. Nevertheless, using the time-series averages as proxies for fixed parameter values, we found that the average information ratio in our sample is reasonably close to the value predicted by using the ex ante fundamental law equation with a transfer coefficient. In addition, the proportions of realized performance variance attributable to signal success and to constraint-induced noise are related to the squared transfer coefficient but with a bias toward more signal contribution than the ex post fundamental law equation predicts. Our subperiod analysis suggests that this bias results from nonstationarities inherent in real markets over time.
Journal: Financial Analysts Journal
Pages: 70-83
Issue: 5
Volume: 61
Year: 2005
Month: 9
X-DOI: 10.2469/faj.v61.n5.2758
File-URL: http://hdl.handle.net/10.2469/faj.v61.n5.2758
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Sociology of Financial Markets (a review)
Abstract: 
 This well-edited book documents intriguing perspectives on the investment world that are emerging from sociology on personal interactions in such settings as trading floors, corporate boards of directors, and central bank policy-making committees.
Journal: Financial Analysts Journal
Pages: 84-84
Issue: 5
Volume: 61
Year: 2005
Month: 9
X-DOI: 10.2469/faj.v61.n5.2759
File-URL: http://hdl.handle.net/10.2469/faj.v61.n5.2759
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Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Secrets of Economic Indicators: Hidden Clues to Future Economic Trends and Investment Opportunities (a review)
Abstract: 
 This timely and necessary contribution to understanding the construction process for U.S. and global economic indicators excels in describing the economic data—why the variable is important, how it is computed, and what it says about the future. 
Journal: Financial Analysts Journal
Pages: 85-86
Issue: 5
Volume: 61
Year: 2005
Month: 9
X-DOI: 10.2469/faj.v61.n5.2760
File-URL: http://hdl.handle.net/10.2469/faj.v61.n5.2760
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In The Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issues.
Journal: Financial Analysts Journal
Pages: 88-88
Issue: 5
Volume: 61
Year: 2005
Month: 9
X-DOI: 10.2469/faj.v61.n5.2761
File-URL: http://hdl.handle.net/10.2469/faj.v61.n5.2761
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:5:p:88-88




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Author-Name: Katrina F. Sherrerd
Author-X-Name-First: Katrina F.
Author-X-Name-Last: Sherrerd
Title: Letter to Readers
Abstract: 
 This piece provides information to FAJ readers from Katrina F. Sherrerd, CFA.
Journal: Financial Analysts Journal
Pages: 8-9
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2765
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2765
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: FAJ Book Reviews: For Relevance, Value, and Scope
Abstract: 
 This piece provides information to FAJ readers from Martin S. Fridson, CFA.
Journal: Financial Analysts Journal
Pages: 10-11
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2766
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2766
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: The Pension Problem: On Demographic Time Bombs and Odious Debt
Abstract: 
 Much has been written recently, particularly after 2000–2002 left pensions in tatters, about the challenge of meeting pension obligations. The challenge discussed here is interesting and multifaceted—embracing issues of demographics, reasonable expectations, business ethics, stakeholder interests, the social compact, and intergenerational equity. The first step is to acknowledge the reality that assuming investments will earn a risk premium without acknowledging the risk that they will not deliver a premium disguises the real size of pension liabilities. 
Journal: Financial Analysts Journal
Pages: 12-17
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2767
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2767
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Author-Name: Henry Kaufman
Author-X-Name-First: Henry
Author-X-Name-Last: Kaufman
Title: Biases and Lessons
Abstract: 
 Today's financial community is suffering from a failure to learn the lessons of the past and from biases that cannot be overcome by all our quantitative techniques. Primary lessons involve the limitations in our modeling and forecasting, the occasional irrationality of the market, and the need to focus on our fiduciary responsibilities. Biases can blind us to the remembrance that the future does not repeat the past and to the inevitability of hard times. During the 60 years of the Financial Analysts Journal's existence, the financial markets have grown in size much more than the economy itself, new credit instruments have come to play important roles in portfolio management and trading, and the volume of new issues and secondary-market trading has grown tremendously. Together with the unprecedented growth and innovations, however, have come financial mishaps, scandals, and credit market upheavals. Investors, institutions, and official authorities should have learned important lessons from this history, but I suspect we have not learned the necessary lessons. We are plagued by financial misconceptions and biases.Many market participants still lose sight of the distinction between the marketability and the liquidity of an obligation. The narrow credit spreads that seem to give emerging market debt and corporate junk bonds such allure when the financial system is awash with credit are only temporary symptoms of marketability, not true liquidity.With the rapid growth of securitization has come the imperfect practice of marking to market. Investors need to realize that when market conditions deteriorate and liquidity declines, one cannot really claim that the last quoted price (even in organized markets or quoted by dealers in the OTC market) is the real market price.The modeling of risks has great limitations. The increasing reliance on quantitative models is understandable; models are comforting, and the quantitative and econometric techniques developed in the last generation have given investors and portfolio managers a sense of confidence in their ability to forecast financial trends and behavior. But models are basically backward looking. They are essentially useless when an underlying structure, such as liquidity, changes. Moreover, models are built on assumptions of rationality, and rational analytical techniques cannot predict extremes in financial behavior.Related to these underlying biases are the rise and prominence of “the consensus forecast.” The concept is understandable. Being with the consensus minimizes risk and avoids isolation; running with the crowd is comfortable; one cannot be singled out for blame or targeted because of success. As a practical matter, however, the consensus forecast cannot be accurate. If a large number of market participants could anticipate big shifts in economic and financial behavior, they would act accordingly, heading off the dramatic changes in the first place.Our forecasting is biased by the weight of history, reinforced by statistical averaging. The widespread impulse to believe that the future is grounded in the past is, again, understandable, but it should be viewed with great caution and skepticism. The critical ingredient in making good projections is often a matter of identifying what differs from the past.We suffer from a clear and chronic bias against negative predictions. People are inclined to optimism, and negative forecasts make for bad politics. Negative forecasts, however, are often the accurate forecasts.Even if one could deliver an absolutely correct forecast of impending crisis, our large business organizations and financial institutions do not have the will (or perhaps the capacity) to take advantage of it. Their people, their machinery, their procedures—all are geared to build market share and to expand. When contraction or crisis forces corporate restructuring, seldom is the process managed with vision. Moreover, when downsizing comes, the resulting write-offs—certainly a reflection of earlier management errors—are heralded by the market. This lack of intellectual honesty extends to the accounting treatment of the losses as one-time write-offs.The most important lesson that we have not yet learned well is that people in finance are entrusted with an extraordinary responsibility—namely, other people's money. This basic fiduciary duty is too often forgotten in our high-voltage, high-velocity financial environment. Our job, however, is to make critical judgments about how to channel money and credit into a broad range of economic activities. To carry out this singular and crucial task properly requires objectivity and a strong appreciation of the public trust in our hands.When this responsibility is not carried out, when financial institutions are not reined in, the causes are laxity on the part of the senior managers of financial institutions; the failure of our professional schools to emphasize economic and financial history, ethics, and the values and responsibility inherent in prudent financial behavior; and the asymmetrical actions of the Board of Governors of the Federal Reserve System. When asset values fall suddenly, the Fed usually eases monetary policy to provide greater liquidity and to counteract any decline in domestic spending. When asset prices advance strongly, however, the Fed usually does not respond by tightening monetary policy in a timely fashion. This asymmetry has given rise to an expectation in the market that faulty investments will be bailed out by the central bank.Eventually, many of these neglected lessons and biases will be learned and overcome. If history is any guide, however, the learning may well not occur until after another round of financial adversity.
Journal: Financial Analysts Journal
Pages: 18-21
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2768
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2768
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:6:p:18-21




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Author-Name: John C. Bogle
Author-X-Name-First: John C.
Author-X-Name-Last: Bogle
Title: The Relentless Rules of Humble Arithmetic
Abstract: 
 The message of this article is simple, obvious, and almost invariably ignored by the investment community: Gross return in the financial markets minus the costs of financial intermediation equals the net return actually delivered to investors. This equation helps explain the failure of the mutual fund industry to deliver to shareholders their fair share of market returns, and it explains the enormous shortfall in the assets of the private and public retirement systems relative to their pension liabilities. It is high time for investment professionals to consider not only the “comparative advantage” of outmanaging their peers but also the “community advantage” that would result from a major reduction in the costs of our investment system. The overarching reality of our system of financial intermediation is both simple and obvious: Gross returns in the financial markets minus the costs of investing equal the net returns actually delivered to investors. Despite the importance of this reality to the collective wealth and security of our citizenry, the investment community has a vested interest in ignoring it.To explain the dire odds that investors face in their quest to beat the market, then, we don't need the efficient market hypothesis; we need only the “cost matters hypothesis” (CMH). Under the CMH, the returns earned by investors as a group must fall short of the market return by precisely the amount of the aggregate costs investors incur. By virtue of the “relentless rules of humble arithmetic,” all of us in the aggregate are average before costs and below average once our investment costs are deducted.America's investment system—our government retirement programs, private retirement programs, and all of the securities owned by stockowners as a group—is plagued by these relentless rules. Just as a gambler's winnings come only from what remains after the croupier's rake descends, so investors' winnings come only after intermediation costs. And these costs devastate long-term returns.This devastation is clearest in the mutual fund industry, the largest of all U.S. financial intermediaries. The enormous but often invisible costs of mutual fund investing and the counterproductive market timing and fund selection decisions made by mutual fund investors have caused the average investor to earn only about 25 percent of the market's cumulative nominal return over the past 20 years. Policymakers must enforce the fiduciary standard implicit in the Investment Company Act of 1940: Mutual funds must be organized, operated, and managed in the interests of their shareholders.The massive shift from defined-benefit to defined-contribution plans in the past 30 years has transferred much of the risk of retirement funding from Corporate America to Main Street America, and the results, thus far, are worrisome. Only 22 percent of U.S. workers save for retirement in a 401(k) thrift plan; a mere 10 percent save through an IRA. And the average balance in each—$33,600 and $26,900, respectively—is hardly the kind of capital necessary to provide a comfortable retirement.Corporate America also has come to ignore these relentless rules. The excessive returns corporations have projected for their pension funds have fostered a substantial underfunding of these plans. Projecting pension fund returns at the current 8.5 percent level allows a corporation to report higher earnings to its shareholders, but such a return has little basis in reality in today's environment.Today, the investment management profession is overwhelmingly focused on “comparative advantage”—providing superior returns to clients. We ignore the fact that in the essentially closed system in which financial markets operate, each dollar of advantage that one professional earns comes at the direct expense of another. As a group, we're average. After costs, we're all destined to fall short of the market return, victims of the relentless rules of humble arithmetic.It is time to expand our pursuit to “community advantage”—providing a higher share of market returns to our clients as a group. This achievement will be possible only by working to reduce system costs. If we do that, capitalism will work better for all stockowners as a group.Two powerful forces stand in the way of realizing this goal. The first is money: Financial intermediaries have become addicted to the stunning profits available in this industry. The second is the failure of financial agents to protect the interests of their principals.In addition to changing the structure, costs, and focus of our system of financial intermediation, we need to change the philosophy of our trustees. As the relentless rules of humble arithmetic and the increased awareness of fiduciary concepts begin to resonate with the investing public, as they inevitably will, we in the financial community, in our own enlightened self-interest, must live up to the responsibilities that we are duty bound to honor.
Journal: Financial Analysts Journal
Pages: 22-35
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2769
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2769
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Author-Name: Clifford S. Asness
Author-X-Name-First: Clifford S.
Author-X-Name-Last: Asness
Title: Rubble Logic: What Did We Learn from the Great Stock Market Bubble?
Abstract: 
 The Financial Analysts Journal's 60th anniversary happens to coincide with the five-year anniversary of the peak of the Great Stock Market Bubble of 1999–2000. The combination of proximity in time, with just a bit of distance, makes this year an appropriate time to consider what we may have learned from this momentous event. This article suggests lessons that, if we haven't learned them, we should have. The Financial Analysts Journal's 60th anniversary happens to coincide with the five-year anniversary of the peak of the Great Stock Market Bubble of 1999–2000. The combination of proximity in time, with just a bit of distance, makes this year an appropriate time to consider what we may have learned from this momentous event. In this article, I suggest lessons for our postbubble world:Long-term average stock returns are poor forecasters of the future.Higher prices today mean lower expected returns tomorrow.Today's high stock prices have two possible meanings: (1) P/Es will revert to the mean with poor short-run returns but, then, historically more normal premiums and returns, or (2) stocks will return somewhat less in the future than they have historically.Long-term investors should not be 100 percent in stocks.International diversification is not a waste of time.Dividends are good and for some surprising reasons; when companies pay out more in dividends, their earnings tend to grow strongly faster over the next decade than when they pay less in dividends.Earnings do not grow at 10 percent a year. If we take a forecast of 2 percent long-term real EPS growth and add it to an assumed steady 2–3 percent inflation from now on, we find that history favors a 4–5 percent long-term nominal EPS growth for the future.The Fed Model must be fought.Value wins in the long term.Arbitrage has real limits; everyone votes on stock prices.Wall Street and the media are not looking out for you.You cannot trust Wall Street to compare apples to apples; beware of pro forma anything.Options issuance is an expense.Timing the market is not all bad. Short-term market timing is almost always bad (in an expected sense), but changing exposure to the stock market based on current prices with a long horizon in mind is a form of market timing that can be beneficial, particularly at extremes.The general public is full of bored, innumerate gamblers.Do-it-yourself trading is a bad idea.Despite many negative signs, I see positive portents that we have learned many of the lessons of the bubble. The idea that future long-term returns will be low has certainly gained traction. However, all is not rosy. For instance, some of the widespread arguments in favor of investing Social Security funds in the stock market reflect vestiges of Bubble Logic.We basically know how to invest. Some simple, but not easy, advice for good investing and financial planning in general includes the following: Diversify widely; keep costs low; rebalance in a disciplined fashion; spend less and save more; make less heroic assumptions about future returns; when something sounds like a free lunch, assume it is not free unless the arguments are very convincing—and then check again; stop watching the stock markets as if they were on ESPN; and work less on investing, not more.The stock market is quite wonderful. In our free capitalist society, it leads to wealth creation, democracy, and economic efficiency. So, the importance of careers in finance to society is exceptional. Doing a good job of giving advice and accurate pricing is vital, something to be proud of, and certainly too important to be left to Bubble Logic.
Journal: Financial Analysts Journal
Pages: 36-54
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2770
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2770
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:6:p:36-54




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Author-Name: Peter L. Bernstein
Author-X-Name-First: Peter L.
Author-X-Name-Last: Bernstein
Title: Capital Ideas: From the Past to the Future
Abstract: 
 Modern finance theory, modern portfolio theory, neoclassical economics—the ideas bestowed on us in 1952–1973 by the giants in our field—are alive and well. Challenges to the efficient market theory, the capital asset pricing model, and mean–variance efficiency have been raised, but while recognizing that the assumptions of the theories do not hold up empirically, we still lean on the ideas and develop them in new directions. To say that this body of work is obsolete is to say that Aristotle and Euclid are obsolete. The body of thought that we consider modern finance theory is extraordinarily important. It infuses most of what investment analysts and managers do and influences how we think, whether we think about it positively or negatively.It is a remarkable story: In the space of 21 years, from 1952 to 1973, an entire body of knowledge was created essentially from scratch, with only a few scattered roots in the past. Nothing in the history of ideas can compare with this cascade of ideas in such a short period of time. Before the creators of modern finance theory, we had no genuine theory of portfolio construction, no genuine theory of asset pricing, no general theory of corporate finance, and no recognition of the overwhelmingly powerful concept of arbitrage. We had only rules of thumb and folklore.The academic creators of all these models knew that the real world is different from the models, but they were in search of a process, a systematic understanding of how markets work, how investors interact, and how portfolios should be composed. They understood that financial markets are about capitalism—a dynamic, complex, rough-and-tumble system in which there are always winners and losers.Of course, modern portfolio theory (MPT) has been challenged. Some have attacked the assumption of a normal distribution in the market as not being the way the world works. The major competing doctrine is in the behavioral finance literature. Prospect theory has revealed that we are risk takers when we have losses and risk averse when we have profits. We tend to emphasize recent news rather than long-term trends, and we yield to powerful, mysterious phenomena—herding and a taste for momentum. The key question is whether the flaws that behavioral finance reveals imply that MPT is irrelevant or whether behavioral finance provides fresh insights. Is behavioral finance the new paradigm?Despite all the anomalies and all the manifestations of a lack of rationality in the markets, and with individualistic, Darwinian markets, the ideas bestowed on us in 1952-1973 by the giants in our field—modern finance theory, modern portfolio theory, neoclassical economics—are alive and well. The assumptions of the theories do not hold up empirically, but we still lean on the ideas and develop them in new directions. To say that this body of work is obsolete is to say that Aristotle and Euclid are obsolete.
Journal: Financial Analysts Journal
Pages: 55-59
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2771
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2771
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:6:p:55-59




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Author-Name: Jeremy J. Siegel
Author-X-Name-First: Jeremy J.
Author-X-Name-Last: Siegel
Title: Perspectives on the Equity Risk Premium
Abstract: 
 The equity risk premium has commanded the attention of professional economists and investment practitioners for decades. It is critical in financial economics; it determines asset allocations, projections of retirement and endowment wealth, and the cost of capital. Economists are still searching for a simple model that justifies the premium in face of the much lower volatility of aggregate economic data. Although the future equity risk premium is apt to be lower than it has been historically, U.S. equity returns of 2–3 percent over bonds will still amply reward those who will tolerate the short-term risk of stocks. The equity risk premium—the difference between the expected return on stocks and the return on risk-free assets—is one of the most important numbers in finance. If geometric average returns are used and the premium is measured against the return on long-term government bonds, the premium in the U.S. markets has risen from 3.31 percent for 1802–1926 to 4.53 percent since 1926. The equity premium, which is only slightly lower in other countries than in the United States, is significantly higher than can be explained by economic models using reasonable levels of risk aversion.Changes in the standard economic model have yielded some promising results. The size of the equity premium can be shown to be related to habit formation in consumption, the riskiness of labor income, and a condition called “loss aversion” that is emphasized in behavioral finance. Fat-tailed risks and long-term cycles that are not represented by the standard normal distribution can also lead to an increase in the equity premium.In the future, because of sharply lower transaction costs and the ability of investors to hold fully diversified portfolios, stock prices should rise relative to fundamentals and reduce the future real returns from equities by about 100 bps, to 5.5–6.0 percent. If future real bond yields return to their long-run historical average of 3.0–3.5 percent, the equity risk premium will settle at 2–3 percent, a level that is consistent with many money managers' expectations. If future real bond returns remain in the 1.5–2.0 percent range that they have fallen to in recent years, the equity risk premium is likely to return to the 4.5 percent level achieved since 1926.The search for the right model of the equity risk premium has yielded insights that can guide practitioners in structuring their clients' portfolios. First, habit formation implies that an investor's short-term and long-term attitudes toward risk may differ. Second, an investor's labor income may cause significant differences in asset allocation. Third, the idea that risk aversion becomes extremely high at low levels of consumption has given rise to “liability investing,” in which investors, especially those approaching retirement, fund what they deem absolute minimum expenditures with risk-free assets and allocate the rest according to the usual risk and return trade-offs.
Journal: Financial Analysts Journal
Pages: 61-73
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2772
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2772
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Author-Name: Don Ezra
Author-X-Name-First: Don
Author-X-Name-Last: Ezra
Title: Retirement Income Guarantees Are Expensive
Abstract: 
 Traditional defined-benefit pension plans depend on funding by employers to preserve the security of their income guarantees. The U.S. Social Security system depends on demographic stability. In both cases, security has proven to be elusive. In neither case does one find contingency reserves created in good times to help sustain security in bad times. Instead, society turns to defined-contribution arrangements, thereby throwing the risk onto individuals. Individuals have their own problems to cope with, however, involving uncertainty of both longevity and investment returns. The unsurprising lesson overall is: Eliminating risk is expensive. It is all too easy, and all too tempting, to forget in good times that retirement income guarantees are expensive. Employee benefit plans, the U.S. Social Security system, and individual retirement arrangements—all confirm this lesson.When the U.S. Congress passed the Employee Retirement Income Security Act in 1974, it strengthened the funding requirements for corporate defined-benefit (DB) pension plans. Congress failed to recognize, however, that uncertain investment returns create risk, which in turn requires funding flexibility so that contingency reserves can be built up in good times and drawn down in bad times. Instead, Congress imposed further restrictions in the 1980s, restrictions that ensured an underfunding bias in DB plans.In addition, actuaries, ignoring equity risk in their valuations, have assumed simply that the risk premium will be realized. In consequence, actuarial funding targets make benefits insecure. Moreover, the confusion between a funding target (which ignores risk) and the value of the benefit (which is based on a risk-free return) leads to defined benefits being underpriced.Sponsors need flexibility to underwrite defined benefits for employees. And employees need to recognize that the cost of the defined benefits is higher than commonly thought.In the Social Security system, the mechanism for security is a demographic balance between retirees and contributors. This balance has become unsustainable in the United States, as in many countries. But no contingency reserve was built while Baby Boomers were contributing to the system, so Social Security benefits are now subject to political risk.Both in traditional employer plans and in Social Security, income guarantees are under attack. This development is a pity because defined benefits are healthy for society. They enable individual risks to be shared by groups, thereby making retirement incomes secure.In the corporate world, defined-benefit plans are rapidly being replaced by defined-contribution plans. Defined-contribution arrangements, however, leave individuals facing two forms of uncertainty in generating retirement income—longevity and investment returns. Experts understand investment uncertainty and speak of distributions and standard deviations of returns. Lifespan uncertainty needs to be understood, and explained, in a similar way. What is the standard deviation of life expectancy? Planners should be as familiar with this concept as they are with the standard deviation of equity returns.Coping with both kinds of uncertainty is difficult and costly, particularly when interest rates are low and the present value (cost) of a fixed retirement income increases. To guarantee their retirement income, many individuals have to take on investment risk or reduce their hoped-for standard of living—or both.Risk is not nice. But retirement income guarantees are expensive.
Journal: Financial Analysts Journal
Pages: 74-77
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2773
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2773
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Author-Name: Jeffrey J. Diermeier
Author-X-Name-First: Jeffrey J.
Author-X-Name-Last: Diermeier
Title: Remember the Age and Purpose of Our Profession
Abstract: 
 We should remember two aspects about our profession. The first is that we began as an honest and noble profession that adhered to the concept of “fiduciary.” The second is that we are a young profession and should not accept our history as “the norm” or as predictive of the future. The series of Reflections articles has been a wonderful treasure of thought and perspectives from some of our best. The opportunity to have noted students of capital markets sit back and share their accumulated wisdom meets the test of the extraordinary.Two aspects drawn from my experience that I would like us to reflect on are (1) our origins and (2) the age of our profession.In the 1970s when I joined this profession, rarely would the question of whether a young apprentice's motivation was greed have arisen. The profession was honest and noble, and the whole investment community adhered to the concept of “fiduciary.” We knew that the only way to make a living in this business was to deliver the goods. Sadly, all these characteristics have changed. And some of our newcomers are amazed to think that this profession was ever anything but “a money job.” We need to remember our roots.The people who are reading this article, however, are largely in “the choir” and don't need preaching to remind them of their duties and ethical responsibilities. The question is how to spread the preaching to other choirs. One way is through the actions of our readers. We can succeed as a profession only by placing client interests above all else. Investment management is about service and integrity. If readers execute this philosophy well, they can generate a highly profitable business in the classic economic definition of profit and be true to basic principles.In addition to our fiduciary roots, we need to remember that our profession is very young. When I began work, supposedly normal equilibrium conditions were still in the formative phase. Conventional wisdom about the key relationships in the markets suffered from severe overconfidence. The theory and science developed in the 1970s, together with the pension explosion of that time, changed our thinking, and we should not accept our history as the norm or as predictive of the future. We should not close off debate about relationships in the markets. They will change, because after all, markets are largely about ideas and people.
Journal: Financial Analysts Journal
Pages: 78-79
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2774
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2774
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Handle: RePEc:taf:ufajxx:v:61:y:2005:i:6:p:78-79




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Author-Name: Burton G. Malkiel
Author-X-Name-First: Burton G.
Author-X-Name-Last: Malkiel
Author-Name: Atanu Saha
Author-X-Name-First: Atanu
Author-X-Name-Last: Saha
Title: Hedge Funds: Risk and Return
Abstract: 
 From a database that is relatively free of bias, this article provides measures of the returns of hedge funds and of the distinctly nonnormal characteristics of the data. The results include risk-adjusted measures of performance and tests of the degree to which hedge funds live up to their claim of market neutrality. The substantial attrition of hedge funds is examined, the determinants of hedge fund demise are analyzed, and results of tests of return persistence are presented. The conclusion is that hedge funds are riskier and provide lower returns than is commonly supposed. Hedge funds have become an increasingly popular asset class since the early 1990s. The amount invested globally in hedge funds rose from approximately $50 billion in 1990 to approximately $1 trillion at the end of 2004. And because these funds characteristically use substantial leverage, they play a far more important role in the global security markets than the size of their net assets indicates. Market makers on the floor of the NYSE have estimated that during 2004, trades by hedge funds often accounted for more than half of the total daily number of shares changing hands. Moreover, investments in hedge funds have become an important part of the asset mix of institutions and even wealthy individual investors. Hedge funds are marketed as an “asset class” that provides generous returns during all stock market environments and thus serves as excellent diversification for an all-equity portfolio.This article reports our study of a reasonably comprehensive database of hedge fund returns. We examine the magnitude of two substantial biases that can influence measures of hedge fund performance in the data series—backfill bias and survivorship bias. We conclude that these biases may be far greater than has been estimated in previous studies. We examine not only the returns of hedge funds but also the distinctly nonnormal characteristics of the returns. We also investigate the substantial attrition of hedge funds, analyze the determinants of hedge fund demise, and provide the results of tests of return persistence.We show that the practice of voluntary reporting and the backfilling of only favorable past results can cause returns calculated from hedge fund databases to be biased upward. Moreover, the considerable attrition that characterizes the hedge fund industry results in substantial survivorship bias in the returns of indices composed of only currently existing funds.Correcting for such biases, we found that hedge funds have lower returns than is commonly supposed. Moreover, although the funds tend to exhibit low correlations with general equity indices and, therefore, are excellent diversifiers—hedge funds are extremely risky along another dimension: The cross-sectional variation and the range of individual hedge fund returns are far greater than they are for traditional asset classes. Thus, investors in hedge funds take on a substantial risk of selecting a dismally performing fund or, worse, a failing one.
Journal: Financial Analysts Journal
Pages: 80-88
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2775
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2775
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Author-Name: Moshe A. Milevsky
Author-X-Name-First: Moshe A.
Author-X-Name-Last: Milevsky
Author-Name: Chris Robinson
Author-X-Name-First: Chris
Author-X-Name-Last: Robinson
Title: A Sustainable Spending Rate without Simulation
Abstract: 
 Financial commentators have called for more research on sustainable spending rates for individuals and endowments holding diversified portfolios. We present a forward-looking framework for analyzing spending rates and introduce a simple measure, stochastic present value, that parsimoniously meshes investment risk and return, mortality estimates, and spending rates without resorting to opaque Monte Carlo simulations. Applying it with reasonable estimates of future returns, we find payout ratios should be lower than those many advisors recommend. The proposed method helps analysts advise their clients how much they can consume from their savings, whether they can retire early, and how to allocate their assets. As the Baby Boomers approach their retirement years, the finance profession is developing a pressing need for more research on sustainable spending rates from suitable investment portfolios. This article meets the demand by developing a forward-looking framework for modeling sustainable spending rates as a function of biological age and portfolio composition. The framework is also applicable to endowments and foundations that hold diversified investment portfolios.We introduce the concept of a stochastic present value (SPV) of a retirement plan that parsimoniously meshes portfolio investment parameters, mortality estimates, and inflation-adjusted spending rates. We avoid resorting to opaque and hard-to-replicate Monte Carlo simulations or backward-looking historical analyses for computing probabilities of “retirement ruin”—that is, the probability that a retirement plan is unsustainable. At best, these analytics can be used to calibrate and test the accuracy of more complicated simulations.The article's key analytic contribution is to recognize that the SPV is well approximated by a reciprocal gamma distribution. Therefore, the probability of sustainability—or 1 minus the probability of retirement ruin—can be computed by evaluating the cumulative distribution function of this distribution at the current value of the retirement nest egg.In fact, the resulting formula is easily coded in Microsoft Excel. Using it, we show that a 65-year-old retiree faces a 10 percent chance of running out of money during the stochastic length of the retirement if he or she consumes more than $4 per $100 principal of an all-equity portfolio with an expected real return of 7 percent and volatility of 20 percent (which leads to a geometric mean return of 5 percent). A diversified portfolio of stocks and bonds can support retirement spending of $5 per $100 at age 65 with the same 10 percent probability of ruin.The payout ratios implied by these examples are well below the optimistic spending rates recommended by many investment advisors, who erroneously believe that a portfolio earning a real return of 7 percent on average can support a spending rate of 7 percent on average. Moreover, if one's view on real equity returns and risk premiums is that they will be much lower than 7 percent arithmetically or 5 percent geometrically, then spending rates must be suitably reduced.These results should also shed light on the relative merits of longevity insurance and payout annuities for individuals, which can be shown—within this framework—to increase the sustainability of a portfolio by creating an income stream that cannot be outlived.In summary, the ideas we develop should help financial analysts advise their clients about (1) how much they can consume from their savings, (2) whether they can afford to retire early, and (3) the ruin implications of various investment strategies. On a broader scale, we hope this research motivates practitioners in the financial services industry to change their mind-set from a wealth accumulation framework to an income and disbursement mode.
Journal: Financial Analysts Journal
Pages: 89-100
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2776
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2776
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Hidden Financial Risk: Understanding Off-Balance Sheet Accounting (a review)
Abstract: 
 This book provides an excellent short course in understanding and revealing financial reporting trickery, with particular emphasis on devices for concealing debt—including leases, pension plans, special-purpose entities, and the equity method of accounting for investments.
Journal: Financial Analysts Journal
Pages: 101-102
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2777
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2777
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In The Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issues.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 6
Volume: 61
Year: 2005
Month: 11
X-DOI: 10.2469/faj.v61.n6.2778
File-URL: http://hdl.handle.net/10.2469/faj.v61.n6.2778
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: 2005 Report to Readers
Abstract: 
 This report details a successful 2005 for the FAJ as it
                    celebrated its 60th anniversary with a conference of industry
                    leaders—Reflections and Insights—and a year-long series of
                    Reflections articles. 
Journal: Financial Analysts Journal
Pages: 8-9
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.2780
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Author-Name: Mark Kritzman
Author-X-Name-First: Mark
Author-X-Name-Last: Kritzman
Title: “Determinants of Portfolio Performance—20 Years Later”: A Comment
Abstract: 
 This material comments on “Determinants of Portfolio Performance—20          Years Later”.
Journal: Financial Analysts Journal
Pages: 10-11
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.2781
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Author-Name: L. Randolph Hood
Author-X-Name-First: L. Randolph
Author-X-Name-Last: Hood
Title: “Determinants of Portfolio Performance—20 Years Later”: Author's Response
Abstract: 
 This material comments on “Determinants of Portfolio Performance—20          Years Later”.
Journal: Financial Analysts Journal
Pages: 11-12
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.2782
File-URL: http://hdl.handle.net/10.2469/faj.v62.n1.2782
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Author-Name: Gary P. Brinson
Author-X-Name-First: Gary P.
Author-X-Name-Last: Brinson
Title: “Determinants of Portfolio Performance—20 Years Later”: Author's Response
Abstract: 
 This material comments on “Determinants of Portfolio Performance—20
                    Years Later”.
Journal: Financial Analysts Journal
Pages: 13-13
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.2783
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Author-Name: David M. Epstein
Author-X-Name-First: David M.
Author-X-Name-Last: Epstein
Title: “Convertible Bonds: How Much Equity, How Much Debt?”: A Comment
Abstract: 
 This material comments on “Convertible Bonds: How Much Equity, How Much          Debt?”
Journal: Financial Analysts Journal
Pages: 13-14
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.2784
File-URL: http://hdl.handle.net/10.2469/faj.v62.n1.2784
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Author-Name: Jeremy J. Siegel
Author-X-Name-First: Jeremy J.
Author-X-Name-Last: Siegel
Author-Name: Jeremy D. Schwartz
Author-X-Name-First: Jeremy D.
Author-X-Name-Last: Schwartz
Title: Long-Term Returns on the Original S&P 500 Companies
Abstract: 
 The S&P 500 Index is continually updated, with approximately 20 companies added          each year and an equal number dropped. In the study reported here, the returns to all 500          of the original S&P 500 companies and returns to the continually updated index          were calculated from March 1957 through 2003. Contrary to earlier research, this study          found that the buy-and-hold returns of the 500 original companies have been higher than          the returns to the continually updated S&P 500 and with lower risk. Furthermore,          the original companies in 9 of the 10 industry sectors outperformed the new companies          added to the index. The S&P 500 Index, first compiled in March 1957, is the most widely used          benchmark for measuring the performance of large-capitalization, U.S.-based stocks. The          index of 500 stocks is continually updated; approximately 20 new companies that meet the          Standard & Poor's Corporation criteria for market value, earnings, and liquidity          are added each year, and an equal number are deleted because they fall below these          standards or are eliminated by mergers or other corporate changes.We calculated the returns of all 500 of the original S&P 500 companies and of the          new companies subsequently added to the index. Contrary to earlier studies, we found that          the buy-and-hold returns of the 500 original companies have been higher than the returns          of the continually updated S&P 500 and with lower risk. Moreover, the new          companies added to the S&P 500 since 1957 have underperformed the original          companies in 9 of the 10 industrial sectors making up the index.We also found that less than one-third of a sector's return from 1957 through 2003 can be          attributed to the expansion and contraction of the sector's market value relative to the          S&P 500. Sector differences in dividend yields, capitalizations, and number of          companies entering and exiting the sector accounted for more than two-thirds of the          changes in market return.Reasons for the underperformance of the continually updated S&P 500 include price          pressures when the addition of a company to the index is announced, investor overoptimism          about certain stocks and industries, and the changes in sector weighting since 1957. Over          time, the original S&P 500 companies became more heavily weighted with          high-dividend-paying and low-P/E (value) stocks, particularly large oil producers. Indeed,          this research supports the finding that value stocks have outperformed growth stocks on a          risk-adjusted basis since 1957.
Journal: Financial Analysts Journal
Pages: 18-31
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.4055
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Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Richard L. Meyer
Author-X-Name-First: Richard L.
Author-X-Name-Last: Meyer
Title: Fault the Tax Code for Low Dividend Payouts
Abstract: 
 Reducing the marginal tax rate on dividend income was not the optimal modification of the          tax code. The U.S. corporate tax code continues to favor debt over equity because          corporate interest payments are tax deductible whereas dividend payments are not. The          recommendation in this article is that dividend payments be deductible at the corporate          level and fully taxable to investors at their marginal income tax rates. The benefits          should be a decline in debt financing and bankruptcy risk, substantial increases in          dividend payouts, fewer stock option grants to managers, a decline in the equity risk          premium, and higher stock valuations. Reducing the marginal U.S. tax rate on dividend income was a move in the right direction          but not the optimal modification to the tax code. The intent of the legislation was to          reduce the double taxation of dividends, which was accomplished. But the real problem is          that the U.S. corporate tax code continues to favor debt issuance over equity issuance          because corporate interest payments are tax deductible whereas dividend payments are not.          We recommend that dividend payments, as well as interest payments, be deductible at the          corporate level and be fully taxable to investors at their marginal income tax rates.Our proposed change in tax law would have numerous benefits: Debt financing should decline because debt's tax incentive will have been                eliminated. Less debt would lead to lower bankruptcy risk.Dividend payout ratios should increase substantially. Failure to pay out dividends                would give rise to corporate income taxes that otherwise could be avoided.Shareholders would receive more of their returns as dividends and less as capital                appreciation. If capital appreciation is modest, then the value of incentive option                grants diminishes, which should bring about a decline in the abuses associated with                these options.If dividends increased substantially, corporate managers would be forced into the                capital markets to raise equity capital to finance expansion. If investment bankers                acted as underwriters, they would have to ensure that all is well at the issuing                companies because the bankers would have their own capital at risk.Even with equal tax rates on capital gains and dividends, as now exist, companies                may not increase dividends because investors can defer capital gains taxes whereas                taxes on dividends have to be paid when the dividends are received. Our recommended                modification to the tax code would force companies to increase dividends to increase                stock value. Increased dividends would mean that managers would have less cash                available for inefficient empire building.Investor confidence in companies that paid out the great majority of their earnings                could increase because higher dividend payout ratios would assuage concerns about                inflated earnings. Consequently, under our proposal, the required risk premium would                decline for high-dividend-paying companies, which should increase stock              valuations.Of course, our proposed change could have some drawbacks: Investors' ability to defer taxes would decline unless investors transferred their                investments from mutual funds into high-cost variable annuities.Federal tax revenues would decline because employee benefit plans defer taxes and                investors might do the same by shifting their investments into variable annuities.                The tax revenue decline would be temporary, however, because the taxes would be                payable when the investors withdrew funds for consumption.Because dividend payouts would have to increase, companies would need to enter the                capital markets to fund their new projects or investments. Issuing equity can be                costly, but if the number of equity deals available to bankers increases, the                efficiencies of scale should reduce underwriting costs.If the costs of issuing equity are prohibitive, companies could "sweeten" dividend                reinvestment plans by issuing new stocks to existing investors at modest discounts.                The cost of the discount would be less than the tax savings generated by higher                dividends.High-risk companies might want to retain earnings and pay taxes rather than issue                new equity because of the high issue costs they would face. This scenario should                happen only if the issue costs for these companies exceed the tax penalty because                their tax rates are low.In conclusion, the benefits of our tax code change would be declines in debt financing          and bankruptcy risk, substantial increases in dividends, fewer stock option grants, and a          decline in the equity risk premium. We expect that such a policy shift would also increase          stock valuations.
Journal: Financial Analysts Journal
Pages: 32-34
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.4056
File-URL: http://hdl.handle.net/10.2469/faj.v62.n1.4056
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Author-Name: Owain ap Gwilym
Author-X-Name-First: Owain
Author-X-Name-Last: ap Gwilym
Author-Name: James Seaton
Author-X-Name-First: James
Author-X-Name-Last: Seaton
Author-Name: Karina Suddason
Author-X-Name-First: Karina
Author-X-Name-Last: Suddason
Author-Name: Stephen Thomas
Author-X-Name-First: Stephen
Author-X-Name-Last: Thomas
Title: International Evidence on the Payout Ratio, Earnings, Dividends, and Returns
Abstract: 
 Recent evidence for the U.S. market has shown that, contrary to popular wisdom, the          greater the proportion of earnings paid out as dividends, the greater the subsequent real          earnings growth. This study extends previous work by examining whether a similar          relationship exists in 11 international markets and by considering the role the payout          ratio plays in explaining future real dividend growth and returns. Higher payout ratios do          indeed lead to higher real earnings growth—but not to higher real dividend          growth. This information has limited use, however, for predicting future returns. Although the payout ratio has long been of importance to corporate finance researchers,          it has been relatively neglected in the asset-pricing and prediction literature, despite          market fascination with investment strategies based on dividends and earnings (e.g., the          “Dow 10”). Recent research has established the somewhat surprising          result that higher aggregate payout ratios for the United States are associated with          higher future earnings growth. This finding offers support for theories that view          dividends as signals for earnings expectations.Our article contributes to the literature by investigating whether similar conclusions          can be drawn about 11 major international markets and by extending the analysis to          consider the relationship between payout ratio and returns, which we believe to be          important because returns are the ultimate focus of portfolio managers and investment          strategists. For each country, we used monthly values of the dividend yield, earnings          yield, a retail price index or consumer price index (as appropriate), and the stock market          index level. We also constructed a return series for each country's index.We investigated the explanatory power of the following variables: payout ratio, dividend          yield, earnings yield, lagged dividend growth, and lagged earnings growth. We examined          three time periods (determined by data availability) and for the lagged variables used          lags of 10 years, 5 years, and 1 year—depending on the length of the sample          period.We found that, despite the different institutional, tax, and legal environments of the 11          countries, substantial reinvestment of retained earnings did not increase future real          earnings growth, although it did produce faster real dividend growth. Investing in the          countries with the higher payout ratios also resulted in higher earnings growth.Unfortunately, these findings did not translate to return predictability in a persuasive          fashion: The results varied by country and time period. The notable exception was the U.S.          market, where we found the payout ratio to be a significant variable in explaining          subsequent 5-year and 10-year returns.Currently, the components of the S&P 500 are paying out around one-third of their          earnings as dividends, well below the post-World War II average of 50-60 percent.          Therefore, our findings suggest that the outlook for earnings growth in the next few years          is ominous.
Journal: Financial Analysts Journal
Pages: 36-53
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.4057
File-URL: http://hdl.handle.net/10.2469/faj.v62.n1.4057
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Author-Name: Edward I. Altman
Author-X-Name-First: Edward I.
Author-X-Name-Last: Altman
Author-Name: Herbert A. Rijken
Author-X-Name-First: Herbert A.
Author-X-Name-Last: Rijken
Title: A Point-in-Time Perspective on Through-the-Cycle Ratings
Abstract: 
 The role and performance of credit-rating agencies are currently under debate.
                    Several surveys conducted in the United States reveal that most investors
                    believe rating agencies are too slow in adjusting their ratings to changes in
                    corporate creditworthiness. It is well known that agencies achieve rating
                    stability by their through-the-cycle methodology. This study provides
                    quantitative insight into this methodology from an investor's point-in-time
                    perspective and quantifies the effects of the methodology on three, somewhat
                    conflicting, objectives: rating stability, rating timeliness, and performance in
                    predicting defaults. The results can guide the search for an optimal balance
                    among these three objectives. The role and performance of credit-rating agencies are currently under debate.
                    Several surveys conducted in the United States reveal that most investors
                    believe the rating agencies are too slow in adjusting their ratings to changes
                    in corporate creditworthiness. At the same time, investors want to keep their
                    portfolio rebalancing to a minimum and desire some level of rating stability.
                    They do not want ratings to be changed to reflect small changes in financial
                    condition. Apparently, investors want both stable and timely ratings, which are
                    likely to be two conflicting objectives.Agencies achieve rating stability by their through-the-cycle methodology. This
                    methodology has two aspects: (1) a focus on the permanent component of default
                    risk and (2) a prudent "migration" (rating-change) policy. In an earlier
                    article, we focused primarily on the modeling of the
                    through-the-cycle methodology, especially the prudent migration policy. In this
                    article, we emphasize thequantitative consequences of the
                    through-the-cycle methodology for rating stability, timeliness, and default
                    prediction—from an investor's point-in-time perspective. To proxy the
                    investor's perception as closely as possible, we carefully formulated and
                    estimated credit-scoring models for default prediction with various time
                    horizons. We found that these credit-scoring models could serve as credible
                    benchmarks because their long-term default prediction was comparable to that of
                    agency ratings.In this benchmark study, we compared the properties of agency ratings with
                    ratings based on credit scores. We used data on agency ratings from the July
                    2002 version of Standard & Poor's CreditPro Database for the January
                    1981–July 2002 period. We linked corporate ratings at the end of each
                    calendar quarter to stock price data and accounting data, which are used to
                    estimate default prediction models and an agency rating prediction model. Scores
                    of these benchmark credit-scoring models represent a range of point-in-time
                    perspectives with different time horizons and different sensitivities to the
                    temporary component of default risk. After conversion of credit model scores to
                    credit model ratings, equivalent to agency ratings, actual agency ratings were
                    benchmarked on rating stability, rating timeliness, and default prediction
                    performance.We came to the following conclusions. Rating stability is enhanced primarily by
                    the prudent migration policy, not by the focus on the permanent component of
                    credit risk. Through-the-cycle rating procedures delay migration in agency
                    ratings, on average, by 1/2 year on the downgrade side and 3/4 year on the
                    upgrade side. From the perspective of an investor's one-year horizon,
                    through-the-cycle rating significantly affects default prediction. In this case,
                    the advantage in information quality that the agencies have over credit scoring
                    is more than offset by the agencies' use of the through-the-cycle methodology.
                    Long-term default predictions are less affected by the methodology than are
                    short-term predictions.Our results can guide the search for an optimal balance among rating stability,
                    rating timeliness, and default prediction. We suggest that incorporating the
                    agencies' “rating outlook” and “watchlist” information
                    in future analysis would improve the accuracy of the agency ratings.
Journal: Financial Analysts Journal
Pages: 54-70
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.4058
File-URL: http://hdl.handle.net/10.2469/faj.v62.n1.4058
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Author-Name: Sherrill Shaffer
Author-X-Name-First: Sherrill
Author-X-Name-Last: Shaffer
Title: Corporate Failure and Equity Valuation
Abstract: 
 An important problem for portfolio managers is how to adjust the valuation of equity for          the risk that the company may fail. Traditional adjustments seem ad hoc,          and previous research on the topic has ignored the irreversible nature of failure. Here, a          standard equity valuation model is extended to include a parsimonious but rigorous          correction for a stationary annual probability of failure. Although the correction is          nonlinear, it can be reduced to an equivalent function that enters the valuation equation          in the traditional additive way. Empirical benchmarking suggests that, even without          assuming risk-averse investors, this approach comes closer to predicting observed equity          premiums than the traditional approach. An important problem for portfolio managers is how to adjust the valuation of a company's          equity for the risk that the company may fail. Traditional approaches incorporatead hoc adjustments to risk premiums in the discount rate or to the          assumed average growth rate of cash flows, which are convenient in practice but possibly          inaccurate. Theoretical research on the topic has typically ignored the irreversible          nature of corporate failure and focused on second-moment effects (which matter only for          risk-averse investors) rather than on first-moment effects (which matter even for          risk-neutral investors). Furthermore, standard models typically generate predictions that          are inconsistent with the historical comparison of returns between stocks and bonds.This article incorporates a stationary annual probability of corporate failure into a          standard equity valuation model to provide a parsimonious but rigorous correction for          failure risk. Although the correction is nonlinear, it can be reduced to an equivalent          function that enters the valuation equation in the traditional additive way. Empirical          benchmarking suggests that, even without assuming risk-averse investors, this approach          comes closer to predicting observed equity premiums than the traditional approach.          Extensions of the model provide valuation under two growth regimes with stochastic          transition times.The results presented in the article can be applied either as an alternative correction          for risk or as a complementary correction for risk. The model improves the results          obtained by using conventional risk premiums and subjective adjustments to assumed growth          rates in several ways. The model's key parameter for measuring failure risk can be          calibrated in practice by using either historical business failure rates or          company-specific probabilities of failure predicted by statistical models. Another use of          the model would be to infer, based on the risk premium observed for a company's stock, the          market's anticipated risk of failure for a given company.
Journal: Financial Analysts Journal
Pages: 71-80
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.4059
File-URL: http://hdl.handle.net/10.2469/faj.v62.n1.4059
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Author-Name: Seung-Woog Kwag
Author-X-Name-First: Seung-Woog
Author-X-Name-Last: Kwag
Author-Name: Ronald E. Shrieves
Author-X-Name-First: Ronald E.
Author-X-Name-Last: Shrieves
Title: Chronic Bias in Earnings Forecasts
Abstract: 
 Whatever the source or explanation of bias in forecasts of company earnings, if such bias          persists, it is potentially discoverable and exploitable by investors. This research          addresses (1) whether characterizing forecasts as if they were a homogeneous group with          respect to bias is accurate or useful and (2) whether a long-term record of forecast          errors contains information useful in predicting subsequent errors. We found that earnings          forecasts are heterogeneous with respect to direction and degree of bias. We also found          evidence of extremes in optimism and pessimism and that extreme errors tend to persist in          the same direction, which suggests certain potentially profitable trading strategies. Whatever the source or explanation of bias in forecasts of a company's earnings, if such          bias persists long enough, it is potentially discoverable and exploitable by investors.          “Exploitation” in this context implies that investors, through          examination of historical forecasting performance, can more or less reliably estimate the          direction and extent of any bias and impute unbiased estimates for themselves. The absence          of persistence in forecast errors would suggest that analysts' behavior ultimately          self-corrects within a time frame that eliminates the possibility that the patterns can be          exploited by investors.We addressed two primary issues related to bias in forecasts: (1) whether characterizing          forecasts as if they were a homogeneous group with respect to bias is accurate or useful          and (2) whether a long-term record of forecast errors contains information that would be          useful in predicting subsequent errors.We devised a method for using historical data on forecast errors to separate earnings          forecasts into classes (portfolios) based on “chronic”          bias—the presence of a pattern of forecast errors that pervades long series of          forecasts. The methodology for formation of portfolios used 20 quarters of past consensus          forecast errors to identify the forecasts that have been at the extremes of optimism and          pessimism. The portfolio formation algorithm, called the          “mean—frequency forecast error” (MFFE) method, was based on          mean forecast errors and the weighted-average frequency of negative errors.We applied several parametric and nonparametric tests to determine whether historical          bias is persistent (i.e., whether it has predictive power with respect to subsequent          forecast errors). The MFFE portfolio formation method resulted in a range of portfolios,          with the observations classified as optimistic (pessimistic) having reliably negative          (positive) mean contemporaneous forecast errors and a reliably higher percentage of          negative (positive) forecast errors than the full sample. Furthermore, we found that the          predictive power was incremental to that of the prior-period forecast error and persisted          even when we controlled for the effects of unexpected earnings shocks related to time          period, industry, or exchange listing and for company-specific factors.On the whole, our findings imply that analysts' behavior in both the optimistic and the          pessimistic extremes does not entirely self-correct, leaving open the possibility that          investors may find historical forecast errors useful in making inferences about current          forecasts. Tests of a simple announcement-period trading strategy support the conclusion          that the forecast bias identified by using the historical data on consensus forecasts may          already be reflected in stock prices prior to earnings-announcement dates.          Postannouncement drift, however, appears to be positive for optimistically biased          forecasts and negative for pessimistically biased forecasts.
Journal: Financial Analysts Journal
Pages: 81-96
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.4060
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Author-Name: Peng Chen
Author-X-Name-First: Peng
Author-X-Name-Last: Chen
Author-Name: Roger G. Ibbotson
Author-X-Name-First: Roger G.
Author-X-Name-Last: Ibbotson
Author-Name: Moshe A. Milevsky
Author-X-Name-First: Moshe A.
Author-X-Name-Last: Milevsky
Author-Name: Kevin X. Zhu
Author-X-Name-First: Kevin X.
Author-X-Name-Last: Zhu
Title: Human Capital, Asset Allocation, and Life Insurance
Abstract: 
 Financial planners and advisors increasingly recognize that human capital must be taken          into account when building optimal portfolios for individual investors. But human capital          is not simply another pre-endowed asset class; it contains a unique mortality risk in the          form of the loss of future income and wages in the event of the wage earner's death. Life          insurance hedges this mortality risk, so human capital affects both optimal asset          allocation and demand for life insurance. Yet, historically, asset allocation and life          insurance decisions have been analyzed separately. This article develops a unified          framework based on human capital that enables individual investors to make these decisions          jointly. Academics and practitioners increasingly recognize that the risk and return          characteristics of human capital—such as wage and salary—should be          taken into account when building portfolios for individual investors. A unique aspect of          an investor's human capital is mortality risk, the loss of the family's human capital in          the event of the wage earner's death. Life insurance has long been used to hedge against          mortality risk. Typically, the greater the value of human capital, the more life insurance          the family needs.Intuitively, human capital affects not only optimal life insurance demand but also          optimal asset allocation. However, these two important financial decisions—how          much life insurance to buy and what the optimal asset allocation is—have          consistently been analyzed separately in theory and practice. Popular investment and          financial planning advice regarding how much life insurance one should acquire is seldom          framed in terms of the riskiness of one's human capital. And conversely, optimal asset          allocation has only lately been framed in terms of the risk characteristics of human          capital. Rarely is this decision integrated with the life insurance decision.We argue that these two decisions must be determined jointly because they serve as risk          substitutes when viewed from the perspective of an individual investor's portfolio. Life          insurance is a perfect hedge for human capital in the event of the wage earner's death;          that is, term life insurance and human capital have a negative 100 percent correlation          with each other in the “alive” (consumption) state versus the          “dead” (bequest) state. If life insurance pays off at the end of the          year, human capital does not, and vice versa. Thus, the combination of the two provides          great diversification to an investor's total portfolio.Motivated by the need to integrate these two decisions, we developed a framework that          merges these traditionally distinct lines of thought. The framework is based on human          capital. We investigated the impact on the optimal combination of life insurance and          traditional asset classes of the magnitude of human capital, its volatility, and its          correlation with other assets, investor preferences regarding bequests, and subjective          survival probabilities. We use five case studies in the article to illustrate          implementation of our model.Our analysis validates some intuitive rules of thumb but also provides additional results          that are not immediately obvious: Investors need to make asset allocation decisions and life insurance decisions                jointly.The magnitude of human capital, its volatility, and its correlation with other                assets significantly affect the two decisions over the life cycle.Bequest preferences and a person's subjective survival probability have significant                effects on the person's demand for insurance but little influence on the person's                optimal asset allocation.Conservative investors should invest relatively more in risk-free assets and buy                more life insurance.
Journal: Financial Analysts Journal
Pages: 97-109
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.4061
File-URL: http://hdl.handle.net/10.2469/faj.v62.n1.4061
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Author-Name: Michael A. Martorelli
Author-X-Name-First: Michael A.
Author-X-Name-Last: Martorelli
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Profits You Can Trust (a review)
Abstract: 
 Two accounting professors and an editor at the Harvard Business Review          have produced a useful set of guidelines and advice for any board member, trustee,          shareholder, or corporate employee interested in the use and misuse of accounting          techniques. Profits You Can Trust is worthwhile reading for anyone with a          stake in corporate financial reporting. 
Journal: Financial Analysts Journal
Pages: 110-110
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.4062
File-URL: http://hdl.handle.net/10.2469/faj.v62.n1.4062
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In The Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issue.
Journal: Financial Analysts Journal
Pages: 112-112
Issue: 1
Volume: 62
Year: 2006
Month: 1
X-DOI: 10.2469/faj.v62.n1.4063
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: The Fiduciary Time Line: Implications for Asset Allocation
Abstract: 
 In a world of lower prospective returns and lower yields, the challenge for the fiduciary          who wishes to add value over the long fiduciary time horizon is to manage our clients'          return expectations toward reasonable objectives and then manage client          assets to meet those reasonable objectives. For managing the assets, four          approaches are promising: a willingness to stray from conventional stock and bond          investments, a careful and prudent quest for alpha, disciplined management of the asset          mix, and the use of leverage.
Journal: Financial Analysts Journal
Pages: 8-10
Issue: 2
Volume: 62
Year: 2006
Month: 3
X-DOI: 10.2469/faj.v62.n2.4076
File-URL: http://hdl.handle.net/10.2469/faj.v62.n2.4076
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Author-Name: Joerg Schroeder
Author-X-Name-First: Joerg
Author-X-Name-Last: Schroeder
Title: “The Pension Problem: On Demographic Time Bombs and Odious Debt”: A Comment
Abstract: 
 This material comments on “The Pension Problem: On Demographic Time Bombs and          Odious Debt.”
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 2
Volume: 62
Year: 2006
Month: 3
X-DOI: 10.2469/faj.v62.n2.4077
File-URL: http://hdl.handle.net/10.2469/faj.v62.n2.4077
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Author-Name: Edward J. Stavetski
Author-X-Name-First: Edward J.
Author-X-Name-Last: Stavetski
Title: “Hedge Funds: Risk and Return”: A Comment
Abstract: 
 This material comments on “Hedge Funds: Risk and Return.”
Journal: Financial Analysts Journal
Pages: 12-13
Issue: 2
Volume: 62
Year: 2006
Month: 3
X-DOI: 10.2469/faj.v62.n2.4079
File-URL: http://hdl.handle.net/10.2469/faj.v62.n2.4079
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Author-Name: M. Barton Waring
Author-X-Name-First: M. Barton
Author-X-Name-Last: Waring
Author-Name: Laurence B. Siegel
Author-X-Name-First: Laurence B.
Author-X-Name-Last: Siegel
Title: The Myth of the Absolute-Return Investor
Abstract: 
 The notion of "absolute return" investing is spreading like wildfire. Many people believe          that superior returns can be achieved by managers with strong views and little regard for          benchmarks. This article attempts to define absolute-return investing and figure out          whether it exists. The conclusion is that all investment returns consist of a beta part          (representing the correlation of the active portfolio with one or more market benchmarks          or normal portfolios) and an active alpha part. Thus, all investing is relative-return          investing in which active returns are earned relative to an appropriate benchmark or mix          of benchmarks.The recent enthusiasm for so-called absolute-return investing is based on a          misunderstanding of the way active investment returns are generated. All investment          returns consist of a market, or beta, part (representing the correlation of the active          portfolio with one or more market benchmarks or normal portfolios) and a purely active, or          alpha, part. Thus, all investing is relative-return—not          absolute-return—investing, in which active returns are earned relative to the          appropriate benchmark or mix of benchmarks.Hedge funds are currently the most visible and popular of would-be absolute-return          investments, but the term "absolute return" is also applied to certain other structures,          including some concentrated long-only active managers. Practically all of the managers who          disdain benchmarks say they do so because the use of benchmarks to measure performance          limits the creativity and aggressiveness that can be achieved by those with superior          skill. Actually, benchmarks do nothing of the kind: They merely achieve a fair          apportionment between the return from skill and the return from being exposed to markets.          Investors need this information to make successful decisions about active managers,          including hedge funds.Although most investment strategies mix alpha and beta exposures, a well-engineered          market-neutral long?short hedge fund does not. Such a fund—if it is really          market neutral in all the dimensions of market risk—allows investors to earn          pure alpha, although even this return is not an absolute return: It is alpha relative to          the properly specified benchmark—in this case, the return on cash. Investors can          add beta exposures as desired, using inexpensive futures contracts or other vehicles, in          what is popularly called a "portable alpha" strategy but which might be better described          as portable beta.Thus, all investing is benchmark relative. Even Warren Buffett has a benchmark, an          opportunity cost of capital that he must beat if he wants Berkshire Hathaway to go up more          than the market. So does your favorite hedge fund. And having a low or zero beta, as many          hedge funds do, does not mean you have a high alpha. One has nothing to do with the other;          alpha must always and everywhere be earned by having insights superior to those of the          other players in the market, and that is very difficult, although not impossible, to do.
Journal: Financial Analysts Journal
Pages: 14-21
Issue: 2
Volume: 62
Year: 2006
Month: 3
X-DOI: 10.2469/faj.v62.n2.4080
File-URL: http://hdl.handle.net/10.2469/faj.v62.n2.4080
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Author-Name: Narasimhan Jegadeesh
Author-X-Name-First: Narasimhan
Author-X-Name-Last: Jegadeesh
Author-Name: Joshua Livnat
Author-X-Name-First: Joshua
Author-X-Name-Last: Livnat
Title: Post-Earnings-Announcement Drift: The Role of Revenue Surprises
Abstract: 
 The study reported here consisted of estimating earnings and sales (or revenue) surprises          either with historical time-series data or with analyst forecasts.          Post-earnings-announcement drift was found to be stronger when the revenue surprise was in          the same direction as the earnings surprise. This result proved to be robust to various          controls, including the proportions of stock held by institutional investors, arbitrage          risk, and turnover (prior 60-month average trading volume). This finding is consistent          with prior evidence that earnings surprises have a more persistent effect on future          earnings growth when they consist of higher revenue surprises than when they consist of          lower expense surprises.The study we report shows that the magnitude of post-earnings-announcement drift in          security returns after the announcement of earnings depends on the magnitude of          contemporaneous revenue surprises. When the two signals for a company confirm each other,          drift is larger.Drift is stronger when the revenue surprise is in the same direction as the earnings          surprise quite probably because revenue surprises identify companies for which earnings          surprises should have a more persistent effect on future earnings growth. This result held          even after we controlled for the sophistication of investors (as indicated by the          proportion of shares held by institutions), arbitrage risk (based on the correlation of          the company returns with S&P 500 Index returns), and turnover (prior          60–month average trading volume). These results proved to be robust across          subperiods, including the 1998–2002 period, which spanned extreme market          fluctuations. The results proved to be robust also for three different subsamples of          data—a large subsample of companies that had historical earnings and revenue          data in the Compustat quarterly database, a subsample of companies for which at least two          analysts provided earnings forecasts and historical revenue data were used, and a much          smaller subsample of companies for which at least one analyst forecasted revenues as well          as earnings. In all three cases, a portfolio of companies with extreme earnings surprises          and extreme revenue surprises in the same direction earned significantly higher abnormal          returns in the quarter after the preliminary earnings announcement.These higher abnormal returns were most pronounced when we used analyst forecasts of both          earnings and revenues to estimate the surprises. The difference between analyst forecasts          of earnings and the actual earnings reported by I/B/E/S provided a better measure of          earnings surprise than the difference between time-series estimates of earnings surprise          garnered from Compustat data.Naturally, the improvement in performance when we used a trading strategy based on          revenue surprises as well as earnings surprises came at a minor cost; the portfolio of          companies with extreme earnings and revenue surprises in the same direction comprised a          smaller number of companies than the portfolio of companies with extreme earnings          surprises alone. The portfolio of extreme revenue+earnings surprises nevertheless          contained a sufficient number of companies for adequate portfolio diversification.Investors and other market participants can use the evidence in this study to improve          trading strategies that use earnings surprise as a signal. Revenue surprises can be useful          as an additional signal to determine future earnings growth. Similarly, analysts can use          revenue surprises when forecasting future earnings.The results also indicate that analysts should carefully examine the sources of earnings          surprises to forecast future earnings growth. Fundamental analysis should take into          account the differential effects of revenue and expense surprises on the persistence of          future earnings growth. In particular, earnings growth driven by revenue growth has a          stronger effect on future earnings levels than does earnings growth stemming from expense          reduction. Finally, research into the reasons and implications of post-earnings-announcement drift          should take into account the differential drift implications of revenue and expense          surprises.
Journal: Financial Analysts Journal
Pages: 22-34
Issue: 2
Volume: 62
Year: 2006
Month: 3
X-DOI: 10.2469/faj.v62.n2.4081
File-URL: http://hdl.handle.net/10.2469/faj.v62.n2.4081
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Author-Name: Bruce I. Jacobs
Author-X-Name-First: Bruce I.
Author-X-Name-Last: Jacobs
Author-Name: Kenneth N. Levy
Author-X-Name-First: Kenneth N.
Author-X-Name-Last: Levy
Author-Name: Harry M. Markowitz
Author-X-Name-First: Harry M.
Author-X-Name-Last: Markowitz
Title: Trimability and Fast Optimization of Long–Short Portfolios
Abstract: 
 Optimization of long–short portfolios through the use of fast algorithms takes          advantage of models of covariance to simplify the equations that determine optimality.          Fast algorithms exist for widely applied factor and scenario analysis for long-only          portfolios. To allow their use in factor and scenario analysis for long–short          portfolios, the concept of "trimability" is introduced. The conclusion is that the same          fast algorithms that were designed for long-only portfolios can be used, virtually          unchanged, for long–short portfolio optimization—provided the          portfolio is trimable, which usually holds in practice.We discuss fast optimization algorithms for long–short portfolios, including          market-neutral equity portfolios that have zero market exposure and enhanced active equity          portfolios that have a full market exposure, such as 120–20 portfolios (with 120          percent of the capital long and 20 percent short). Fast algorithms that greatly enhance          the speed and ease of portfolio optimization were designed for long-only portfolios.          Whether fast algorithms can be used to optimize long–short portfolios has not been          apparent, because such portfolios may violate assumptions used in formulating the          long-only portfolio optimization problem. We describe a sufficient condition under which a          portfolio optimization algorithm designed for long-only portfolios will find the correct          long–short portfolio, even if the algorithm's use would violate certain assumptions made          in the formulation of the long-only problem. This condition, the "trimability condition,"          is widely satisfied in practice.Fast portfolio optimization algorithms for long-only portfolios achieve their speed by          taking advantage of models that define new fictitious securities whose magnitudes are          linearly related to the magnitudes of the real securities in such a way that the          covariance matrix of the securities' returns becomes diagonal, or almost so, and          idiosyncratic terms are uncorrelated. Under these conditions, portfolio optimization          amounts to the solution of sparse, well-structured sets of equations and can be performed          rapidly.This approach may not be applicable to long–short portfolios, however, because          of the possibility that such portfolios may hold long and short positions in the same          security. In that case, the idiosyncratic terms will not be uncorrelated. Yet, despite          this violation of the assumption of no correlation of the idiosyncratic terms, we find          that fast algorithms are still applicable to long–short portfoliosif the trimability condition holds. This condition essentially requires          that if a portfolio with short and long positions in the same stock is feasible, then it          is also feasible to net the long and short positions while keeping the holdings of all          other risky securities the same and not reducing the expected return of the portfolio.We present two cases of particular interest. In the first case, if one uses a factor or          scenario model of covariance and the trimability condition is satisfied, then existing          fast algorithms for long-only portfolios will find the correct long–short          portfolio. In the second case, if one uses a historical covariance model (where the number          of securities greatly exceeds the number of observations), then, again, existing fast          algorithms for long-only portfolios will produce the correct long–short          portfolio and, in this case, will do so whether or not the trimability condition holds.We also discuss the incorporation of practical and regulatory constraints into the          optimization of long–short portfolios. Examples include budget constraints, the          U.S. Federal Reserve Board's Regulation T margin requirements, upper bounds on long or          short positions in individual or groups of assets, and the requirement that the difference          between the sum of long positions and the sum of short positions be close to an          investor-chosen value (e.g., 0 for market-neutral portfolios or 1 for enhanced active          120–20 portfolios). To our knowledge, all such constraints—whether imposed by          regulators, brokers, or investors themselves—are expressible as linear          equalities or weak inequalities. Therefore, they can be incorporated into the general          portfolio selection model.
Journal: Financial Analysts Journal
Pages: 36-46
Issue: 2
Volume: 62
Year: 2006
Month: 3
X-DOI: 10.2469/faj.v62.n2.4082
File-URL: http://hdl.handle.net/10.2469/faj.v62.n2.4082
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Author-Name: Gary Gorton
Author-X-Name-First: Gary
Author-X-Name-Last: Gorton
Author-Name: K. Geert Rouwenhorst
Author-X-Name-First: K. Geert
Author-X-Name-Last: Rouwenhorst
Title: Facts and Fantasies about Commodity Futures
Abstract: 
 For this study of the simple properties of commodity futures as an asset class, an          equally weighted index of monthly returns of commodity futures was constructed for the          July 1959 through December 2004 period. Fully collateralized commodity futures          historically have offered the same return and Sharpe ratio as U.S. equities. Although the          risk premium on commodity futures is essentially the same as that on equities for the          study period, commodity futures returns are negatively correlated with equity returns and          bond returns. The negative correlation is the result, primarily, of commodity futures'          different behavior over a business cycle. Commodity futures are positively correlated with          inflation, unexpected inflation, and changes in expected inflation.Imagine an asset class that has returns that (1) are the same as those on the U.S. stock          market but (2) are less volatile than stock returns, (3) are negatively correlated with          the returns on stocks and bonds, and (4) are positively correlated with inflation. The          asset class is an investment in commodity futures.Despite being an old asset class, commodity futures are not widely appreciated. Futures          contracts are agreements to buy or sell a commodity at a future date at a price that is          agreed upon today. Except for collateral requirements, futures contracts do not require a          cash outlay for either buyers or sellers. The buyer of a futures contract is, on average,          compensated by the seller of futures if the futures price is set below the expected spot          price at the time of the expiration of the futures contract. The opposite is true when the          futures price is set above the expected future spot price. In 1930, John Maynard Keynes          postulated that sellers of futures (hedgers) would, on average, compensate the buyers of          futures (speculators)—a situation he referred to as "normal backwardation." By          examining the returns to futures over long periods, we indirectly tested this Keynesian          prediction.We constructed a dataset of returns on individual commodity futures going back as far as          1959. The dataset combines information about individual commodity futures prices obtained          from the Commodity Research Bureau (covering, among other exchanges, the Chicago Board of          Trade and Chicago Mercantile Exchange) and the London Metal Exchange. We computed          investment returns by rolling positions in individual futures contracts forward over time.          Commodity futures were combined into an equally weighted index, and much of the article is          concerned with the behavior of this index.We show that over a 45-year period, a diversified investment in collateralized commodity          futures earned historical returns that are comparable to U.S. stock returns. The economic          rationale for these returns is the reward that investors in commodity futures receive for          providing price insurance to commodity producers. The reward for providing price          protection (rather than foreseeable trends in commodity prices) is the key to the returns          that a futures investor can expect. Individual commodity futures can be very volatile, but          much of this volatility can be avoided by investing in a diversified index of commodity          futures.The average historical returns to the equally weighted index of commodity futures has          exceeded the return on U.S. T-bills by about 5 percent a year. This excess return is about          the same as the historical risk premium on the S&P 500 Index over the          1959–2004 period, but the commodity futures index had a slightly lower standard          deviation than the S&P 500. The relatively low volatility of the commodity futures          index stems from the fact that the pairwise correlations between individual commodity          futures are relatively low.Commodity futures are less risky by other standards. First, the distribution of commodity          futures returns is skewed to the right, whereas equity return distributions are skewed to          the left. In other words, relative to a normal bell-shaped curve, equities experience          proportionally more crashes whereas the "crashes" in commodities most often occur on the          upside, leading to positive returns to investors in commodity futures. Second, commodity          futures have the ability to diversify portfolios of stocks and bonds. The sources of the          diversification benefits are the ability of commodity futures to provide a (partial) hedge          against inflation—stocks and bonds are poor hedges by comparison—and          to partially offset the cyclical variation in the returns of stocks and bonds.Finally, when we compared an investment in our index with a portfolio of stocks of          commodity-producing companies, we found that these portfolios are not close substitutes:          The stocks of commodity producers are more correlated with the broad stock market than          with an index of commodity futures.
Journal: Financial Analysts Journal
Pages: 47-68
Issue: 2
Volume: 62
Year: 2006
Month: 3
X-DOI: 10.2469/faj.v62.n2.4083
File-URL: http://hdl.handle.net/10.2469/faj.v62.n2.4083
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Author-Name: Claude B. Erb
Author-X-Name-First: Claude B.
Author-X-Name-Last: Erb
Author-Name: Campbell R. Harvey
Author-X-Name-First: Campbell R.
Author-X-Name-Last: Harvey
Title: The Strategic and Tactical Value of Commodity Futures
Abstract: 
 Investors face numerous challenges when seeking to estimate the prospective performance          of a longonly investment in commodity futures. For instance, historically, the average          annualized excess return of the average individual commodity futures has been          approximately zero and commodity futures returns have been largely uncorrelated with one          another. The prospective annualized excess return of a rebalanced portfolio of commodity          futures, however, can be "equity-like." Some security characteristics (such as the term          structure of futures prices) and some portfolio strategies have historically been rewarded          with above-average returns. It is important to avoid naive extrapolation of historical          returns and to strike a balance between dependable sources of return and possible sources          of return.Should investors have the same long-term return expectations for portfolios of commodity          futures as they might have for equities? Naive extrapolation of history suggests the          answer is "yes." However, extrapolating past performance into the future is often          dangerous. The challenge for investors contemplating a long-only investment in commodity          futures is to develop a framework for thinking about prospective returns. Such a framework          requires an examination of the historical returns of individual commodity futures and          portfolios of commodity futures. It also requires an analysis of the drivers of these          returns.We summarize the research we have carried out and the research of others into the role of          commodity futures in investment portfolios. Several key findings result from this          research. The average compound (geometric) excess return of the average individual          commodity futures contract has historically been close to zero. This finding raises an          important question for investors considering a long-only investment in commodity futures:          How can a commodity futures portfolio have "equity-like" returns when the average returns          of the portfolio's constituents have been close to zero? Two answers are revealed by our          research.First, portfolios of commodity futures that periodically rebalance may          have equity-like excess returns. The rebalancing return is attributable to portfolio          diversification, not to seemingly fundamental influences, such as the rate of inflation,          economic growth, or risk premiums. The rebalancing return, or diversification return, is a          relatively predictable source of portfolio return.Second, portfolios of commodity futures that overweight those commodity futures with          relatively high returns may produce equity-like excess returns. Of course, finding          securities with above-average returns is not an easy task. In the search for above-average          returns, investors can pursue two potentially return-enhancing strategies.One strategy is to turn to security characteristics that in the past have been associated          with above-average returns. One such characteristic for commodity futures is the term          structure of futures prices, which has historically been highly correlated with the          cross-sectional dispersion of returns among individual commodity futures. That is,          commodity futures with the relatively more attractive term-structure characteristics have          had higher returns than commodity futures with the relatively less-attractive          term-structure characteristics. The term structure of commodity futures prices allows          investors, with the benefit of hindsight, to identify commodity futures that performed          well in the past. Of course, an investor faces the risk that the historically observed          payoff from investing in commodity futures with above-average term-structure          characteristics will not persist in the future.Another approach is to pursue a momentum strategy. Historically, a payoff has been          available from investing in commodity futures with past relatively high returns.Finally, a diversified portfolio of commodity futures seems to be an excellent          diversifier of a traditional stock and bond portfolio but is a questionable hedge of          inflation and pension liabilities.
Journal: Financial Analysts Journal
Pages: 69-97
Issue: 2
Volume: 62
Year: 2006
Month: 3
X-DOI: 10.2469/faj.v62.n2.4084
File-URL: http://hdl.handle.net/10.2469/faj.v62.n2.4084
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Author-Name: David Hillier
Author-X-Name-First: David
Author-X-Name-Last: Hillier
Author-Name: Paul Draper
Author-X-Name-First: Paul
Author-X-Name-Last: Draper
Author-Name: Robert Faff
Author-X-Name-First: Robert
Author-X-Name-Last: Faff
Title: Do Precious Metals Shine? An Investment Perspective
Abstract: 
 The investment role of precious metals in financial markets is investigated by analysis          of daily data for gold, platinum, and silver from 1976 to 2004. All three precious metals          have low correlations with stock index returns, which suggests that these metals may          provide diversification within broad investment portfolios. Moreover, the data reveal that          all three precious metals have some hedging capability, particularly during periods of          "abnormal" stock market volatility. Financial portfolios that contain precious metals          perform significantly better than standard equity portfolios.Precious metals have recently become of increasing interest worldwide to investors and          politicians. Gold, for example, following a sustained bear run in prices lasting more than          15 years, has regained its luster in the eyes of investors through double-digit annual          price appreciation.We examined the investment role of precious metals in financial markets through the          analysis of daily price and return data for gold, platinum, and silver from 1976 to 2004.          Gold and silver are traditionally perceived to be "investments of last resort" and have a          central investment role in many countries, but platinum is normally used for industrial          purposes and plays only a small role in investment activity. So, we included platinum as a          control metal for comparative purposes.This study differs from previous research in the area in several important ways. First,          we examined the properties of precious metals in a global context by examining their          relationships to both the S&P 500 Index and the MSCI Europe/Australasia/Far East          (EAFE) Index. Second, our study covers almost 30 years of precious metal price data and          includes the bull run of the late 1970s, the bear period of the 1980s and 1990s, and the          strong performance of precious metals in the early 2000s. Third, we used recent          improvements in volatility modeling to examine the hedging properties of gold, silver, and          platinum within a time-varying context. Finally, by comparing the investment properties of          gold and silver with platinum, we were able to differentiate the unique investment          characteristics of gold and silver from that of their industrial counterparts.We found that all three precious metals have low correlations with the S&P 500          and EAFE, which suggests that they have the potential to provide diversification within          broad-based investment portfolios. Moreover, and most importantly, all three precious          metals have some hedging capability, particularly during periods of "abnormal" stock          market volatility. The real benefits of holding precious metals come during periods of          market uncertainty but not necessarily in market downturns. From a risk management          standpoint, precious metals are possible alternatives to financial derivatives and are          clearly of more importance in those countries where derivative markets in equities have          not been established.An examination of precious metals as part of a broad-based equity portfolio shows that          their inclusion can be of great benefit. Including precious metals in a passive          buy-and-hold strategy improved the efficiency of portfolios in the study. Furthermore, our          results suggest that over the past 25 years, the optimal weight of gold in broad-based          international equity portfolios was approximately 9.5 percent, significantly higher than          is seen in most funds' equity portfolios today.
Journal: Financial Analysts Journal
Pages: 98-106
Issue: 2
Volume: 62
Year: 2006
Month: 3
X-DOI: 10.2469/faj.v62.n2.4085
File-URL: http://hdl.handle.net/10.2469/faj.v62.n2.4085
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Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Why the Bubble Burst: U.S. Stock Market Performance since 1982 (a review)
Abstract: 
 With the thoroughness of an able scholar, the author offers evidence that the          flow-of-funds methodology provides a unique and superior perspective to the task of          "unpacking" the determinants of equity price movements. 
Journal: Financial Analysts Journal
Pages: 107-108
Issue: 2
Volume: 62
Year: 2006
Month: 3
X-DOI: 10.2469/faj.v62.n2.4086
File-URL: http://hdl.handle.net/10.2469/faj.v62.n2.4086
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Author-Name: Michael A. Martorelli
Author-X-Name-First: Michael A.
Author-X-Name-Last: Martorelli
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Using Investor Relations to Maximize Equity Valuation (a review)
Abstract: 
 This short, easy-to-read volume describes aspects of the investor relations function;          comments about methods to attract different portions of the investor audience will be of          particular interest to analysts and money managers. The authors, however, exaggerate the          role of IR in influencing a company's valuation and appear to believe that investors can          be persuaded to pay more attention to a well-crafted message than to financial facts. 
Journal: Financial Analysts Journal
Pages: 108-109
Issue: 2
Volume: 62
Year: 2006
Month: 3
X-DOI: 10.2469/faj.v62.n2.4087
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Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Oxford Guide to Financial Modeling: Applications for Capital Markets, Corporate Finance, Risk Management, and Financial Institutions (a review)
Abstract: 
 Through steady and consistent writing, the authors deliver a unified approach in a single          volume to a subject that covers all of the complex issues of financial modeling across the          entire spectrum of finance. 
Journal: Financial Analysts Journal
Pages: 109-109
Issue: 2
Volume: 62
Year: 2006
Month: 3
X-DOI: 10.2469/faj.v62.n2.4088
File-URL: http://hdl.handle.net/10.2469/faj.v62.n2.4088
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In The Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issue.
Journal: Financial Analysts Journal
Pages: 112-112
Issue: 2
Volume: 62
Year: 2006
Month: 3
X-DOI: 10.2469/faj.v62.n2.4089
File-URL: http://hdl.handle.net/10.2469/faj.v62.n2.4089
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Implementation Shortfall
Abstract: 
 Much of our industry focuses on identifying winners, whether stock picks, asset                    classes, managers, or strategies. We could eliminate a main source of                    implementation shortfall, however, by spending at least as much effort on                    identifying and purging losers. Also in need of our attention are problems or                    practices that exacerbate the effects of chasing winners, including agency                    effects that encourage comfortable, not profitable, investing; ignoring hidden                    costs; holding cash reserves; and allowing inertia to inadvertently change the                    asset mix of our portfolios.
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4151
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4151
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Author-Name: John A. Tatom
Author-X-Name-First: John A.
Author-X-Name-Last: Tatom
Title: Not All Deficits Are Created Equal
Abstract: 
 Recent academic and popular discussions of budget deficits rely on a simplistic, and largely     false, conception of the effects of deficits. The effects depend on the source of the deficit     and on private-sector responses to it. Also important are whether budget changes arise     passively through the workings of the business cycle and whether deficit-inducing policy     actions are permanent or transitory. The key expectations arising from the simple theories     connecting interest rates and deficits are precisely opposite to what modern theory and     evidence indicate.Recent academic and popular discussions of budget deficits rely on a simplistic—and     largely false—conception of the effects of deficits. This literature ignores the fact     that the effects of deficits depend on their source and on private-sector responses to them.     Also significant are whether budget changes arise passively through the workings of the     business cycle and whether deficit-inducing policy actions are permanent or transitory.As to source, on the one hand, large movements in U.S. budget deficits/surpluses are     principally a result of the business cycle. Deficits caused by downturns in the business cycle     are associated with interest rate reductions and boost aggregate demand, thereby limiting the     extent of cyclical decline. Deficits caused by tax reductions also can be beneficial. For     example, they can lead to offsetting changes in private saving and investment. Deficits caused     by tax incentives for capital formation can be even more beneficial because their incentive     effects can boost investment, productivity, and growth. Moreover, deficits associated with cuts     in individual income tax rates can lower market interest rates and required expected market     rates of return. On the other hand, deficits caused by increased government spending can be     harmful because of their crowding-out effects, even when these effects are not brought about by     higher real interest rates and/or by an increase in the value of the dollar.Correct theory and evidence show that deficits are typically not related to higher real     interest rates. Usually, they are associated with lower interest rates,     because the rate of return to capital is depressed or the tax wedge between market yields and     the after-tax rate of return to investors is reduced by tax rate cuts. In either case, market     interest rates fall when deficits increase.Finally, the widely popular idea that current account deficits arise from budget deficits is     also not correct, at least for the U.S. economy during the past 25 years. Current account     movements are related to international capital flows that respond more to incentives for     domestic investment than to budgetary developments.Not surprisingly, the key expectations of simple theories now     circulating—especially about interest rates, the current account deficit, and the     dollar—are precisely opposite to what modern theory and evidence indicate. Investment     and asset allocation decisions that rely on the popular misrepresentations of why and how     deficits matter do material damage to investor interests.
Journal: Financial Analysts Journal
Pages: 12-19
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4152
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4152
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Author-Name: William J. Bernstein
Author-X-Name-First: William J.
Author-X-Name-Last: Bernstein
Title: Corporate Finance and Original Sin
Abstract: 
 The unique characteristics of the financial services industry present practitioners with          challenging ethical demands. Of these, the potential for extraordinary monetary gain and          the moral anesthesia resulting from the inward-looking nature of the profession conspire          to hamstring effective regulation by industry insiders. Effective control of the industry          must come from outside the industry. The choice is between regulation by a private entity          and regulation by a governmental body.Recent articles in the Financial Analysts Journal have made a powerful          case for a self-regulatory approach to the conflicts of interest revealed by recent          corporate scandals. The authors argued that in the long run, ethical behavior is both          morally and economically satisfying and that a robust industry-derived          educational and institutional ethical framework should prove adequate to the task.I disagree. The probability of ethical failure is affected by several factors, prime          among which are the amount of remuneration involved, the emotional reinforcement provided          by peers, and the length of time participants have been exposed to industry norms. The          larger the amount of compensation involved, the more the practitioner is inappropriately          reassured of the rectitude of his unethical behavior, and the longer the practitioner has          been exposed to such behavior, the higher the likelihood of an unethical outcome.Unfortunately, all three factors conspire against the financial services industry. The          amount of compensation is so high that it not only induces unethical behavior but also          actually serves to attract unethical players to the field. Moreover, the hothouse          atmosphere of the financial services industry produces a moral anesthesia that blinds          participants to conflicts obvious to outsiders; the longer such activities are deemed          acceptable, the more likely they are to occur in the future and become the norm.Because of these factors, ethical reform of the financial services industry must come          primarily from outside the industry. Furthermore, examination of other professions, as          well as the dismal recent records of the National Association of Securities Dealers and          NYSE board of directors, argues for a substantial governmental role in the process of          reform and oversight.
Journal: Financial Analysts Journal
Pages: 20-23
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4153
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4153
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Author-Name: Neil Constable
Author-X-Name-First: Neil
Author-X-Name-Last: Constable
Author-Name: Jeremy Armitage
Author-X-Name-First: Jeremy
Author-X-Name-Last: Armitage
Title: Information Ratios and Batting Averages
Abstract: 
 The information ratio (IR) and the batting average are two commonly quoted measures of     investment success, but these measures have shortcomings: The IR contains no information about     higher moments, and the batting average contains only directional information. This article     demonstrates how the IR and batting average interact and how they can be usefully combined to     allow investors to construct a comprehensive picture of the choices they face. The intriguing     result is that large batting averages can result in low IRs and, conversely, impressive IRs can     be obtained with low batting averages. Furthermore, in choosing between two managers with     equivalent IRs, an investor who is averse to blowups should choose the manager with the lower     batting average.The information ratio (IR) is a common measure of the success (or failure) of money managers.     Conceptually, it is simply the ratio of the excess return (relative to a benchmark) to the     excess risk of an investment strategy. Unfortunately, when a fund manager quotes only the IR at     the end of some fixed investment horizon, investors in the fund cannot easily ascertain the     string of successes and failures that led to that final outcome. Did the manager win or lose     most of the bets? A measure of success that addresses this shortcoming of the IR is the     “batting average.” It is the percentage of investment decisions that led     to a profit. The shortcoming of this measure is that it does not give any information about how     much money was made or lost as a result of a particular investment decision.This article demonstrates how the IR and batting average interact and how these two measures     of success can be usefully combined to allow investors to construct a comprehensive picture of     the manager or fund choices they face.Although the investment strategy used by a particular manager cannot be “reverse     engineered,” we show how one can extract a batting average once an IR is specified.     Our batting average indicates how often managers must make independent and profitable     investment decisions to obtain their stated IRs. It also provides insight into how much mileage     has been obtained from the available information.The batting average, which is a function of the number of “at bats,”     allows differentiation among managers who are using different investment strategies, because     the number of at bats is a good proxy for how often a manager receives information relevant to     the implementation of the manager’s strategy.We find that the IR and batting average do not convey equivalent information. Indeed, they     often provide seemingly contradictory information. One of our main points is that this     confusion arises because success is a multidimensional concept and the IR and batting average     measure different components of success. We argue that whereas the IR measures the     risk-adjusted returns of a particular strategy, the batting average is a useful proxy for the     skewness of the distribution of returns. The batting average, therefore, provides information     about the higher moments in a particular distribution of returns, information that cannot be     measured by the IR.We first demonstrate that if the payoffs for winning and losing are symmetrical (a win     followed by a loss results in zero return), a winning strategy need surpass a batting average     of 50 percent by only a tiny margin to generate spectacular IRs—provided the strategy     is implemented frequently.Next, we investigate the consequences of assuming the more realistic scenario in which     investment decisions have asymmetrical upside and downside returns. Here, we find the     intriguing result that large batting averages can result in low IRs and that impressive IRs can     be obtained with low batting averages.Finally, we demonstrate that in choosing between two managers with equivalent IRs, an     investor who is averse to blowups should choose the manager with the lower     batting average. Such investors should be wary of standard marketing messages that go no     further than claiming “our fund outperformed our benchmark in 8 of the last 10     years.”Success is a multidimensional concept, and IRs and batting averages approach it from     different directions. Used together, the IR and the batting average provide orthogonal and     complementary information, allowing investors to effectively disentangle the multitude of     choices presented to them by the investment community.
Journal: Financial Analysts Journal
Pages: 24-31
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4154
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4154
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Author-Name: Dalia Marciukaityte
Author-X-Name-First: Dalia
Author-X-Name-Last: Marciukaityte
Author-Name: Samuel H. Szewczyk
Author-X-Name-First: Samuel H.
Author-X-Name-Last: Szewczyk
Author-Name: Hatice Uzun
Author-X-Name-First: Hatice
Author-X-Name-Last: Uzun
Author-Name: Raj Varma
Author-X-Name-First: Raj
Author-X-Name-Last: Varma
Title: Governance and Performance Changes after Accusations of Corporate Fraud
Abstract: 
 Using a sample of companies charged with government, financial reporting, or stakeholder          fraud or regulatory violation in the United States during the 1978–2001 period,          this study found that after the accusation of fraud, companies increased the proportion of          outsider directors on their boards of directors and on the monitoring committees of the          boards. Furthermore, the results show comparable long-run stock price and operating          performance between companies charged with fraud and a matching sample of companies not          accused of fraud. Collectively, these results suggest that improvements in internal          control systems following accusations of fraud help repair a company’s damaged          reputation and reinstate confidence in the company.The commission of corporate fraud is a glaring failure of a company’s internal          control system. In previous studies, such failures have been shown to impose significant          costs on shareholders. We examine whether the costs of corporate fraud are sufficiently          high to motivate changes in internal control systems that may lower the likelihood of          future commissions of fraud. We focus on changes in the structure of the board of          directors and its committees after the accusation or revelation of fraud because the board          stands at the apex of the company’s internal control system.Using press announcements of corporate frauds, we constructed a sample consisting of 133          pairs of “fraud” and “no-fraud” companies          matched by industry and size. We found that companies increase the percentage of outside          directors on their boards following accusations of corporate fraud and increase the          proportion of independent outside directors on the boards’ oversight          committees. These changes result in board and committee structures that are comparable to          those of no-fraud companies, suggesting that fraud companies attempt to reduce further          incidents of fraud.We also examined changes in corporate board structures before and following the 1991          corporate sentencing guidelines instituted by the U.S. Sentencing Commission and present          evidence that market-imposed reputational costs alone are sufficient to induce positive          changes in the boards of directors of fraud companies.Finally, we examined the long-term financial and operating performance of fraud          companies. We found that the postfraud performance of fraud companies is comparable to          that of the matched no-fraud companies, indicating that changes in internal control          systems following accusations of fraud work toward restoration of the company’s          reputation in financial and product markets.Our study has important implications for the ongoing debate on the appropriate size of          penalties imposed on companies because our evidence suggests that civil and criminal          penalties can be set at low levels. The evidence we present also has implications for          recent reforms to reduce the occurrence of corporate fraud, including the          Sarbanes–Oxley Act of 2002 and reforms initiated by the NYSE and NASDAQ. These          reforms impose several governance provisions on publicly traded companies in the United          States that increase the independence of corporate boards and their committees. Our study          reinforces the reasoning underlying these reforms because our results indicate that the          markets induce companies that have committed or been accused of committing fraud to alter          their board structures in a manner consistent with these reforms. But this market-imposed          transformation of board structure is largely reactive in nature. Sarbanes–Oxley          and the NYSE and NASDAQ rules achieve the same by being proactive.
Journal: Financial Analysts Journal
Pages: 32-41
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4155
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4155
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Author-Name: Eurico J. Ferreira
Author-X-Name-First: Eurico J.
Author-X-Name-Last: Ferreira
Author-Name: Stanley D. Smith
Author-X-Name-First: Stanley D.
Author-X-Name-Last: Smith
Title: Effect of Reg FD on Information in Analysts’ Rating Changes
Abstract: 
 A rich literature examines the effects of analysts’ recommendations on stock          prices, and literature is developing on the effect of Regulation Fair Disclosure on the          information associated with corporate earnings forecasts and announcements. This study          examines the effect of Reg FD on the information content of analysts’ rating          changes. Based on recommendations associated with a random sample of S&P 500 Index          stocks, the major finding is that investors have been responding to analysts’          recommendations in the same way since Reg FD as they did before implementation of Reg FD.          In addition, the results suggest that Reg FD does not require that practitioners change          the way they view the analyst recommendation process.The U.S. SEC’s Regulation Fair Disclosure was first drafted in December 1999,          was released in August 2000, and became effective on 23 October 2000. Reg FD was designed          to eliminate “selective disclosure” that operated between the company          and its analysts or institutional investors. Selective disclosure occurs when a company          releases material nonpublic information to specific groups at different times. The          practitioner media have extensively discussed the effects of Reg FD on the behavior of          corporate financial officers and their interactions with stock analysts and on the          analyses carried out by the analysts. In addition, a growing number of academic studies          have focused on the effect of Reg FD on earnings announcements or analysts’          earnings forecasts. A rich literature also examines the effects of analyst recommendations          on stock prices.This study contributes to the literature by examining the effect of Reg FD on the          information content of analysts’ changes in recommendations between a          preregulation period (1 August 1999 to 31 July 2000) and a postregulation period (1          January 2001 to 31 December 2001). We used a large sample of upgrade and downgrade recommendations for a random sample of          167 S&P 500 Index stocks. We compared stock reactions (price and volume) to          upgrades and downgrades in the preregulation period with reactions in the postregulation          period. The analyst recommendations fell into 14 action levels, which could be grouped          into five categories: 1 = strong buy, 2 = buy, 3 = market outperformance, 4 = hold, and 5          = sell.With respect to downgrades, the overall results in the form of price impact for the          announcement day were negative and significant in the pre- and postregulation periods. The          change in the effect of Reg FD in the postregulation period, however, varied by action          level (but at the action level, samples were small). The overall conclusion is that there          has been no Reg FD impact on downgrades.With respect to upgrades, the overall results in the form of price impact for the          announcement day were significant in the pre- and postregulation periods, but we found no          significant difference between the effect by period. Reg FD does not appear to have          affected the impact of upgrades on stock prices.The volume associated with a rating change, as measured by abnormal volume, declined          after Reg FD was implemented.The sample of 2,247 observations included 1,329 observations of single actions and 918          observations of multiple recommendations—that is, several actions recommended          for the same stock simultaneously on Day 0 or a few days apart within the Day –4          to Day +4 announcement period. Moreover, the initial analyses did not consider the effect          of decimalization of the U.S. exchanges, which occurred in the period studied (for the          NYSE and Amex, 19 January 2001; for NASDAQ, 9 April 2001). These factors were controlled          for in further tests. We used regression analyses to examine the effects of the multiple          same-day and overlapping recommendations and decimalization on stock prices in the pre-          and postregulation periods. The multiple same-day recommendations were found to be statistically significant control          variables and increased the magnitude of the average prediction errors on the announcement          day. Downgrades had a much larger impact on abnormal returns than upgrades. The decimalization variables were not significant but did pose a problem in estimating          the value of the variable to test for a change in the impact of Reg FD on the value of          analysts’ rating changes after the implementation of Reg FD on 23 October 2000.          The coefficient for this variable was negative but insignificant.The major finding of this study is that investors continue to respond to          analysts’ recommendations in the same way after the implementation of Reg FD as          they did before its implementation. Given the lack of a significant change in the impact          of recommendation changes on stock prices, the results do not require practitioners to          change the way they view the analyst recommendation process.
Journal: Financial Analysts Journal
Pages: 44-57
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4156
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4156
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Author-Name: Ping Zhou
Author-X-Name-First: Ping
Author-X-Name-Last: Zhou
Author-Name: William Ruland
Author-X-Name-First: William
Author-X-Name-Last: Ruland
Title: Dividend Payout and Future Earnings Growth
Abstract: 
 Because dividends reduce the funds available for investment, many market observers and          investors associate high dividend payout with weak future earnings growth. Tests using          aggregate market data, however, provided evidence that contradicts that view. Because          aggregate results may not apply at the company level, we conducted a company-by-company          analysis of the relationship between payout and future earnings growth. Our tests also          show that high-dividend-payout companies tend to experience strong, not weak, future          earnings growth. These results are robust to alternative measures of payout and earnings,          sample composition, mean reversion in earnings, the effects of particular industries, time          periods, and share repurchases.Market observers and investors often view low dividend payout as a precursor of high          future earnings growth. The rationale is that companies pay fewer dividends or retain more          earnings when growth opportunities are high. Low payout, in this view, indicates strong          future earnings growth. Considerable theoretical and empirical work supports this belief.Others, however, have found in examining the aggregate U.S. equity market that future          earnings growth is associated with high rather than low dividend payout, a result that          contrasts sharply with conventional wisdom. Although these results for the aggregate          market have important implications with respect to the valuation of the overall markets,          whether the aggregate-level results pertain also to individual companies has not been          determined.We report research to examine that issue. Using company-level data from Compustat, we          examined one-, three-, and five-year future earnings growth as a function of dividend          payout. In our initial tests, the control variables were company size, return on assets,          financial leverage, earnings yield, past earnings growth, and growth in total assets. The          large sample included observations from 1950 through 2003. Our tests show that the          coefficients on payout are all positive and highly significant, which indicates that          companies with high current dividend payouts tend to have high future earnings growth.In tests of robustness, we included controls for the potential effects of survivor bias,          potential nonlinearity in the relationship between payout and future earnings growth,          alternative measures of earnings, small companies, regulated industries, specific time          periods, industry membership, and share repurchases. The relationship between dividend          payment and high future earnings growth remained strong.What explains the positive relationship between current payout and future earnings          growth? A possibility is that the companies with low dividend payouts are overinvesting          free cash flow. To test for the operation of this free cash flow theory, we adopted as a          proxy for growth opportunities the ratio of a company’s market value of equity          and book value of debt to the book value of its assets,V/A. We found that the relationship between payout and          future earnings growth continued to be strong despite the introduction of theV/A variable. These results indicate that when growth          potential is low, the association between payout and earnings growth is strong, a          relationship that is consistent with the overinvestment of free cash flow.Our company-level analysis complements the previous aggregate-level analysis that found          that high payout is related to high future earnings growth. And both studies challenge          conventional wisdom. The previous study is important for valuing the aggregate markets;          our results shed light on the valuation of individual stocks.
Journal: Financial Analysts Journal
Pages: 58-69
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4157
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4157
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Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: A Behavioral Approach to Asset Pricing (a review)
Abstract: 
 Theoretical and quantitative in orientation, this book provides a thorough analysis of          the sentiment factor, which stems from systematic errors committed by          investors, as one of the major determinants of asset pricing in the behavioral        approach.
Journal: Financial Analysts Journal
Pages: 70-71
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4158
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4158
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Author-Name: Michael A. Martorelli
Author-X-Name-First: Michael A.
Author-X-Name-Last: Martorelli
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Deals from Hell: M&A Lessons That Rise Above the Ashes (a review)
Abstract: 
 This readable volume analyzes old and new merger and acquisition failures (and successes)          to extract six common factors that influence failures in complex engineering systems and          in complex corporate mergers.
Journal: Financial Analysts Journal
Pages: 71-72
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4159
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4159
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Distressed Debt Analysis: Strategies for Speculative Investors (a review)
Abstract: 
 This authoritative resource for anybody with financial exposure to a company teetering on          the edge of, or already in, bankruptcy—either by the investor’s          design or through an investment gone bad—shows how in this fascinating sector of          the market, players follow moves akin to chess moves.
Journal: Financial Analysts Journal
Pages: 72-72
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4160
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4160
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Author-Name: Bob Litterman
Author-X-Name-First: Bob
Author-X-Name-Last: Litterman
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Fischer Black and the Revolutionary Idea of Finance (a review)
Abstract: 
 The tale of Fischer Black’s life, with all its eccentricities, is marvelously          told in the weaving together of two stories—the history of Black’s          ideas about the capital asset pricing model and a biography of the man.
Journal: Financial Analysts Journal
Pages: 74-75
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4161
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4161
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Author-Name: Emanuel Derman
Author-X-Name-First: Emanuel
Author-X-Name-Last: Derman
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Legacy of Fischer Black (a review)
Abstract: 
 This wide-ranging, well-edited book provides a good taste of Black’s approach          to quantitative finance through a thoughtful introduction and a variety of essays on          Black’s many interests in finance theory and application.
Journal: Financial Analysts Journal
Pages: 75-76
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4162
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4162
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Pension Fund Politics: The Dangers of Socially Responsible Investing (a review)
Abstract: 
 This short and highly readable book presents the conflict between the need for pension          funds to pursue the mission of ensuring retirement income for their beneficiaries and the          diversion of public employees’ retirement funds to the advancement of          non-investment-related (sometimes return-destroying) causes.
Journal: Financial Analysts Journal
Pages: 76-77
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4163
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4163
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Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Principles of Private Firm Valuation (a review)
Abstract: 
 This book explains, but with a number of flaws, the modifications to textbook methodology          that are required to value private companies.
Journal: Financial Analysts Journal
Pages: 77-78
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4164
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4164
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issue.
Journal: Financial Analysts Journal
Pages: 80-80
Issue: 3
Volume: 62
Year: 2006
Month: 5
X-DOI: 10.2469/faj.v62.n3.4165
File-URL: http://hdl.handle.net/10.2469/faj.v62.n3.4165
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Expectations Shortfall
Abstract: 
 Some causes of implementation shortfall are exogenous—outside a                    manager’s direct control—which leads to expectations                    shortfall. Such causes are asset/liability mismatch, inflation, the demographic                    challenge of increasing life spans (will the purchasing power of a                    person’s assets last as long as the person does?), and taxes. The                    investment challenges posed by exogenous factors are manageable but only if the                    risks are anticipated, client expectations are managed, and portfolios are                    positioned to weather future storms.
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4178
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4178
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Author-Name: Dana N. Merrill
Author-X-Name-First: Dana N.
Author-X-Name-Last: Merrill
Title: “The Myth of the Absolute-Return Investor”: A Comment
Abstract: 
 This material comments on “The Myth of the Absolute-Return                    Investor.”
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4179
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4179
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Author-Name: M. Barton Waring
Author-X-Name-First: M. Barton
Author-X-Name-Last: Waring
Author-Name: Laurence B. Siegel
Author-X-Name-First: Laurence B.
Author-X-Name-Last: Siegel
Title: “The Myth of the Absolute-Return Investor”: Author Response
Abstract: 
 This material comments on “The Myth of the Absolute-Return                    Investor.”
Journal: Financial Analysts Journal
Pages: 11-11
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4180
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4180
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Author-Name: Ned W. Schmidt
Author-X-Name-First: Ned W.
Author-X-Name-Last: Schmidt
Title: “Long-Term Returns on the Original S&P 500 Companies”: A Comment
Abstract: 
 This material comments on “Long-Term Returns on the Original                    S&P 500 Companies”.
Journal: Financial Analysts Journal
Pages: 11-12
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4181
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4181
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Author-Name: Jeremy J. Siegel
Author-X-Name-First: Jeremy J.
Author-X-Name-Last: Siegel
Author-Name: Jeremy D. Schwartz
Author-X-Name-First: Jeremy D.
Author-X-Name-Last: Schwartz
Title: “Long-Term Returns on the Original S&P 500 Companies”: Author Response
Abstract: 
 This material comments on “Long-Term Returns on the Original                    S&P 500 Companies.”
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4182
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4182
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Author-Name: William Reichenstein
Author-X-Name-First: William
Author-X-Name-Last: Reichenstein
Title: After-Tax Asset Allocation
Abstract: 
 Several studies have found fundamental flaws in the traditional approach to                    managing individual investors’ portfolios, including a failure to                    distinguish between $1 of pretax funds in a 401(k) and $1 of after-tax funds in                    either a taxable account or Roth IRA. This study recommends that an                    individual’s asset values be converted to after-tax values and the                    asset allocation be based on the after-tax values. In general, within the target                    asset allocation, individuals should hold bonds and other assets subject to                    ordinary income tax rates in retirement accounts and hold stocks, especially                    passively managed stocks, in taxable accounts.Several studies have concluded that we have been mismanaging individual                    investors’ asset allocations in two ways. In this article, I describe                    one of these errors—namely, the failure to calculate an                    individual’s asset allocation on an after-tax basis. The traditional                    approach to calculating asset allocation fails to distinguish between $1 of                    pretax funds in a 401(k) and $1 of after-tax funds in a taxable account or Roth                    IRA. Yet, if withdrawn in retirement today by someone in the 33 percent tax                    bracket, the $1 in the 401(k) will buy $0.67 of goods and services whereas the                    $1 in the taxable account or Roth IRA will buy $1 of goods and services.This study advocates the calculation of after-tax asset allocation. To calculate                    an individual’s after-tax asset allocation, we must first convert all                    asset values to after-tax values. From my experience, the major adjustment that                    must be made with this approach is the conversion of pretax funds in 401(k) and                    other tax-deferred accounts. To convert these pretax funds to after-tax funds,                    one multiplies the pretax value by (1 –tr), where tr is the                    expected tax rate during retirement. Another issue is that assets in taxable                    accounts may have embedded but unrealized capital gains or losses. In those                    cases, it may be appropriate to reduce an asset’s market value to                    account for the embedded tax liability or increase the market value to account                    for the tax saving from the embedded tax loss. The “best”                    way to handle this issue depends on when, if ever, the gain or loss will affect                    the taxes to be paid.Other investment implications flow from the after-tax framework. This framework                    changes the determination of an individual’s optimal asset allocation                    and asset location, where asset location refers to the decision to locate                    primarily bonds in retirement accounts and stocks in taxable accounts, or vice                    versa, while the target asset allocation is retained. Until recently, scholars                    recommended that these decisions be made sequentially by first determining                    optimal asset allocation, then optimal asset location. Today, we recognize that                    these decisions must be made jointly. In general, bonds and other assets whose                    returns are taxed at ordinary income tax rates should be held in retirement                    accounts whereas stocks, especially passively managed stocks, should be held in                    taxable accounts.Financial advisors who use the traditional approach to calculate                    individuals’ asset allocations are miscalculating their true                    allocations. This approach fails to distinguish pretax funds from after-tax                    funds. Furthermore, the measurement errors can be substantial. This study                    advocates the calculation of an individual’s after-tax asset                    allocation so that after-tax funds are compared with after-tax funds. Thus, the                    approach corrects a major deficiency in the traditional approach.
Journal: Financial Analysts Journal
Pages: 14-19
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4183
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4183
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Author-Name: Raymond A. LeClair
Author-X-Name-First: Raymond A.
Author-X-Name-Last: LeClair
Author-Name: Evan Schulman
Author-X-Name-First: Evan
Author-X-Name-Last: Schulman
Title: Revenue Recognition Certificates: A New Security
Abstract: 
 Revenue recognition certificates provide returns as a specified function of a                    company’s sales or gross revenues over a defined period of time in                    the future. To explore whether certificates would be an advantage in the                    financial markets, this article discusses the agency problems of these                    certificates as well as the benefits to investors and issuers of debt and                    certificates. A corporate bond pricing model is adapted to value the                    certificates and is used to produce representative numerical examples.We explore the concept of a security that provides returns as a direct function                    of a company's gross revenue over a specified future period, expires worthless                    at maturity, and requires no assets to be segregated as collateral. Novel                    features of such “revenue recognition certificates” include                    transparency, high cash flow, and inflation protection. Investors in                    certificates would not be residual claimants on revenue, as equityholders are,                    nor would they offer to management an implied put option, as corporate                    bondholders do.This contract is not new: Some financing joint ventures are structured in this                    way, and similar contracts have been used to finance asset management companies                    for restructuring or for other purposes.What would be the benefits and problems associated with securitizing such a                    contract? And would the investment characteristics of such an instrument allow                    it to garner more than a niche position in the financial markets? To answer                    these questions, we compare the issuance of revenue recognition certificates (or                    simply, certificates) with the issuance of bonds because both types of                    securities raise capital with instruments that eventually mature. Our analysis                    suggests that certificates, although not without disadvantages, offer appealing                    benefits for both investors and issuers.Because certificates would behave much like equity when first issued and much                    like money market instruments just prior to expiry, investors would need to                    trade or “ladder” issues to maintain an appropriate risk                    exposure. Because certificates would require investors and traders to have less                    specialized knowledge of the issuer’s accounting practices than bond                    investing requires, we expect market participants will create the infrastructure                    necessary to both issue and trade certificates in a standardized form, much like                    exchange-traded options. As a result, certificates should be more liquid than                    corporate bonds.To exploit negative insights about the management of a company while hedging                    against an increase in the company’s sales or revenue, investors                    would be able to purchase positions in long-duration certificates of the company                    while shorting the company’s stock. Certificates would help to                    complete markets.Issuers of certificates would have no need for restrictive covenants to maintain                    debt coverage, and there would be fewer bankruptcies because investors in                    certificates would have no call on the company’s assets. As a result,                    the interests of certificate issuers and equity investors would be more closely                    aligned. However, certificates would provide a clear incentive for issuers to                    use the proceeds of a certificate to improve the company’s                    productivity rather than increase its sales. Although this subject warrants                    additional investigation, our analysis indicates that the agency problems                    involved with the issuance of debt—risk shifting and                    underinvestment— would be lessened by the issuance of certificates                    instead of debt.To provide numerical examples, we developed a structural approach for valuing                    certificates based on a model for valuing risky corporate debt. We found the                    distribution of expected values for revenue recognition certificates and                    portfolios of such certificates to be broader than the distribution of values                    for comparable debt issues or debt portfolios. And the certificate distributions                    exhibited significantly longer upside tails. We believe that with such                    investment characteristics, certificates would provide corporate debt markets                    with competition.We also discuss the accounting appropriate for revenue recognition certificates                    based on recent guidance from the American Institute of Certified Public                    Accountants. And we compare an example income statement for a company issuing                    debt with an income statement for a company issuing revenue recognition                    certificates.
Journal: Financial Analysts Journal
Pages: 20-30
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4184
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4184
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Author-Name: Honghui Chen
Author-X-Name-First: Honghui
Author-X-Name-Last: Chen
Author-Name: Gregory Noronha
Author-X-Name-First: Gregory
Author-X-Name-Last: Noronha
Author-Name: Vijay Singal
Author-X-Name-First: Vijay
Author-X-Name-Last: Singal
Title: Index Changes and Losses to Index Fund Investors
Abstract: 
 Because of arbitrage around the time of index changes, investors in funds linked to the     S&P 500 Index and the Russell 2000 Index lose between $1.0 billion and $2.1 billion a     year for the two indices combined. The losses can be higher if benchmarked assets are     considered, the pre-reconstitution period is lengthened, or involuntary deletions are taken     into account. The losses are an unexpected consequence of the evaluation of index fund managers     on the basis of tracking error. Minimization of tracking error, coupled with the predictability     and/or pre-announcement of index changes, creates the opportunity for a wealth transfer from     index fund investors to arbitrageurs.The growth in popularity of index funds is a testament to portfolio theory and the virtues of     diversification. According to Frank Russell Company, about $2,000 billion in assets were     benchmarked to major indices as of June 2003—an indication that indices are an     important component of the financial landscape. Investors drawn to the broad diversification     and low turnover that characterize index mutual funds no doubt expect the fund portfolios to be     invested in the companies constituting the index in the proper proportions at any given time.     But fund managers rewarded for performance have an incentive to assume more risk than     contracted for by their investors. To address this agency problem, fund managers implicitly or     explicitly contract to minimize the size and volatility of tracking error. Accordingly, the     performance of index fund managers is usually measured in terms of both the cost of managing     the fund and its tracking error.We show that when the predictability and timing of index changes are combined with fund     managers’ objective of minimizing tracking error, index fund investors lose a     significant amount. The loss to an investor in the Russell 2000 Index is about 130 bps a year     but can be as high as 184 bps a year, and S&P 500 Index investors may lose as much as     12 bps a year. Consistent with this finding, we found that the Russell 2000 underperformed     other small-cap indices by more than 3 percentage points a year in the 1995–2002     period, even though comparable indices did not entail greater risk. Moreover, the     underperformance was concentrated in months surrounding the annual reconstitution of the index.In dollar terms, the losses range from $1.0 billion and $2.1 billion a year for the two     indices together and can be higher if benchmarked assets, a longer pre-reconstitution period,     and involuntary deletions are considered. These losses are an unexpected consequence of     evaluation of index fund managers by index fund investors on the basis of tracking error in an     effort to control agency costs. Minimization of tracking error, coupled with the predictability     and/or pre-announcement of index changes, creates the opportunity for a wealth transfer from     index fund investors to arbitrageurs.No type of index is a perfect solution to index arbitrage. An open but not heavily used index     is the best short-term solution, but once it becomes popular, it can create significant costs     for the index fund. The best long-term solution is a silent index (one that announces changes     only after they are made), but it is not permissible under current U.S. SEC regulations. A     popular index is not a good solution for small-cap portfolios because index changes are usually     large relative to the index’s market cap. A popular index is more acceptable for     large-cap portfolios because most changes to the index are small and inconsequential to the     overall index return. Fund investors indexed to popular large-cap indices can suffer when large     companies—such as Yahoo!, JDS Uniphase Corporation, Goldman Sachs, and United Parcel     Service of America (UPS)—are added to the index.We suggested steps that can be taken by index fund managers, index fund investors, and     indexing firms to recoup a significant part of their losses. Managers of index funds can     minimize losses by not trading on the effective date because the price pressure is the greatest     at that time. To provide the necessary flexibility to fund managers, investors should rely on     overall risk and return of the portfolio for performance evaluation instead of focusing on     tracking error. Indeed, we found that the risk of funds that used the strategies we outlined     would not be greater than the risk of the benchmark index, although the return would be higher.     Finally, small individual investors can protect themselves by choosing index funds on the basis     of not only expenses and loads but also the likelihood of the fund being timed by    arbitrageurs.
Journal: Financial Analysts Journal
Pages: 31-47
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4185
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4185
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Author-Name: Joshua Livnat
Author-X-Name-First: Joshua
Author-X-Name-Last: Livnat
Author-Name: Massimo Santicchia
Author-X-Name-First: Massimo
Author-X-Name-Last: Santicchia
Title: Cash Flows, Accruals, and Future Returns
Abstract: 
 This study explored the “accrual anomaly.” The study is                    unique because it analyzed originally                    reported—unrestated—quarterly data for 1991 through the                    first quarter of 2004 to calculate accruals and used U.S. SEC filing dates to                    identify the day on which investors first obtained information about accruals.                    The study found that the accrual anomaly exists for quarterly accruals as has                    been found for annual accruals. Future quarterly earnings were found to be more                    highly associated with current net operating cash flows than with accruals                    because accruals have less persistence than cash flows. Companies with extremely                    high (low) current quarterly accruals have significant and negative (positive)                    abnormal returns through the subsequent four quarters.Rigorous studies have documented that net operating cash flow is more closely                    associated with future income and stock returns than are                    accruals—which represent roughly the difference between income and net                    operating cash flows. Accruals are likely to reverse in subsequent periods                    whereas net operating cash flows tend to persist—which leads to                    mispricing known as the “accrual anomaly.”Researchers have found that when annual data are used, a trading strategy that                    holds long positions in companies with extremely low accruals and short                    positions in companies with high accruals produces significantly high abnormal                    returns over the subsequent three years. Because practitioners are unlikely to                    wait a whole year for the annual accrual data in order to make portfolio                    decisions or forecasts of future earnings, we investigated whether the accrual                    anomaly can be found in quarterly data. We discuss the persistence of quarterly                    cash flows and accruals and the implications of our findings for future returns                    to portfolio strategies.For the study, we used the quarterly original and unrestated Compustat data                    provided by Charter Oak Investment Systems. This database contains three numbers                    for each company for each Compustat line item in each quarter. The period                    covered was the first quarter of 1991 through the second quarter of 2004. The                    initial population consisted of all company-quarter observations for which                    earnings and net operating cash flows were available for the current quarter,                    the market value of equity at quarter-end was at least $50 million, and total                    assets were available for the “current” and prior quarter.We first investigated whether quarterly net operating cash flows are more                    persistent than quarterly accruals and found a negative and statistically                    significant association between current accruals and subsequent abnormal stock                    returns through all four quarters subsequent to the quarter in which the company                    filed financial forms with the U.S. SEC. In addition, we found for the quarterly                    data that, consistent with findings about annual accruals, net operating cash                    flow is more persistent than accruals. Current accruals are likely to reverse                    within one quarter.Next, to focus on the companies that would be more likely to have extremely high                    or low accruals, we required that all observations in the bottom two deciles of                    accruals (i.e., the most negative accruals) have both positive incomes and                    positive net operating cash flows. Company-quarter observations were sorted each                    quarter into deciles according to accruals, and we examined the differential                    future returns to the extreme-decile portfolios. We found the lowest returns for                    the portfolio that shorted the highest-accrual decile, higher returns for the                    portfolio that went long the lowest-accrual decile, and the highest returns for                    the hedge portfolio that combined those positions.The study documents that future abnormal returns are significantly more closely                    associated with current net operating cash flows than with current accruals. The                    study also shows that there is a negative association between current accruals                    and subsequent abnormal stock returns. It shows that a hedge portfolio that                    holds long positions in companies with the most extreme negative accruals and                    short positions in companies with the most extreme positive accruals yields                    positive and significant abnormal returns, whether held for one, two, three, or                    even four quarters.These results indicate the importance of a careful examination and breakdown of                    quarterly net operating cash flows and accruals when an analyst is interpreting                    current quarterly earnings. Portfolio managers and other investors are likely to                    benefit from incorporating quarterly accruals and net operating cash flows in                    their portfolio decisions. Similarly, security analysts may improve their                    forecasts of future quarterly earnings by incorporating the information in                    current cash flows and accruals.
Journal: Financial Analysts Journal
Pages: 48-61
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4186
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4186
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# input file: UFAJ_A_12047689_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Qiao Liu
Author-X-Name-First: Qiao
Author-X-Name-Last: Liu
Author-Name: Rong Qi
Author-X-Name-First: Rong
Author-X-Name-Last: Qi
Title: Do We Accept Accrual Profits at Our Peril?
Abstract: 
 The study described documented evidence that informed traders use their proprietary     information on accrual quality to trade against average investors. The informed     traders’ arbitrage strategy generated annualized abnormal returns adjusted by size     and book-to-market value of 19.8 percent over the 1993–2002 period. The accrual     profits were still significant after trading costs were subtracted. The findings suggest that     (1) informed traders’ profits from accruals-based strategies derive mainly from     their costly information on accrual quality and (2) the persistence of the “accrual     anomaly” may be driven by nondiversifiable information risk. The study suggests a     strategy for uninformed traders to overcome the information barrier by mimicking informed     traders.The “accrual anomaly”—the evidence that companies with higher     (lower) accruals earn lower (higher) abnormal returns—has been widely documented in     the literature and is well understood by portfolio managers. Studies on the accrual anomaly     have failed to explain the source of accrual profits, however, and the persistence of accrual     mispricing. If accrual profits are significant in size, why do the more sophisticated investors     not exploit this opportunity and quickly eliminate accrual mispricing?We used the return and stock trading information on NYSE and Amex stocks for the period     1993–2002 (from the CRSP, Compustat, and Trade and Quote databases) to examine     whether informed traders can take advantage of accrual mispricing and develop profitable     trading strategies based on information about accruals. We first used an algorithm developed to     compute the “probability of information-based trading” (PIN) for a stock     during a given time period. We then sorted the stocks by their PIN values. We identified     evidence that the arbitrage strategy confined to the stocks with high PIN values—that     is, the stocks where private information-based trading would be     concentrated—generates an annualized abnormal return to a portfolio adjusted for     company size and book-to-market value (B/M) of 19.8 percent. The evidence shows that informed     traders actively use their proprietary information about accrual quality and trade against the     average investor.We then applied three methods to compute trading costs and control for their impact on the     profitability of the accruals-based trading strategy. We found that informed traders could make     an abnormal return ranging from 6.5 percent to 17.5 percent after trading     costs. These results are robust to testing methods, asset-pricing models used, and     various ways of controlling for trading costs. The results suggest that the source of accrual     profits and of their persistence may be nondiversifiable information risk rather than high     trading costs. The accrual profits to the informed traders derive mainly from their access to     costly information on accrual quality.The implications of our findings for portfolio managers are twofold. First, using the results     reported here allows portfolio managers to better understand the source and persistence of     accrual profits. This understanding may help them design effective arbitrage strategies around     accrual information. Second, our analysis suggests a way for uninformed traders to overcome the     information barrier and mimic informed traders’ behavior. Because of a high level of     autocorrelation in the measure of the extent of informed trading (PIN), an accruals-based     strategy can be based on PINs from the previous period, which is known to investors when     forming their portfolios. In our tests, stocks with high previous-period PINs generated     abnormal profits similar in size and significance to those informed traders could obtain. Thus,     portfolio managers and even individual investors can harvest accrual profits by using data     publicly available to compute the probability of informed trading.
Journal: Financial Analysts Journal
Pages: 62-75
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4187
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4187
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Author-Name: Steven P. Peterson
Author-X-Name-First: Steven P.
Author-X-Name-Last: Peterson
Author-Name: John T. Grier
Author-X-Name-First: John T.
Author-X-Name-Last: Grier
Title: Covariance Misspecification in Asset Allocation
Abstract: 
 Series of returns to broad asset classes often possess histories of unequal length and have     been subject to smoothing. Estimates of covariances are generally based on the common, although     shorter, series length, and covariances for smoothed series are necessarily biased downward.     These characteristics pose serious problems that can generate suboptimal and misleading     allocations among asset classes. The article discusses elements of the underlying theory in     proposing an informationally efficient covariance estimator. The estimator is then compared     with conventional covariance estimates in an empirical application. Covariance estimates are     found to be sensitive to both truncated estimates involving shorter series and the effects of     smoothing.Problems related to estimation of mean returns are well known, but problems related to     covariance estimation are thought to be benign. In applications, however, solutions to     quadratic optimization problems often fail because of ill-conditioned covariance matrices. This     problem is especially relevant for the search for optimal allocations among broad asset classes     whose covariance estimates must first circumvent a number of obstacles—in particular,     return series of unequal length and return smoothing.We find that cross-moments estimated on truncated return series (because of different series     lengths) are informationally inefficient and that smoothing biases volatilities downward. In     both cases, covariance estimates can produce seriously misleading portfolio allocations.     Drawing together the theoretical literature on these issues, we propose a procedure for     covariance estimation that is informationally rich, more efficient than in traditional methods,     and free of the biases associated with naive estimates. Empirically, we compare this improved     estimator with the naive estimator in applications to allocations for asset classes typically     considered by large institutional investors.We use a framework from the literature that maximizes the informational efficiency in     constructing covariance estimates for series of different length. We extend this framework to     provide an algorithm for updating covariances sequentially, and we include a formal process     that addresses some common types of return smoothing. We also analyze relative portfolio     performance in a Monte Carlo experiment that isolated and measured the allocative inefficiency     and higher risk common to portfolios based on naive covariance estimates for truncated and     smoothed series.Using historical returns to seven asset classes and applying the corrections for truncation     and smoothing, we first estimated a corrected covariance matrix, which we contrasted to the     corresponding naive covariances. We then addressed allocative inefficiency in the Monte Carlo     experiment, in which we used this corrected covariance matrix with a corresponding vector of     asset-class returns to generate repeated samples of quarterly returns. We then estimated     corrected and naive covariance matrices and mean returns for each sample, and we used these     data as arguments in separate mean–variance-optimization problems to solve for the     optimal portfolio. Because the “true” returns and covariances that     generated these samples were known a priori, these simulated portfolios could     be compared with the “full-information” portfolio.On the one hand, we found that for N = 10,000 repetitions, the average     quarterly misallocation (measured as deviation in asset-class weights from the true weight     vector) for the naive portfolio was 28.66 percent. And a Wilcoxon test easily rejected the null     hypothesis that the weight distributions for the full-information and naive estimates are     equal.On the other hand, the corrected covariances reduced misallocation by 8.14 percentage points     per quarter, and we failed to reject the null hypothesis that the corrected and     full-information portfolio weight distributions share the same median. Moreover, the median     quarterly naive return underperformed both the full-information and corrected median quarterly     returns. The naive portfolio’s tendency to take on extreme positions could be     clearly seen in this portfolio’s return volatility (2.51 percent) per quarter     relative to the volatility of the full-information portfolio (2.17 percent) and corrected     portfolio (2.22 percent).Finally, a long-only constraint exacerbated underperformance of the naive portfolio; it     forced approximately 13 percent more extreme (zero-weight) positions than did the     full-information portfolio, whereas the corrected covariance portfolio produced only 5 percent     more extreme positions.In general, naive covariance estimates generate portfolios with lower returns and higher     risks than corrected estimates, and naive covariance estimates underestimate true value at     risk.
Journal: Financial Analysts Journal
Pages: 76-85
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4188
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4188
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# input file: UFAJ_A_12047691_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jeff Anderson
Author-X-Name-First: Jeff
Author-X-Name-Last: Anderson
Author-Name: Gary Smith
Author-X-Name-First: Gary
Author-X-Name-Last: Smith
Title: A Great Company Can Be a Great Investment
Abstract: 
 A classic investment mistake is to confuse a great company with a great                    investment. It is a mistake because a company’s well-known virtues                    are presumably already factored into the price of the company’s                    stock. This study tested this “mistake” by looking at the                    stock performance of the companies identified each year byFortune magazine as the most admired companies in the United                    States for 1983 through 2004. Surprisingly, a portfolio of these stocks                    outperformed the market by a substantial and statistically significant margin,                    which contradicts the efficient market hypothesis.When we buy groceries, clothing, or a television set, we ask not only whether the                    food is good, the clothing attractive, and the television well built, we also                    ask how much an item costs. Is it worth the price? When we buy stock, we should                    ask the same question—not whether it is issued by a good company, but                    whether the price is right. Is the stock worth the cost? A classic investment                    mistake is to confuse a great company with a great investment. It is considered                    a mistake because a company’s well-known virtues are presumably                    already factored into the price of the company’s stock.This study tested this “mistake” by looking at the stock                    performance of the companies identified each year by Fortune                    magazine as the most admired companies in the United States. We used the CRSP                    database to obtain the daily returns on every publicly traded top-10 company for                    each year from 1983 through 2004 beginning on that year’sFortune publication date. The strategy was to invest an                    equal dollar amount in each of the most admired stocks each year. In various                    calculations, the trading day was the publication date or 5, 10, 15, or 20                    market days after the publication date. The comparison portfolio was fully                    invested in the S&P 500 Index for the entire 22 years. TheFortune strategy beat the S&P 500 by a margin that                    is both substantial and statistically persuasive.From this comparison, we concluded that this observed difference in returns is                    unlikely to represent some sort of risk premium, because the companies selected                    as America’s most admired are large and financially sound and their                    stocks are unlikely to be viewed by investors as riskier than average. To                    investigate this conclusion formally, we estimated the Fama–French                    three-factor model augmented by a momentum factor. We found that the success of                    the Fortune portfolio does not appear to be attributable to the                    effects of market, size, value, or momentum.We also analyzed the levels of wealth for the Fortune portfolio                    and the S&P 500 portfolio at 250-day intervals over a period                    encompassing the selection year and four subsequent years. TheFortune portfolios achieved, on average, a 16.51 percent                    increase in value, whereas the S&P 500 showed an average increase of                    only 10.27 percent.The portfolio of Fortune’s most admired companies                    outperformed an S&P 500 portfolio, whether the stocks were purchased on                    the publication date or 5, 10, 15, or 20 trading days later. This result is a                    clear challenge to the efficient market hypothesis, becauseFortune’s picks are readily available public                    information. We have no compelling explanation for this anomaly. Perhaps Peter                    Fisher’s conclusion in Common Stocks and Uncommon                    Profits was right: The way to beat the market is to focus on                    scuttlebutt—those intangibles that do not show up in a                    company’s balance sheets. Fortune’s list                    of the most admired companies is the ultimate scuttlebutt.
Journal: Financial Analysts Journal
Pages: 86-93
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4189
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4189
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Managing Pension and Retirement Plans: A Guide for Employers, Administrators, and Other Fiduciaries (a review)
Abstract: 
 In clear, concise, and well-organized prose, this book provides valuable insights into          the legal matters and also the investment and administrative aspects that bear close          examination by anyone involved in pension or retirement plans. 
Journal: Financial Analysts Journal
Pages: 94-94
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4190
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4190
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and                issue.
Journal: Financial Analysts Journal
Pages: 96-96
Issue: 4
Volume: 62
Year: 2006
Month: 7
X-DOI: 10.2469/faj.v62.n4.4191
File-URL: http://hdl.handle.net/10.2469/faj.v62.n4.4191
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: What Is Wealth?
Abstract: 
 Whether defined as “fecundity” or “sustainable spending,” the primary goal for investors is to increase the real spending that a portfolio can sustain. A closely related goal is to avoid shocks that jeopardize that future real spending. When sustainable real spending is the measure, a portfolio of “all asset classes,” but not a balanced U.S. stock/bond portfolio, provides true diversification to see the investor through bull and bear markets.The Editor’s Corner is a regular feature of the Financial Analysts Journal. It reflects the views of Robert D. Arnott and does not represent the official views of the FAJ or CFA Institute.
Journal: Financial Analysts Journal
Pages: 6-9
Issue: 5
Volume: 62
Year: 2006
Month: 9
X-DOI: 10.2469/faj.v62.n5.4275
File-URL: http://hdl.handle.net/10.2469/faj.v62.n5.4275
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Author-Name: Robert M. Braun
Author-X-Name-First: Robert M.
Author-X-Name-Last: Braun
Title: “Corporate Finance and Original Sin”: A Comment
Abstract: 
 This material comments on “Corporate Finance and Original                    Sin”.
Journal: Financial Analysts Journal
Pages: 10-12
Issue: 5
Volume: 62
Year: 2006
Month: 9
X-DOI: 10.2469/faj.v62.n5.4276
File-URL: http://hdl.handle.net/10.2469/faj.v62.n5.4276
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Author-Name: William J. Bernstein
Author-X-Name-First: William J.
Author-X-Name-Last: Bernstein
Title: “Corporate Finance and Original Sin”: Author Response
Abstract: 
 This material comments on “Corporate Finance and Original                    Sin.”
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 5
Volume: 62
Year: 2006
Month: 9
X-DOI: 10.2469/faj.v62.n5.4277
File-URL: http://hdl.handle.net/10.2469/faj.v62.n5.4277
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Author-Name: Paul L. Davis
Author-X-Name-First: Paul L.
Author-X-Name-Last: Davis
Author-Name: Michael S. Pagano
Author-X-Name-First: Michael S.
Author-X-Name-Last: Pagano
Author-Name: Robert A. Schwartz
Author-X-Name-First: Robert A.
Author-X-Name-Last: Schwartz
Title: Life after the Big Board Goes Electronic
Abstract: 
 The NYSE’s “Hybrid Market” will be a floor-based facility (a
                    “slow” market) combined with an electronic platform (a
                    “fast” market). Technological advances, regulatory pressure, and
                    competition have forced the exchange to introduce an electronic platform, but
                    its success will not be known for some time. This article addresses some of the
                    broad issues involved. The Big Board is considered as a network that provides
                    price and quantity discovery. The article raises several questions about the
                    integration of fast- and slow-market components and presents evidence that in
                    one European electronic exchange, roughly half the euro value of trades does not
                    go through the electronic order book.With portfolio managers under pressure to reduce the costs of trading securities,
                    financial markets are responding in new and creative ways to meet
                    managers’ needs. In the U.S. equity market, technological advances,
                    regulatory pressure, and competition have forced the NYSE to respond by
                    instituting the “Hybrid Market,” a floor-based facility
                    (“slow” market) combined with an electronic platform
                    (“fast” market). The success of the exchange’s electronic
                    platform and its efforts to combine floor-based trading with electronic trading
                    will not be known for some time. We address some of the broad issues
                    involved.We discuss the Big Board as a network that provides both price discovery and
                    quantity discovery to market participants. Price discovery refers to finding the
                    price that best reflects the underlying desire of participants to buy and sell
                    shares. Quantity discovery involves participants disclosing their orders so that
                    they can meet each other and transact the total number of shares they wish to
                    buy or sell. The market’s structure and size establish the network. Given
                    a market’s structure, large markets are expected to deliver better price
                    and quantity discovery. Ideally, price and quantity discovery should go hand in
                    hand, much as in any microeconomics course the simultaneous solution for price
                    and quantity is given by the intersection of a demand curve and a supply curve.
                    In real-world equity markets, however, quantity discovery is rarely
                    simultaneously achieved with price discovery, nor is it generally complete.In addition to the discussion of price and quantity discovery, we raise several
                    questions about the integration of fast- and slow-market components. And we
                    present evidence that in the German electronic exchange–based trading
                    environment, roughly 50 percent of the euro value of trades does not go through
                    the exchange’s electronic order book. Our empirical results reveal a clear
                    size-based difference between on-book and off-book trading percentages.
                    Larger-capitalization stocks trade more heavily off the book (only 41 percent of
                    trades are done on the book), roughly half (48 percent) of midcap volume goes
                    through the book, and a clear majority (65 percent) of small-cap stock trading
                    goes through the book.Our finding that larger stocks experience more off-book trading is reasonable.
                    Large institutional investors, which are typically more active in the larger-cap
                    issues, are less likely to direct their block orders to the book, and retail
                    orders for the larger-cap stocks are more likely to be netted and internalized
                    by German banks and brokers. Furthermore, participants generally have greater
                    confidence in the prices discovered in the larger, more liquid markets, which
                    can result in free riding on exchange-provided price discovery being more
                    prevalent for the large-cap stocks.We do not attempt to foretell merger outcomes or regulatory consequences in the
                    future. We do know that the future will hold fast-market competitors for the
                    1,000-share orders (whether these orders are retail, part of a basket, or slices
                    of a larger block). And without question, introduction of the Hybrid Market will
                    affect the operations of the NYSE as a network that provides price and quantity
                    discovery. The reassuring news for the exchange is that trading in Germany is
                    split roughly 50–50 between on-book and off-book trades—despite the
                    fact that this national market offers a state-of-the-art electronic trading
                    platform. This finding suggests that demand will exist for both the fast- and
                    slow-market services that the reengineered Big Board will supply.
Journal: Financial Analysts Journal
Pages: 14-20
Issue: 5
Volume: 62
Year: 2006
Month: 9
X-DOI: 10.2469/faj.v62.n5.4279
File-URL: http://hdl.handle.net/10.2469/faj.v62.n5.4279
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Author-Name: Scott B. Beyer
Author-X-Name-First: Scott B.
Author-X-Name-Last: Beyer
Author-Name: Gerald R. Jensen
Author-X-Name-First: Gerald R.
Author-X-Name-Last: Jensen
Author-Name: Robert R. Johnson
Author-X-Name-First: Robert R.
Author-X-Name-Last: Johnson
Title: Gridlock’s Gone, Now What?
Abstract: 
 This article examines the relationship between security returns and
                    “political gridlock,” which occurs when the U.S. House of
                    Representatives, Senate, and presidency are not controlled by the same political
                    party. The findings support the following conclusions: First, the common view
                    that equities prosper during political gridlock is a myth. Second, fixed-income
                    securities do prosper during gridlock. Third, large companies exhibit higher
                    returns than small companies during gridlock. Finally, the relationship between
                    gridlock and security returns is independent of monetary conditions; this
                    finding supports the existence of a unique “gridlock effect.”
                    Overall, political conditions are relevant for investors, but previous views
                    about their influence are misguided.With the 2006 elections approaching and the possibility of a change in control of
                    the U.S. Congress, the effect on the markets of “political
                    gridlock”—when the party controlling Congress differs from the party
                    of the U.S. president—is on investors’ minds. The press, political
                    analysts, and financial analysts consistently contend that gridlock is good for
                    the equity markets. The rationale for this theory is that equity investors
                    prefer gridlock because it reduces the chances for significant legislative
                    changes. To date, however, this topic has come under little academic
                    scrutiny.In the study reported, we evaluated returns from 1949 through 2004 for 10 equity
                    indices, 4 fixed-income indices, and an inflation index. Two broad types of
                    statistical analysis were applied: First, we focused exclusively on political
                    conditions by examining security performance during periods of political
                    gridlock versus periods of political “harmony” (the same party
                    controlling Congress and the presidency). Second, we estimated regressions with
                    monthly return as the dependent variable and two independent dummy variables
                    representing (1) political harmony versus gridlock and (2) expansive versus
                    restrictive monetary conditions.Contrary to the popular contention, our results show that political gridlock is
                    associated with lower equity returns than the returns associated with political
                    harmony. Furthermore, the superior performance during periods of political
                    harmony was especially prominent for small companies.No small-company premium is available during gridlock periods; we found that, on
                    average, large companies’ returns exceeded the returns of small companies
                    by 3.22 percentage points during gridlock in the sample period. In contrast, the
                    performance difference between small and large companies is immense during
                    periods of political harmony, with small companies returning 27.03 percent
                    versus 8.78 percent for large companies. This evidence indicates that the
                    well-documented small-company premium has prevailed primarily during periods of
                    political harmony.In contrast to equity returns, we found bond returns to be significantly higher
                    during periods of political gridlock. We observed return differences (of
                    “gridlock” returns minus “harmony” returns) of 7.17
                    percentage points for long-term government bonds and 6.28 percentage points for
                    corporate bonds. This finding suggests that the return difference can be
                    attributed primarily to changes in the general level of interest rates rather
                    than changes in credit spreads.Given the potential interaction between political conditions and monetary
                    conditions, we reexamined the relationship between gridlock and security returns
                    while controlling for changes in monetary conditions. Our regression results
                    confirm that political harmony is associated with superior performance for
                    small-company equities but political gridlock is associated with stellar
                    performance of fixed-income securities.This article makes several key contributions. First, we present evidence
                    indicating that the “gridlock is good” tenet is a myth for equities;
                    equity returns actually tend to be lower during periods of political gridlock.
                    Second, we show that the small-company premium has existed only during periods
                    of political harmony. Third, we show that fixed-income returns are significantly
                    higher during periods of gridlock. Finally, we note that even after control for
                    monetary conditions, equities performed poorly during periods of gridlock
                    whereas fixed-income securities prospered.Overall, our evidence suggests that political conditions are an important
                    consideration for both equity and fixed-income investors. Thus, our findings
                    support the considerable attention that financial market participants and the
                    media pay to political conditions.
                        Editor’s Note: This article was submitted for publication
                            prior to the decision in January 2006 that the FAJ
                            would no longer publish articles written by CFA Institute
                            staff.
Journal: Financial Analysts Journal
Pages: 21-28
Issue: 5
Volume: 62
Year: 2006
Month: 9
X-DOI: 10.2469/faj.v62.n5.4280
File-URL: http://hdl.handle.net/10.2469/faj.v62.n5.4280
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Author-Name: Joanne M. Hill
Author-X-Name-First: Joanne M.
Author-X-Name-Last: Hill
Author-Name: Venkatesh Balasubramanian
Author-X-Name-First: Venkatesh
Author-X-Name-Last: Balasubramanian
Author-Name: Krag (Buzz) Gregory
Author-X-Name-First: Krag (Buzz)
Author-X-Name-Last: Gregory
Author-Name: Ingrid Tierens
Author-X-Name-First: Ingrid
Author-X-Name-Last: Tierens
Title: Finding Alpha via Covered Index Writing
Abstract: 
 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.Covered S&P 500 Index call strategies have, on average, outperformed the
                    S&P 500 total return index over the past 15+ years while realizing lower
                    total risk (as measured by standard deviation of returns). The most broadly
                    quoted benchmark for index call–selling strategies is the BXM, a
                    return-based buy-write index on the S&P 500 Index introduced by the Chicago
                    Board Options Exchange in 2002. We dissect the strategy underlying the BXM and
                    consider its returns in the 1990–2005 period. We find it has outperformed
                    the S&P 500 with only two-thirds of the risk of the S&P 500. Even though
                    some of the lowered risk came from eliminating upside swings in rising markets,
                    its track record has been impressive.We propose and analyze some alternative structured S&P 500
                    option–overwriting strategies that have even more attractive
                    risk–return trade-offs than the BXM because they take advantage of the
                    implicit positive risk premium of equities. We first examine the impact of
                    selling out-of-the-money (OTM) calls rather than at-the-money (ATM) calls, which
                    underlie the BXM. Selling 2–5 percent OTM calls combined with a long
                    position in the S&P 500 generated returns that averaged about 2 percentage
                    points a year above the S&P 500 return in 1990–2005. The annualized
                    risk was 1.5–3.5 percentage points below the risk of the S&P 500, and
                    tracking error ranged between 3 percent 6 percent a year.We also analyze more flexible covered index strategies, which dynamically adjust
                    the strike price of the call sold on the basis of the current volatility
                    environment. In our tests, these strategies produced a return–risk profile
                    similar to that of the fixed-strike strategies but with a more stable exercise
                    frequency.
Journal: Financial Analysts Journal
Pages: 29-46
Issue: 5
Volume: 62
Year: 2006
Month: 9
X-DOI: 10.2469/faj.v62.n5.4281
File-URL: http://hdl.handle.net/10.2469/faj.v62.n5.4281
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:62:y:2006:i:5:p:29-46




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# input file: UFAJ_A_12047701_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Fan Yu
Author-X-Name-First: Fan
Author-X-Name-Last: Yu
Title: How Profitable Is Capital Structure Arbitrage?
Abstract: 
 The article examines the risk and return of capital structure arbitrage, which
                    exploits the mispricing between a company’s credit default swap (CDS)
                    spread and equity price. The analysis uses the CreditGrades benchmark model, a
                    convergence-type trading strategy, and 135,759 daily CDS spreads on 261 North
                    American obligors. At the level of individual trades, substantial losses can
                    occur as a result of the low correlation between the CDS spread and the equity
                    price. An equally weighted portfolio of all trades, however, produced Sharpe
                    ratios similar to those for other fixed-income arbitrage strategies and hedge
                    fund industry benchmarks.Debt–equity trading, or capital structure arbitrage, has been increasingly
                    embraced by hedge funds and bank proprietary trading desks in recent years. Some
                    traders have even touted it as the “next big thing” or “the
                    hottest strategy” in the arbitrage community. Fueling this enthusiasm, the
                    popular press has given several vivid accounts of how traders were able to use
                    simple debt–equity trades to produce fabulous returns.To understand capital structure arbitrage, I conducted a comprehensive study of
                    the risk and return of the strategy by using 135,759 daily credit default swap
                    (CDS) spreads on 261 North American obligors from 2001 through 2004. Following
                    the common practice, I used the first 10 daily observations of a company’s
                    CDS spread to calibrate an industry standard debt–equity model, the
                    CreditGrades model. When the subsequent model spread deviated from the observed
                    market spread, the hypothetical trader entered into a CDS position with a
                    model-determined equity position taken as a hedge. Both positions were closed
                    out when the model spread and the market spread converged or at the end of a
                    prespecified holding period, whichever occurred first. I computed the daily
                    returns to each trade by valuing the outstanding CDS position as a
                    survival-contingent annuity, with the survival probabilities inferred from the
                    CreditGrades model.The strategy entailed a high degree of risk at the level of individual trades.
                    Not only did the trades rarely converge, they frequently suffered from large
                    drawdowns of initial capital that, in practice, would almost surely have
                    triggered withdrawal by hedge fund investors. Compared with other fixed-income
                    arbitrage strategies, such as swap spread arbitrage, capital structure arbitrage
                    requires a much higher initial capital to attain the same profile of profits and
                    losses. Ultimately, these findings can be attributed to the relatively low
                    correlation between daily changes in the CDS spread and the equity price, which
                    averaged between –5 percent and –20 percent among the sample
                    obligors I studied.To examine the risk and return from the perspective of a diversified investor, I
                    aggregated the returns from the individual trades into an equally weighted
                    monthly capital structure arbitrage index return. For the speculative-grade
                    portfolio, the monthly index returns had a Sharpe ratio of 0.75, similar to the
                    Sharpe ratios of hedge fund industry benchmarks. These returns were not
                    correlated with common equity and bond market risk factors. Moreover, evidence
                    suggests that the returns are consistent with “statistical
                    arbitrage,” a notion of long-horizon profitability that is independent of
                    any asset-pricing model.
Journal: Financial Analysts Journal
Pages: 47-62
Issue: 5
Volume: 62
Year: 2006
Month: 9
X-DOI: 10.2469/faj.v62.n5.4282
File-URL: http://hdl.handle.net/10.2469/faj.v62.n5.4282
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:62:y:2006:i:5:p:47-62




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# input file: UFAJ_A_12047702_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Arjan B. Berkelaar
Author-X-Name-First: Arjan B.
Author-X-Name-Last: Berkelaar
Author-Name: Adam Kobor
Author-X-Name-First: Adam
Author-X-Name-Last: Kobor
Author-Name: Masaki Tsumagari
Author-X-Name-First: Masaki
Author-X-Name-Last: Tsumagari
Title: The Sense and Nonsense of Risk Budgeting
Abstract: 
 A framework is described for the optimal allocation of active risk among broad
                    asset classes or external asset managers. Unlike most risk allocation models
                    used by practitioners, this framework does not assume that cross-correlations
                    are zero. An analytical expression for the optimal allocation of tracking error
                    among investment decision areas (assets and external managers) in the presence
                    of correlations is provided. The key to understanding optimal risk allocation is
                    the correlation-adjusted information ratio, a novel concept introduced in this
                    article. Also discussed are various approaches to setting realistic input
                    assumptions, such as the expected IR, for deriving optimal risk allocation.Risk budgeting is popular. Everyone talks about it, but when asked to define it,
                    they give a variety of answers. The growing risk-budgeting literature also does
                    not provide a clear definition. We attempt to define risk budgeting clearly and
                    concisely. To appreciate what risk budgeting is all about, analysts need to
                    realize that risk management consists of three stages: risk measurement, risk
                    attribution, and risk allocation.Risk budgeting starts with an institutional investor deciding how it wants to
                    allocate risk among, for example, asset classes or active managers to achieve
                    the highest risk-adjusted return. This risk allocation should be monitored on a
                    regular basis to ensure that the institution does not over- or underspend the
                    risk budget. The risk allocation may need to be rebalanced to bring
                    risk-spending activities in line with optimal risk allocation. Risk budgeting
                    consequently entails both risk allocation (where to spend the risk) and risk
                    attribution/decomposition (whether risk is being spent accordingly).Important criteria in developing a risk allocation framework are that risk
                    budgeting do the following:integrate performance attribution and risk
                                attribution to allow evaluation of whether the risk allocation paid
                                off accordingly;tie in directly with
                                the investment decision process of the
                                investor;effectively allocate risk
                                among asset classes and provide clear guidelines to portfolio
                                managers in terms of their risk budget for the purpose of portfolio
                                construction;create clear
                                accountability and delegate measurable investment responsibilities
                                to portfolio managers;guarantee
                                transparency through the use of a formal, disciplined, but simple
                                approach in which portfolio managers are held accountable only for
                                areas that are within their control or
                            responsibility.We propose and discuss a framework
                    for risk budgeting that meets these criteria. The optimal risk allocation among
                    asset classes we derive depends on three critical inputs: (1) the overall risk
                    budget (or total tracking error) set by an oversight committee, (2) the target
                    information ratios (IRs) provided by portfolio managers in each asset class, and
                    (3) assumptions about correlations between the various investment
                    activities.We briefly review the literature and discuss the difference between risk
                    allocation and asset allocation. We introduce the concept of
                    correlation-adjusted IRs and discuss the important role they play in deriving
                    the optimal risk allocation. We also introduce the concept of an implied
                    IR—a useful statistic that can help in tracking how much the current risk
                    allocation deviates from the optimal one. We discuss how our framework can be
                    applied to decide on the optimal allocations among sources of systematic (beta)
                    risk and active (alpha) risk. And finally, we discuss various approaches to
                    setting expected IRs.
Journal: Financial Analysts Journal
Pages: 63-75
Issue: 5
Volume: 62
Year: 2006
Month: 9
X-DOI: 10.2469/faj.v62.n5.4283
File-URL: http://hdl.handle.net/10.2469/faj.v62.n5.4283
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# input file: UFAJ_A_12047703_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark Haug
Author-X-Name-First: Mark
Author-X-Name-Last: Haug
Author-Name: Mark Hirschey
Author-X-Name-First: Mark
Author-X-Name-Last: Hirschey
Title: The January Effect
Abstract: 
 Analysis of broad samples of value-weighted and equal-weighted returns of U.S.
                    equities documents that abnormally high rates of return on small-capitalization
                    stocks continue to be observed during the month of January. This January effect
                    in small-cap stock returns is remarkably consistent over time and does not
                    appear to have been affected by passage of the Tax Reform Act of 1986. This
                    finding brings new perspective to the tax-loss selling hypothesis and suggests
                    that behavioral explanations are relevant to the January effect. After a
                    generation of intensive study, the January effect continues to present a serious
                    challenge to the efficient market hypothesis.Using 1802–2004 value-weighted data and 1927–2004 equal-weighted
                    data, we update evidence on the January effect in stock returns. We found a
                    persistent January effect for small-capitalization stocks. We also document that
                    the anomalous pattern in monthly returns exists by using portfolios based on
                    size and book-to-market factors. Both size and book-to-market effects appear to
                    be at work in the January effect, but size effects predominate. We also found a
                    persistently negative January effect for momentum stocks. The observation of a
                    January effect primarily for small-cap stocks supports others’ findings of
                    an abrupt switch to net buying of small-cap stocks by individual investors in
                    January.We found the January effect to exist for small-cap stocks even in the period
                    following passage of the Tax Reform Act of 1986. The Tax Reform Act required
                    mutual funds to distribute at least 98 percent of realized capital gains and
                    dividend income generated during the 12-month period ending 31 October. So,
                    since 1986, net capital gains distributions to mutual fund shareholders have
                    been determined without regard to capital losses attributable to transactions
                    occurring during the last two months of the calendar year. Those capital losses
                    are carried over to the subsequent tax year. Any seasonal tendencies related to
                    tax-motivated selling by institutional investors after 1986, therefore, should
                    occur well before the end of the calendar year. Although tax effects have long
                    been offered as a plausible explanation for a January effect in the United
                    States, the continuing presence of a January effect since 1987 appears to weaken
                    that argument.Because we found that the January effect remains largely a small-cap phenomenon,
                    and one that has been unaffected by the Tax Reform Act of 1986, our findings
                    offer support for behavioral explanations of the January effect that are tied to
                    the anomalous buying and selling behavior of individual investors at the turn of
                    the year. Because many institutions retain a January–December reporting
                    period despite the new November–October tax period, “window
                    dressing” by institutions to improve reports to clients may be
                    contributing to the January effect in the post-1986 period. Tax-motivated
                    selling by individual investors at the turn of the year also remains a plausible
                    explanation.In any event, we conclude that the January effect is a real and continuing
                    anomaly in small-cap stock returns, and one that defies easy explanation more
                    than 30 years after its discovery.
Journal: Financial Analysts Journal
Pages: 78-88
Issue: 5
Volume: 62
Year: 2006
Month: 9
X-DOI: 10.2469/faj.v62.n5.4284
File-URL: http://hdl.handle.net/10.2469/faj.v62.n5.4284
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# input file: UFAJ_A_12047704_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: James A. Bennett
Author-X-Name-First: James A.
Author-X-Name-Last: Bennett
Author-Name: Richard W. Sias
Author-X-Name-First: Richard W.
Author-X-Name-Last: Sias
Title: Why Company-Specific Risk Changes over Time
Abstract: 
 Company-specific risk climbed steadily between 1962 and 1999 in the U.S. market
                    but fell sharply between 2000 and 2003. This article explores the hypothesis
                    that three factors are primarily responsible for observed changes in
                    company-specific risk: changes in the market weights of “riskier”
                    industries, changes in the relative role of small-capitalization stocks in the
                    market, and measurement error associated with changes in within-industry
                    concentration. Empirical tests reveal that each factor contributes to changes in
                    company-specific risk over time and that, combined, these three factors largely
                    explain changes in company-specific risk over the past 40 years.Recent studies have demonstrated that company-specific risk steadily increased
                    between the early 1960s and the late 1990s. Since the market peak in 2000,
                    however, company-specific risk has exhibited a secular decline. These changes
                    are important to active managers because they have an impact on the
                    effectiveness of portfolio diversification, tracking error, return dispersion
                    across managers, and the ability of traders to exploit mispriced securities and
                    because some recent research suggests company-specific risk may be rewarded
                    (i.e., priced). A number of potential explanations have been offered that suggest fundamental
                    changes in the economy and/or markets as the explanation for the rise in
                    company-specific risk over time. Suggestions include decreases in operational
                    diversification as companies narrowed their product/market focus, increased use
                    of stock options as compensation, a rise in the volatility of returns on equity
                    or growth opportunities, a decline in financial reporting quality, an increase
                    in the role of institutional investors in the market and their tendency to herd,
                    increases over time in levels of informed trading, an increase in capital market
                    openness, and an increase in competition between companies.In the study reported here, we proposed and tested an alternative explanation for
                    changes in aggregate company-specific risk: Carrying out tests for the August
                    1962–December 2003 U.S. market, we found that company-specific risk
                    changes over time not as a result of fundamental changes in the market but,
                    rather, as a result of changes in the composition of the securities that make up
                    the market. Specifically, we proposed that three key changes in the composition
                    of the market explain changes in company-specific risk over time: changes in the
                    relative importance of industries, changes in the relative importance of small
                    companies in the market, and changes in measurement error induced by changing
                    within-industry concentration. Distinguishing between these explanations is
                    important in practice because our explanation suggests that changes in
                    company-specific risk faced by a given manager will be a function of the changes
                    in that manager’s portfolio. For example, if a manager does not have great
                    exposure to small-capitalization stocks, the rise in aggregate company-specific
                    risk attributed to the growth of small-cap stocks in the market will not affect
                    that manager.Empirical tests support each of our three hypotheses. Changes in within-industry
                    concentration and the relative roles of small-cap stocks and riskier industries
                    largely explain the patterns in company-specific risk over time. We conclude
                    that these three factors are the primary culprits behind the long rise and
                    recent decline of company-specific volatility over the past 40 years.
Journal: Financial Analysts Journal
Pages: 89-100
Issue: 5
Volume: 62
Year: 2006
Month: 9
X-DOI: 10.2469/faj.v62.n5.4285
File-URL: http://hdl.handle.net/10.2469/faj.v62.n5.4285
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Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Greenspan's Fraud: How Two Decades of His Policies Have Undermined the Global Economy (a review)
Abstract: 
 The author accuses the former U.S. chief central banker of deceit primarily in two          areas—(1) raising the Social Security tax to help preserve tax cuts and thereby          enrich the already rich and (2) altering his economic philosophy to fit the viewpoint of          presidential administrations.
Journal: Financial Analysts Journal
Pages: 101-102
Issue: 5
Volume: 62
Year: 2006
Month: 9
X-DOI: 10.2469/faj.v62.n5.4286
File-URL: http://hdl.handle.net/10.2469/faj.v62.n5.4286
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Forerunners of Modern Financial Economics: A Random Walk in the History of Economic Thought, 1900–1950 (a review)
Abstract: 
 This valuable contribution to the intellectual history of the field of finance describes          the forerunners of modern portfolio theory and behavioral finance.
Journal: Financial Analysts Journal
Pages: 102-103
Issue: 5
Volume: 62
Year: 2006
Month: 9
X-DOI: 10.2469/faj.v62.n5.4287
File-URL: http://hdl.handle.net/10.2469/faj.v62.n5.4287
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and                issue.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 5
Volume: 62
Year: 2006
Month: 9
X-DOI: 10.2469/faj.v62.n5.4288
File-URL: http://hdl.handle.net/10.2469/faj.v62.n5.4288
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Title: Illusions and Delusions
Abstract: 
 Many of the greatest errors in asset management stem from cultural and structural                    pressures to do the wrong things at the wrong times, from wrong-headed                    conventional wisdom, and from unexamined acceptance of theory as fact. We need                    to remember that neither people nor companies can earn returns on money they                    haven’t first set aside for investment; we need to question why each                    $1 in stocks is not considered to be worth the same as $1 in bonds; and we need,                    always, to test our assumptions.
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4343
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4343
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Author-Name: Alexander Kozhemiakin
Author-X-Name-First: Alexander
Author-X-Name-Last: Kozhemiakin
Title: “The Myth of the Absolute-Return Investor”: A Comment
Abstract: 
 This material comments on “The Myth of the Absolute-Return                Investor.”
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4344
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4344
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Author-Name: M. Barton Waring
Author-X-Name-First: M. Barton
Author-X-Name-Last: Waring
Author-Name: Laurence B. Siegel
Author-X-Name-First: Laurence B.
Author-X-Name-Last: Siegel
Title: “The Myth of the Absolute-Return Investor”: Author Response
Abstract: 
 This material comments on “The Myth of the Absolute-Return                Investor.”
Journal: Financial Analysts Journal
Pages: 11-12
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4345
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4345
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Author-Name: Jerry H. Tempelman
Author-X-Name-First: Jerry H.
Author-X-Name-Last: Tempelman
Title: “Not All Deficits Are Created Equal”: A Comment
Abstract: 
 This material comments on “Not All Deficits Are Created Equal.”.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4346
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4346
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Author-Name: Peter L. Bernstein
Author-X-Name-First: Peter L.
Author-X-Name-Last: Bernstein
Title: “Gridlock’s Gone, Now What?”: A Comment
Abstract: 
 This material comments on “Gridlock’s Gone, Now What?”
Journal: Financial Analysts Journal
Pages: 12-13
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4347
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4347
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “Gridlock's Gone, Now What?” by Scott B. Beyer, CFA,
                    Gerald R. Jensen, CFA, and Robert R. Johnson, CFA in the September/October 2006
                    issue of the FAJ.
Journal: Financial Analysts Journal
Pages: 13-13
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4348
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4348
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Author-Name: Glyn A. Holton
Author-X-Name-First: Glyn A.
Author-X-Name-Last: Holton
Title: Investor Suffrage Movement
Abstract: 
 Recent market crashes and financial scandals are symptomatic of a capitalism in
                    which shareholders have lost control over the corporations they own. To reassert
                    control, shareholders must overcome obstacles that prevent them from voting
                    their shares. The solution is to form a “proxy exchange” through
                    which investors can conveniently secure, transfer, aggregate, and exercise their
                    voting rights.Recent market crashes and financial scandals are symptomatic of a capitalism in
                    which shareholders have lost control over corporations. To reassert control,
                    investors must overcome practical and legal obstacles that prevent them from
                    voting the shares they beneficially own. They can do so by implementing a novel
                    “proxy exchange.” Unlike an exchange for trading stocks or futures,
                    this exchange will be for transferring voting rights. It will allow investors to
                    conveniently secure, transfer, aggregate, and exercise those rights.Today, the notion that shareholders can select their own proxy resembles the
                    remark attributed to Henry Ford that people can buy any color of Model T they
                    want—so long as it is black. Before each annual meeting, corporate
                    managers mail to shareholders proxy assignment cards allowing them to appoint
                    those same managers—or the managers’ agent—as their proxy.
                    That is the only choice the cards offer—take it or leave it. The system is
                    so broken down that managers seek proxy rights more to ensure a quorum at the
                    shareholder meeting than out of fear that they might actually lose a vote. Only
                    in rare circumstances does a proxy fight arise in which a competing group also
                    sends out a mailing to shareholders soliciting a grant of proxy rights. That
                    situation is akin to offering automobiles that are either black or gray.For investors who beneficially own shares through an intermediary, such as a
                    mutual fund or pension plan, the situation is even more stark. Because the
                    intermediaries legally own the shares, it is they—not the
                    investors—who decide how to vote those shares.A proxy exchange will dramatically change all this. Imagine investors going to a
                    secure website and, with a single mouse click, transferring current and future
                    voting rights in all stocks they beneficially own to anyone they choose—a
                    charity, professional association, investment adviser, trade union, advocacy
                    group, faith-based organization, family member—anyone willing to accept
                    them.What will recipients do with the voting rights they receive? Some will receive
                    enough rights that it will be worth the effort to actually vote them. They will
                    do so through the same secure website. Others will receive fewer voting rights.
                    Rather than vote them, they will use the website to transfer the rights on to
                    other trusted parties. In this manner, small blocks of rights will be aggregated
                    into medium blocks, which will be aggregated into large blocks. Large blocks
                    will be voted through the website. In this manner, fragmented voting rights that
                    are now worthless anachronisms of U.S. capitalism will suddenly become
                    valuable.Corporate governance is the biggest problem facing capitalism today. The costs of
                    the current system—fraud, diversion of resources, cronyism, and just plain
                    mediocrity—are incalculable. Legislative responses like the
                    Sarbanes–Oxley Act of 2002 do some good but impose significant costs of
                    their own. A proxy exchange is a market-based solution that will succeed by
                    putting owners back in charge. It will be a new market for corporate
                    control—a market more efficient and far less costly than hostile takeovers
                    or traditional proxy fights. If implemented, investors will benefit; financial
                    institutions will benefit; and society as a whole will benefit.
Journal: Financial Analysts Journal
Pages: 15-20
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4349
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4349
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:62:y:2006:i:6:p:15-20




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Author-Name: Adam Lichtenstein
Author-X-Name-First: Adam
Author-X-Name-Last: Lichtenstein
Title: Home-State Investment Bias in Venture Capital Funds
Abstract: 
 A widespread assumption is that U.S. venture capitalists source their best
                    investments locally, so out-of-state venture funds are at a disadvantage in
                    relation to local competitors. This assumption drives most venture funds to
                    focus their investments on local companies. The study reported here tested this
                    hypothesis by analyzing IPO rates by the state of venture-funded companies for
                    the past 25 years. Locally funded companies actually achieved a lower average
                    IPO rate than that of nationally funded companies. Therefore, venture funds
                    should seek to capitalize on any local advantage but should also seek to balance
                    their investments by diversifying geographically.From 1980 through 2005, more than 26,000 venture-stage companies were funded in
                    the United States by venture capital (VC) funds. Of these companies, more than
                    3,300, or approximately 13 percent, completed an IPO during the same period.
                    Although the majority of venture-funded companies were based in a relatively few
                    states, the geographical distribution of IPOs approximately equaled the
                    geographical distribution of the VC-funded companies. VC funds, however, have
                    demonstrated a strong bias toward investing in companies in their home states.
                    This bias is predicated on the beliefs that VC funds in the United States source
                    their best venture investments locally and that out-of-state venture funds are
                    at a disadvantage in sourcing deals against the local competitors.In this study of VC deals and IPOs in the United States in the 1980–2005
                    period, approximately 57.7 percent of all venture investments were completed in
                    the top five states (California, Massachusetts, Texas, New York, and
                    Pennsylvania). The number of IPOs per state followed approximately the same
                    distribution, with about 60.0 percent of all IPOs in the sample from the same
                    top five states.Despite the relative diversification of successful companies across the country,
                    venture funds tend to invest locally. In all but one of the states in the
                    sample, the in-state investment rate of local funds was higher than the national
                    average. For instance, 31.4 percent of all venture investments were completed in
                    California, but California-based venture funds completed 56.6 percent of their
                    investments in California-based venture-funded companies. The average in-state
                    investment rate by local funds (i.e., the percentage of all investments by all
                    venture funds in a given state made in venture-funded companies in that same
                    state) was 28.8 percent, or 2.7 times higher (as a weighted average) than the
                    expected investment rate based on the national average.This home-state investment bias could lead to one of two possible outcomes.
                    Either the increased competition for local investments could result in a lower
                    IPO rate for venture-funded companies funded by local funds, or (if local funds
                    have an inherent advantage in selecting local venture companies) the local funds
                    could experience an equal or higher IPO rate. In other words, if local funds get
                    the first look at local investments, then they should logically make a higher
                    percentage of their investments in local companies because these companies are
                    their best source of deal flow.Venture funds often bring up the so-called home-court advantage when marketing
                    their funds to investors. The data of this sample, however, do not, on average,
                    support this popular hypothesis. Although the average IPO rate by state (for the
                    50 states with locally funded companies) in the sample period was 11.0 percent,
                    the average IPO rate for locally funded companies by state was only 7.2 percent,
                    or 34.0 percent less than the national average. In the 28 states with a minimum
                    of 100 investments per state, the national average IPO rate was 12.4 percent
                    whereas the average IPO rate for locally funded companies was only 10.1 percent,
                    or 18.4 percent less.In summary, not only do the local funds appear not to have an advantage in
                    investing in local companies, they actually appear to perform worse than
                    out-of-state funds, as measured by IPO rate.Although concentrated in a few states, successful venture investments are spread
                    across the United States. By concentrating investments locally, venture funds
                    are possibly increasing competition for venture investments at a local level
                    and, consequently, reducing their chances for achieving a successful
                    exit—particularly in regions with a large number of venture funds and thus
                    substantial competition. Although venture funds should seek to capitalize on
                    their local advantage in sourcing local investments, the funds should also seek
                    to balance their investments by carefully diversifying geographically.
Journal: Financial Analysts Journal
Pages: 22-26
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4350
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4350
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:62:y:2006:i:6:p:22-26




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Author-Name: John R. Graham
Author-X-Name-First: John R.
Author-X-Name-Last: Graham
Author-Name: Campbell R. Harvey
Author-X-Name-First: Campbell R.
Author-X-Name-Last: Harvey
Author-Name: Shiva Rajgopal
Author-X-Name-First: Shiva
Author-X-Name-Last: Rajgopal
Title: Value Destruction and Financial Reporting Decisions
Abstract: 
 The comprehensive survey reported here allowed analysis of how senior U.S.
                    financial executives make decisions related to performance measurement and
                    voluntary disclosure. Chief financial officers were asked what earnings
                    benchmarks they cared about and which factors motivated executives to exercise
                    discretion—even sacrifice economic value—to deliver earnings. These
                    issues are crucially linked to stock market performance. The results show that
                    the destruction of shareholder value through legal means is pervasive, perhaps
                    even a routine way of doing business. Indeed, the amount of value destroyed by
                    companies striving to hit earnings targets exceeds the value lost in recent
                    high-profile fraud cases.Based on a survey of 401 senior U.S. financial executives and in-depth interviews
                    with an additional 22 executives, we document a willingness to routinely
                    sacrifice shareholder value to meet earnings expectations or to smooth reported
                    earnings. Whereas much previous research focused on the use of accounting for
                    earnings management, such as accrual decisions, we provide new evidence of the
                    widespread use of “real earnings” management. Real earnings
                    management, which might include deferring a valuable project or slashing
                    research and development expenditures, is almost always value decreasing.The survey, administered in the fall of 2003, explored both earnings management
                    and voluntary disclosures in some depth. In addition, from the fall of 2003 to
                    early 2005, we interviewed 22 chief financial officers (CFOs), which added to
                    our understanding of corporate decision making. Our results indicate that CFOs believe that earnings, not cash flows, are the key
                    metric watched by investors and other outsiders. They consider the two most
                    important earnings benchmarks to be quarterly earnings for the same quarter last
                    year and the analyst consensus estimate. CFOs believe that hitting earnings benchmarks is very important because such
                    actions build credibility with the market and help maintain or increase the
                    company’s stock price in the short run. To avoid the severe market
                    reaction to a failure to deliver on the earnings expectations of analysts and
                    investors, CFOs are willing to sacrifice long-term economic value (such as
                    delaying a valuable project). In contrast, executives say that they are hesitant
                    to use legal—that is, within GAAP—accounting adjustments to hit
                    earnings targets, perhaps as a consequence of the stigma attached to accounting
                    fraud in the post-Enron environment.Not surprisingly, almost all CFOs prefer smooth earnings, but a surprising 78
                    percent of the surveyed executives would destroy economic value in exchange for
                    smooth earnings. The executives believe that unpredictable earnings—as
                    reflected in a missed earnings target or volatile earnings—command a
                    higher risk premium. In short, CFOs argued that the system (that is, financial
                    market pressures and overreactions) encourages decisions that at times destroy
                    long-term value to meet earnings targets.We also explore how the malaise of excessive short-termism can be fixed. We argue
                    that a greater emphasis on principles-based rather than rules-based accounting
                    standards, reduction in quarterly earnings guidance, disclosure of how accrual
                    estimates are settledex post, a focus on integrity in the
                    financial reporting process, proactive boards of directors working to balance
                    short-term and long-term goals, and a more active role for investors would
                    mitigate the myopic emphasis on quarterly earnings measures.
Journal: Financial Analysts Journal
Pages: 27-39
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4351
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4351
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Handle: RePEc:taf:ufajxx:v:62:y:2006:i:6:p:27-39




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# input file: UFAJ_A_12047717_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jianguo Chen
Author-X-Name-First: Jianguo
Author-X-Name-Last: Chen
Author-Name: Andrea Bennett
Author-X-Name-First: Andrea
Author-X-Name-Last: Bennett
Author-Name: Ting Zheng
Author-X-Name-First: Ting
Author-X-Name-Last: Zheng
Title: Sector Effects in Developed vs. Emerging Markets
Abstract: 
 This examination of developed and emerging markets suggests that toward the end
                    of the 20th century, sector effects caught up with country effects in the
                    developed markets of the world, as a result of rising sector effects rather than
                    declining country effects. For emerging markets, however, country effects have
                    remained the dominant influence relative to sector effects, although the
                    importance of country effects has been on a steady decline. These results
                    confirm that international equity managers should emphasize sector-based
                    approaches when investing in the developed countries but should continue
                    country-based allocation strategies in emerging markets.A fundamental starting point for global equity managers when applying a top-down
                    approach to their investing has been the selection of a country. Since 2000,
                    however, the relative importance of the country factor has been challenged by
                    several researchers, who concluded that the relative importance of industrial
                    factors has exceeded that of country factors. Two questions of great interest
                    are whether this apparent shift is ongoing and whether it applies to all
                    markets. If the shift varies by country (e.g., between developed markets and
                    emerging markets), investment managers who assume that all markets behave in a
                    similar way could find their strategies becoming ineffective when they widen
                    their horizons from developed to emerging markets. To study the two questions, we collected all monthly returns of market
                    capitalization–weighted equity indices that are available in the
                    Datastream database for 23 countries classified as developed markets and 26
                    countries classified as emerging markets. For analyzing the influence of
                    sectors, we used 10 sector indices (with sector classifications as defined by
                    the Financial Times Actuaries Index). The sample period is January 1994 through
                    May 2005.We applied a factor model used by previous researchers that decomposes an
                    individual equity return index into three parts—a constant, a country
                    effect, and a sector effect. We used pure factor variance and mean absolute
                    deviation (MAD) to measure the pure country effects and pure sector effects.Our results indicate that the relative importance of the sector and country
                    factors is different in the developed markets from their relative importance in
                    the emerging markets. For the developed markets, the sector and country effects
                    have been competing with each other in relative importance since the turn of the
                    21st century. In line with recent research, our findings for the developed
                    markets suggest that (when measured by the variance method) sector effects
                    approach the same level as country effects or (when measured by the MAD method)
                    exceed country effects. Note that both effects as measured by both methods
                    declined steady in the new century, with a markedly smaller difference between
                    them. The reason could be increased financial integration across countries. We
                    found that the ascendancy of sector effects is a consequence of a rise in sector
                    effects rather than a fall in country effects. Global equity managers cannot afford to ignore the sector factor in allocating
                    capital in the developed markets. Managers should keep their eyes on the sector
                    factors and consider the possibility of sector allocation all the time.  Additionally, we provide new explanations of the recent rise in sector effects
                    in the developed markets. First, we argue that the steady sector increase was a
                    general trend in the world market, not purely the impact of the TMT
                    (telecommunications/media/technology) bubble. The sharp increase of the sector
                    effect near the end of 2000 was, however, mainly a result of the TMT bubble, and
                    the sector effect has declined from that peak. Previous literature, because of
                    the sample periods, could only suggest the temporary nature of the sharp TMT
                    sector increase. As far as we know, our study presents the first complete
                    picture of the bubble’s effect on the sector factor.In the emerging markets, we observed much higher pure variance and MAD for the
                    country factor than for the sector factor, indicating that for the emerging
                    markets, a diversification strategy based on country remains more important than
                    a sector-based strategy. Global equity managers should continue to use a
                    strategy of diversification by country.Nevertheless, we also observed a slight rise in sector effects in the emerging
                    markets. Therefore, we warn that the dominance of country factors in the
                    emerging markets may diminish in the future. 
Journal: Financial Analysts Journal
Pages: 40-51
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4352
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4352
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:62:y:2006:i:6:p:40-51




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Author-Name: Pilar Soriano
Author-X-Name-First: Pilar
Author-X-Name-Last: Soriano
Author-Name: Francisco Climent
Author-X-Name-First: Francisco
Author-X-Name-Last: Climent
Title: Region vs. Industry Effects and Volatility Transmission
Abstract: 
 This article presents an analysis of the relative importance of region versus
                    industry effects in stock returns, as opposed to the extensively analyzed
                    country versus industry effects. The sample includes the period after the
                    bursting of the technology bubble. Moreover, volatility transmission patterns
                    are analyzed within an industry across regions
                    to assess whether the same international links found in aggregate stock market
                    indices exist at the industry level. The results confirm the dominance of region
                    effects over industry effects, except during the bubble period. The results of
                    the volatility transmission analysis suggest that the importance of spillovers
                    depends on the industry.In recent years, the enhanced availability of financial information has
                    strengthened existing relationships among stock markets. This development could
                    have resulted in portfolio managers changing their investing strategies from
                    country based to industry based to achieve optimal portfolio diversification.
                    For this reason, whether return variations are driven primarily by geographical
                    (or national) factors or by industry factors is important for practitioners and
                    has long been a challenging area of research for academics. In fact, numerous
                    studies have addressed the question of the relative importance of cross-country
                    versus cross-industry diversification. The mixed empirical results presented in
                    the literature suggest that the importance of country and industry factors may
                    have been changing over time. We analyze this issue from a
                        regional perspective rather than a country perspective.The article has two main thrusts. First, we analyze the relative importance of
                    region versus industry effects in stock returns by using a sample that includes
                    the period during and after the telecommunications/media/technology (TMT)
                    bubble. Second, we analyze patterns of volatility transmission
                        within an industry across regions to
                    assess whether the same international links found in aggregate stock market
                    indices exist at the industry level.The dataset consists of daily price indices in U.S. dollars for 10 industry
                    indices in three regions (North America, Europe, and Asia)—all collected
                    from Datastream. The sample is from January 1995 through December 2004 and is
                    also divided into three subperiods to isolate the TMT bubble and ensuing
                    crisis.To analyze the relative importance of region and industry effects, we used a
                    dummy variable approach. The results confirm the overall dominance of region
                    effects over industry effects except during the TMT crisis period.To analyze volatility transmission patterns within an industry across regions, we
                    estimated a trivariate first-order vector autoregressive
                    [VAR(1)]–asymmetric BEKK model for each of the 10 industries. In this
                    case, the results suggest that spillovers are more or less important depending
                    on the industry being analyzed. For example, the information technology industry
                    was less affected by other international markets.The implication of our research for investors is that now that the TMT financial
                    crisis is over, the traditional strategy of diversifying across countries or
                    regions rather than by industries may still be adequate in terms of reducing
                    portfolio risk. Of course, the most risk reduction will be achieved by taking
                    into account the volatility transmission patterns found in this study and
                    diversifying both across regions and across industries.
Journal: Financial Analysts Journal
Pages: 52-64
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4353
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4353
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:62:y:2006:i:6:p:52-64




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Author-Name: Hans Byström
Author-X-Name-First: Hans
Author-X-Name-Last: Byström
Title: CreditGrades and the iTraxx CDS Index Market
Abstract: 
 In the study reported, the CreditGrades model was used to calculate credit
                    default swap spreads and the spreads were compared with empirically observed CDS
                    spreads for eight iTraxx indices covering Europe. Theoretical and empirical
                    spread changes were found to be significantly correlated. Also, lagged
                    theoretical spread changes were correlated with current iTraxx spread changes.
                    The correlations indicate a close relationship between the stock market and the
                    CDS market and also indicate some predictive ability of the CreditGrades model.
                    Simple trading strategies based on the autocorrelation and predictive ability of
                    the model produced positive profits, before trading costs, when trading was
                    within the bid–ask spread.Credit default swaps are credit derivatives that protect the buyer against losses
                    arising from some kind of predefined credit event (delayed payment,
                    restructuring, bankruptcy, etc.) involving a reference name (company). The price
                    of a credit default swap depends on the probability of the underlying reference
                    name experiencing a credit event in the future. For companies that are listed on
                    stock exchanges, this probability is often estimated from information contained
                    in the company’s stock price. In this study, I thus calculated the
                    theoretical CDS spreads through a simple implementation of the stock
                    market–based CreditGrades (CG) model.A CDS index is a portfolio of credit default swaps. One of the major families of
                    CDS indices is the iTraxx CDS indices. In this article, I compared empirically
                    observed CDS prices (spreads) with the CG-implied CDS prices (spreads) in the
                    iTraxx market. I compared the spreads for eight iTraxx indices covering
                    Europe—seven investment-grade indices and a subinvestment-grade
                    index—with the CG-implied CDS spreads for June 2004 to March 2006.I found theoretical and empirical spread changes to be significantly correlated.
                    I also found one-day-lagged theoretical spread changes to be correlated with
                    current iTraxx spread changes. The significant correlations were confirmed by
                    significant ordinary least-squares (OLS) regression parameters and indicate a
                    fairly close relationship between the stock market and the CDS market, as well
                    as a certain predictive ability of the CG model.Although I found no autocorrelation among the theoretical CG spread changes, I
                    did find significant autocorrelation in the iTraxx market. One-day-lagged
                    theoretical spread changes were also found to be significantly correlated with
                    current iTraxx spread changes. The correlations were confirmed by significant
                    OLS regression parameters and indicate a fairly close relationship between the
                    stock market and the CDS market. This finding also suggests a certain predictive
                    ability of the CG model.Based on these findings, I show how simple trading strategies (autoregression,
                    capital structure arbitrage, and a combined strategy) can produce positive
                    profits if the trades are within the bid–ask spread. The introduction of
                    realistic transaction costs, however, significantly reduced the profitability of
                    the trading strategies.Readers should keep in mind, however, that the iTraxx market is young. In the
                    years to come, the growing maturity of the market will most likely lead to a
                    fall in transaction costs (bid–ask spreads). In addition, the period I
                    studied was one with few credit defaults. Both the risks and the rewards are
                    likely to increase with any marketwide credit deterioration. Finally, trading
                    strategies that are more advanced than the simple strategies I illustrate may
                    produce increased after-cost profits.
Journal: Financial Analysts Journal
Pages: 65-76
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4354
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4354
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:62:y:2006:i:6:p:65-76




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Author-Name: Stephen M. Horan
Author-X-Name-First: Stephen M.
Author-X-Name-Last: Horan
Title: Withdrawal Location with Progressive Tax Rates
Abstract: 
 Optimal withdrawal strategies are developed for retirees with multiple types of
                    tax-advantaged savings accounts. In an environment of progressive tax rates, the
                    ability to convert pretax funds in traditional IRAs at low tax rates
                    substantially increases investors’ residual accumulations and withdrawal
                    sustainability. Specifically, informed withdrawal-location strategies, in which
                    traditional IRA distributions can be applied against exemptions, deductions, and
                    lightly taxed tax brackets, can increase residual accumulations by more than $1
                    million. In these strategies, the optimal tax bracket through which an investor
                    should take distributions is directly related to the investor’s wealth
                    level.The introduction of a variety of tax-advantaged savings accounts [e.g., Roth
                    IRAs, Section 529 plans, and Roth 401(k) plans] presents retirees with an array
                    of new decisions. Retirees with multiple types of tax-advantaged accounts from
                    which to withdraw funds must decide how to make optimal distributions from these
                    accounts. For example, which is optimal: to first draw down balances in
                    tax-sheltered accounts with front-end tax benefits (such as traditional IRAs) or
                    to first drawn down balances in accounts with back-end tax benefits (such as
                    Roth IRAs)? Or should a retiree use some combination of withdrawals from both
                    accounts? This article develops optimal withdrawal-location strategies for
                    investors in an environment characterized by progressive tax rates. The term
                    “withdrawal location” refers to the type of accounts from which
                    investors should make distributions.The withdrawal model recognizes that withdrawals from some types of accounts are
                    taxed as ordinary income and withdrawals from other accounts are not taxed. It
                    highlights opportunities for tax-efficient withdrawal locations created by a
                    progressive tax rate system. In such an environment, investors may be able to
                    apply distributions from a traditional IRA or similarly taxed account against
                    exemptions, deductions, or lightly taxed tax brackets. This ability to convert
                    pretax funds in traditional IRAs to after-tax funds at relatively low tax rates
                    substantially increases investors’ residual accumulations and ability to
                    sustain withdrawals.Examples in the article show that informed withdrawal-location strategies can
                    increase residual accumulations by more than $1 million. The optimal tax bracket
                    through which an investor should take distributions is directly related to the
                    person’s wealth. For example, an investor with $1.7 million in retirement
                    assets would optimally, as long as minimum distribution requirements permitted,
                    take taxable distributions up through the 15 percent tax bracket. An investor
                    with $3.33 million in retirement assets would optimally take taxable
                    distributions up through the 25 percent tax bracket, and the optimal
                    distribution tax bracket for investors with $5 million in retirement assets is
                    28 percent.
Journal: Financial Analysts Journal
Pages: 77-87
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4355
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4355
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:62:y:2006:i:6:p:77-87




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Author-Name: Eric Hughson
Author-X-Name-First: Eric
Author-X-Name-Last: Hughson
Author-Name: Michael Stutzer
Author-X-Name-First: Michael
Author-X-Name-Last: Stutzer
Author-Name: Chris Yung
Author-X-Name-First: Chris
Author-X-Name-Last: Yung
Title: The Misuse of Expected Returns
Abstract: 
 Much textbook emphasis is placed on the mathematical notion of expected return
                    and its historical estimate via an arithmetic average of past returns. But those
                    wanting to forecast a typical future cumulative return should be more interested
                    in estimating the median future cumulative return than in estimating the
                    mathematical expected cumulative return. For that purpose, continuous
                    compounding of the mathematical expected log gross return is more relevant than
                    ordinary compounding of the mathematical expected gross return.
                        Self-test
                Pensions, endowments, and other long-term investors often want to forecast the
                    future cumulative returns associated with various asset-class indices or
                    investment strategies. Because no one can foretell the future, the future
                    cumulative return is always a random variable that has a probability
                    distribution. As a point forecast of the future cumulative return, some analysts
                    have chosen to estimate the mathematical expectation of the future cumulative
                    return’s distribution.We argue that this choice is misguided because the distribution of the future
                    cumulative return is often heavily (positively) skewed. As a result, the
                    mathematical expectation of its distribution is not as good a measure of its
                    central tendency (i.e., what is more likely to happen) as is the median future
                    cumulative return. The median future cumulative return has a 50 percent chance
                    of being met or exceeded, but we show that the probability of meeting or
                    exceeding the mathematical expectation approaches zero as the forecast horizon
                    grows to infinity. As a result, even an accurate forecast of the mathematical
                    expected future cumulative return is a badly overoptimistic forecast of what is
                    likely to occur over long horizons. For example, our simulations indicate that
                    there is only about a 30 percent probability of meeting or exceeding the
                    mathematical expected future cumulative return of a large-capitalization stock
                    index at the 30-year horizon that typifies retirement planning forecasts.We use a relatively recent result in the theory of statistics to argue that
                    analysts who want to estimate the median future cumulative return should focus
                    their attention on the mathematical expected logarithm of a
                    single period’s gross return distribution. Continuously compounding the
                    expected log gross return through T periods approximates the
                    median future cumulative return at the T-period horizon.A simple point forecast of the median future cumulative return is made by (1)
                    computing the average of the historical log gross returns (e.g., historical
                    daily or monthly return data) in all past measurement periods and then (2)
                    continuously compounding Step 1’s result up to the
                    T-period forecast horizon. Substituting the average historical
                    ordinary net return for the average historical log gross return in Step 1 is not
                    recommended.Unfortunately, use of any historical average return is somewhat
                    problematic, even in ideal statistical circumstances that may not characterize
                    the real world. Even if the distribution of period log gross returns has been
                    (and will remain) stable over time, the volatility of these log gross returns
                    can make historical averages significantly different from future long-term
                    averages. We show that typical stock index return volatility (15 percent) is
                    enough to cause substantial fluctuation in historical averages. For example,
                    even with 54 years of historical log gross return data, the fluctuation in
                    future historical log gross return averages will be ±400 bps.
Journal: Financial Analysts Journal
Pages: 88-96
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4356
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4356
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Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Competing for Capital: Investor Relations in a Dynamic World (a review)
Abstract: 
 Within a broad overview of the functions and responsibilities of the investor relations          professional, this book focuses on the job’s increased responsibilities          resulting from new laws and regulations.
Journal: Financial Analysts Journal
Pages: 98-99
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4357
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4357
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Author-Name: Ronald L. Moy
Author-X-Name-First: Ronald L.
Author-X-Name-Last: Moy
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: All About Asset Allocation (a review)
Abstract: 
 A clear and intuitive explanation for individual investors of the benefits of          constructing an appropriate asset allocation and how to do so, this book can serve as an          excellent tool for communicating to clients the importance of holding a well-diversified          portfolio.
Journal: Financial Analysts Journal
Pages: 99-100
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4358
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4358
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Information Efficiency in Financial and Betting Markets (a review)
Abstract: 
 This collection of recent highlights from an extensive literature in which economists          with an affinity for gambling have used the tools of financial analysis to study all kinds          of wagers provides a genuinely useful perspective to serious practitioners.
Journal: Financial Analysts Journal
Pages: 100-101
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4359
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4359
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Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Analysis of Financial Time Series (a review)
Abstract: 
 This useful, clear, concise book not only addresses time series as they arise in finance          but also has an applied focus, covers a wide range of topics, and is accessible to          professional money managers.
Journal: Financial Analysts Journal
Pages: 101-102
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4360
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4360
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and                issues.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 6
Volume: 62
Year: 2006
Month: 11
X-DOI: 10.2469/faj.v62.n6.4361
File-URL: http://hdl.handle.net/10.2469/faj.v62.n6.4361
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: Pensions or Penury?
Abstract: 
 Pensions are the focus of this issue, which includes descriptions of the                        problems confronting defined-benefit and defined-contribution plans and                        thoughtful, creative solutions to the problems.
Journal: Financial Analysts Journal
Pages: 6-6
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4396
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4396
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: 2006 Report to Readers
Journal: Financial Analysts Journal
Pages: 8-10
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4397
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4397
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Author-Name: Dean LeBaron
Author-X-Name-First: Dean
Author-X-Name-Last: LeBaron
Title: “The Pension Problem: On Demographic Time Bombs and Odious Debt”: A Comment
Abstract: 
 This material comments on “Editor’s Corner” of                    November/December 2005.
Journal: Financial Analysts Journal
Pages: 12-13
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4398
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4398
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Author-Name: Jeffrey J. Diermeier
Author-X-Name-First: Jeffrey J.
Author-X-Name-Last: Diermeier
Title: “The Pension Problem: On Demographic Time Bombs and Odious Debt”: CFA Institute Response
Abstract: 
 This material comments on “Editor's Corner” of                    November/December 2005.
Journal: Financial Analysts Journal
Pages: 13-14
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4399
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4399
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Author-Name: Jim Ware
Author-X-Name-First: Jim
Author-X-Name-Last: Ware
Title: “A Great Company Can Be a Great Investment”: A Comment
Abstract: 
 This material comments on “A Great Company Can Be a Great                    Investment”.
Journal: Financial Analysts Journal
Pages: 14-14
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4400
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4400
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Author-Name: Charles D. Ellis
Author-X-Name-First: Charles D.
Author-X-Name-Last: Ellis
Title: Where Were We?
Abstract: 
 As professionals, we owe it to our profession and our society to speak out
                    clearly and effectively on investment-related issues that affect the lives and
                    well-being of our fellow citizens and neighbors. We missed a great opportunity
                    to advocate timely reform in retirement plans, but we still have the chance to
                    advocate swift adoption of the new rules others have promulgated.The real test of a profession is how well it serves laypersons. As
                    defined-contribution (DC) plans replaced defined-benefit (DB) pension plans, the
                    investment management profession took no action and made no pleas for change in
                    retirement security plans, while 20 million workers had no coverage, another 20
                    million workers were inadequately covered, 10 million future retirees were far
                    too concentrated in one stock (in the same company on whom they depended for
                    their jobs), and more than 10 million were in savings vehicles
                    not investment vehicles.The absurdities in the retirement scene can be partly “explained” by
                    the separate regulatory concepts and priorities of two parts of our federal
                    government—the U.S. SEC and the Department of Labor—with control
                    over different aspects of 401(k) plans. But although
                    “territoriality” may explain the large mistakes made by competing
                    parts of government, it cannot excuse our profession’s passive acceptance
                    of the large-scale, multiyear neglect of the center of our professional realm of
                    interest: long-term investing by lay investors for retirement security.As professionals, we all agree that individuals can benefit greatly (and our
                    society rightly wants them to benefit greatly, so we provide large tax
                    incentives) fromsaving—regular and repetitive,long-term, “age-appropriate” investing,diversification—the one true “free lunch,” andbenign neglect of such costly “opportunities” as switching
                            funds and market timing.The U.S. Congress has, no thanks to us, taken action to
                        advanceall these key points. Now, after an overlong delay,
                    the brakes on our involvement in lay education have been taken off, so we can go
                    immediately to Phase II: swift implementation of the Congressional ideas by plan
                    sponsors—the people investment managers talk with several times every day.
                    Here is what we can do now to accelerate and broaden use of the opportunities
                    Congress has given our fellow citizens:Urge each company we cover as analysts or invest in as portfolio managers
                            to take bold action to enroll all employees in 401(k) plans and with
                            employees’ participating at the maximum.Do the same with our colleges and universities.Urge our employers to provide life-cycle funds.Celebrate plan sponsors who take the lead.Let us work together to help millions of workers catch up on providing the
                    financial security they will need. Action does matter.
Journal: Financial Analysts Journal
Pages: 18-20
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4402
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4402
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Author-Name: Keith Ambachtsheer
Author-X-Name-First: Keith
Author-X-Name-Last: Ambachtsheer
Title: Why We Need a Pension Revolution
Abstract: 
 A broad consensus exists that workplace pension arrangements around the world are
                    sick and in need of strong medicine. Rather than resurrect the traditional
                    defined-benefit (DB) plan or broaden defined-contribution (DC) plan coverage,
                    this article argues that we move from an “either/or” to an
                    “and/and” mindset to improve global workplace pension coverage,
                    adequacy, and certainty. Pension arrangements can combine the best of DB and DC
                    plans and minimize the impact of their less-attractive features. However, we
                    must also redesign the institutions through which workplace pensions are
                    delivered. The ideal pension-delivery institution is expert, has scale, and acts
                    solely in the best interests of plan participants.A broad consensus acknowledges that workplace pension arrangements around the
                    world are sick and in need of strong medicine. Pension coverage and adequacy are
                    low, and pension uncertainty is high. The prescription of some pension experts
                    is to resurrect the traditional defined-benefit (DB) plan. Others say broad
                    defined-contribution (DC) plan coverage is the cure. This article argues that we
                    have to move from an “either/or” to an “and/and” mindset
                    if we want to seriously improve global workplace pension coverage, adequacy, and
                    certainty. Integrative thinking about these issues leads to pension arrangements
                    that combine the best of traditional DB and DC plans and minimize the impact of
                    their less-attractive features.The kernel of “the optimal pension system” (TOPS) lies all the way
                    back in Robert Merton’s seminal 1971 article that laid out the optimal
                    consumption and portfolio rules in a continuous-time model. The basic idea is
                    that informed, rational people strive for smooth and adequate lifetime
                    consumption. Unfortunately, we have learned that the “informed,
                    rational” part of the assumption is inoperative in the real world. So, we
                    need to design a series of “autopilot” mechanisms for enrollment,
                    target pension, implied contribution rate, age-based investment policy, and
                    capital-to-annuity conversion processes. Although these redesign ideas might
                    have sounded radical just a few years ago, they are now being widely discussed
                    as the way to move forward.However, redesigning the pension formula is only half the cure. We must also
                    redesign the institutional arrangements through which workplace pensions are
                    delivered. The ideal pension-delivery institution is expert, has scale, and acts
                    solely in the best interests of plan participants. Far too few pension funds in
                    the world today can pass this triple test. Consider each in turn:
                        Expert means that the pension institution would have enough
                    internal expertise in pension finance, investments, and administration to be
                    managed expertly “from the inside out” rather than by outside
                    agents. That does not necessarily mean that all functions would be carried out
                    100 percent internally. It does mean that outsourcing decisions would be based
                    on expert judgment that outsourcing is the cost-effective alternative. A related
                    issue is that organization oversight (or governance) would be carried out by a
                    board with sufficient expertise and experience to expertly perform this critical
                    task.This kind of expertise cannot be assembled and retained without
                        scale. Pension-delivery institutions must be large enough
                    to operate at low unit costs. So, ideally, the institutions would manage assets
                    in at least the tens of billions of dollars and would serve hundreds of
                    thousands of plan memberships.At the same time, the institutions would have to pass the governance test:
                        in the best interests of plan participants. This test
                    requires that the ideal pension-delivery institution has an arms-length, co-op
                    legal structure. Peter Drucker observed 30 years ago that such
                    institutions—acting as motivated, expert owners—are ideally equipped
                    to own capitalism’s means of production. Although a few such institutions
                    already exist, many more are needed. Indeed, we need a literal pension
                    revolution.Editor’s Note: This article is adapted from the
                        introductory chapter to the author’s book Pension
                            Revolution (John Wiley & Sons), which is scheduled for
                        release in January 2007.
Journal: Financial Analysts Journal
Pages: 21-25
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4403
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4403
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Author-Name: Don Ezra
Author-X-Name-First: Don
Author-X-Name-Last: Ezra
Title: Defined-Benefit and Defined-Contribution Plans of the Future
Abstract: 
 Defined-benefit pension plans are in decline. What went wrong? The lessons the
                    investment community learns from this decline will help us create better plans
                    in the future—plans that incorporate desirable features of both
                    defined-benefit and defined-contribution plans.Two main causes explain the decline of defined benefit (DB) pension plans. One
                    cause starts with the confusion between what benefits are worth (calculated by
                    discounting benefits at bond yields) and what constitutes the best estimate of
                    the long-term funding target (where discounting includes an equity risk
                    premium). This confusion led to overly generous benefit promises. And with
                    funding based solely on the best estimate, without an additional reserve for
                    investment risk, benefits became underfunded when the risk premium did not
                    arrive. The second cause is legislation that, on the old-fashioned assumption
                    that most corporations last forever, permitted underfunding to continue.The next generation of DB plans will look different from yesterday’s
                    plans. The benefit will probably start as a career average (possibly enhanced
                    periodically by a catch-up provision). It will be valued and funded on the basis
                    of bond yields, with a full funding requirement. There will be no benefit
                    confiscation on an employee’s early death or termination; the benefit
                    will transparently be the reserve held for the employee and will be communicated
                    to the employee each year. Investment risk will require an additional
                    reserve.Future defined contribution (DC) plans will have “autopilot”
                    features—default options designed to mimic desirable DB features, such as
                    extended coverage, contributions increasing with age and pay, and a sensible
                    investment policy that is professionally executed. Other arrangements will be
                    able to convert the employee’s account into postretirement income less
                    expensively than through individual annuity purchases.When we have transparency of DB and DC plans, we will be able to see that
                    retirement income guarantees are expensive. We will have to make individual
                    decisions about bridging the gap between what we wish for and what pension plans
                    can help us achieve. That situation is no different from the past, but perhaps
                    we will confront it more explicitly in the future.
Journal: Financial Analysts Journal
Pages: 26-30
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4404
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4404
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Author-Name: M. Barton Waring
Author-X-Name-First: M. Barton
Author-X-Name-Last: Waring
Author-Name: Laurence B. Siegel
Author-X-Name-First: Laurence B.
Author-X-Name-Last: Siegel
Title: Don’t Kill the Golden Goose! Saving Pension Plans
Abstract: 
 Defined-benefit (DB) pension plans are an endangered species; they are perceived
                    as too risky and costly. But the emerging substitute, the defined contribution
                    plan, has many shortcomings. The risk of DB plans can be controlled, first, by
                    modeling the liability in terms of its market-factor exposures through surplus
                    (asset minus liability) optimization. Then, sponsors may hold the minimum-risk
                    position (a liability-defeasing portfolio) or they may move up on the efficient
                    frontier—taking equity and other risks. The economic cost of a DB plan
                    also needs to be managed, but it is a matter of managing the size of the pension
                    promise; it is not an asset allocation problem.Defined-benefit (DB) plans are like a goose that lays golden eggs—monthly
                    retirement income at a decent level, guaranteed for life. The gradual
                    disappearance of these plans is a tragedy for employees and for society because
                    they are the only practical way to provide an adequate retirement benefit.
                    Defined-contribution (DC) plans are not a suitable replacement.DB plans offer forced savings, the sharing of longevity risk through
                    annuitization, institutional-quality investment strategies, and institutional
                    fee levels. Although DC plans could theoretically replicate all these features,
                    in today’s legal and regulatory environment in the United States, there
                    is no way this replication will actually happen. In fact, most DC-plan
                    participants retire with plan balances so small they provide only a small
                    supplement to Social Security income; they aren’t really pension plans at
                    all.A back-of-the-envelope estimate shows that from sharing longevity risk alone, a
                    given dollar amount of retirement benefit is 35 percent cheaper to provide
                    through a DB plan than through a DC plan.DB plans are also valuable to employers because the economics of labor
                    negotiation requires that this 35 percent (or greater) savings be shared between
                    employer and employee. Thus, the total cost to the employer of obtaining a unit
                    of labor is lower with a DB plan.DB plans are disappearing because employers perceive that the financial risk of
                    being a DB-plan sponsor is unacceptably great. For illustration, employers point
                    to the “perfect storm” of 2000–2002, during which equity
                    prices fell by 50 percent from peak to trough while the present value of pension
                    liabilities was rising dramatically because of the decline in long-term interest
                    rates.However, these market events resulted in a perfect storm only because DB plans
                    were poorly hedged. If assets had been selected with market risk exposures
                    closer to those of the liability, there would have been little damage to pension
                    plans over this period.To save DB plans, sponsors should use existing—although often poorly
                    understood—technology to: (1) hedge the market-related risks in the
                    liability that can be hedged and (2) use “surplus optimization” to
                    rationally take additional risk in pursuit of higher returns.To hedge the risks that can be hedged, one must understand that the liability is
                    someone else’s asset and can be modeled as one would any
                    asset—namely, as the sum of the riskless rate, exposures to various market
                    risks (in this case, inflation risk and real interest rate risk), and a residual
                    or alpha portion. A portfolio of nominal U.S. T-bonds and Treasury
                    Inflation-Protected Securities can be designed that will hedge the liability
                    quite satisfactorily.Note that the market value of the liability is the value
                    relevant to this analysis. This approach is required to build a hedge portfolio
                    and eliminate most of the risk from DB-plan sponsorship. Market-value accounting
                    is a good thing; it provides the transparency that allows risks to be managed by
                    using available market tools.The hedge portfolio is, however, an extreme position. Its yield is too low to be
                    acceptable to most sponsors. Surplus optimization, which is like asset-only
                    optimization but with the liability included as an asset held short, should be
                    used to assess the decision to hold equities and other risky assets. The sponsor
                    can try to add value by taking “surplus beta risk”—that is,
                    equity or equitylike risk not needed to hedge the risks in the
                    liability—and by taking active (alpha) risk.A financially strong plan sponsor can afford to take more surplus beta risk than
                    a weak one because the strong company can afford the higher plan contributions
                    that will be required if the risk does not “work out” (that is, if
                    the stock market performs poorly). In general, however, equity allocations in DB
                    plans should be lower than they are in current practice.Most DB portfolios, then, should have a longer duration and less in equities than
                    they do. Although the expected return from such a strategy is
                    slightly lower than in today’s equity-heavy plans,
                        theworst-case scenarios are much less bad. By holding
                    assets that are closer to the liability in terms of their risk exposures, DB
                    plans can be saved because the risk of sponsoring them will have been managed to
                    acceptable levels.
Journal: Financial Analysts Journal
Pages: 31-45
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4405
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4405
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:63:y:2007:i:1:p:31-45




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Author-Name: Bernard Dumas
Author-X-Name-First: Bernard
Author-X-Name-Last: Dumas
Author-Name: Juerg Syz
Author-X-Name-First: Juerg
Author-X-Name-Last: Syz
Title: Why Not Trade Pension Claims?
Abstract: 
 Trading pension claims would serve many purposes. Beneficiaries would be able to
                    diversify the idiosyncratic credit risk of their plan sponsors. And systematic
                    risk could be reallocated to comply with individual risk–return
                    preferences. The result would be an alignment of companies’ and pension
                    fund managers’ incentives to keep fund plans fully funded—in line
                    with beneficiary interests—which would lower agency costs and costs of
                    government bailouts of defined-benefit plans and would improve the general
                    welfare. As an accurate valuation of pension liabilities, trading would provide
                    a measurable yardstick for plan managers.Trading defined-benefit (DB) pension claims would serve many purposes.
                    Beneficiaries would be able to diversify the idiosyncratic credit risk of their
                    plan sponsors. And systematic risk could be reallocated to comply with
                    individual risk–return preferences. The result would be a realignment of
                    companies’ and pension fund managers’ incentives with the
                    interests of beneficiaries—namely, to keep fund plans fully funded. Full
                    funding would lower agency costs and the costs of government bailouts of DB
                    plans and would improve the general welfare. As an accurate valuation of pension
                    liabilities, trading would provide a measurable yardstick for plan managers.We propose a flexible, low-cost mechanism for transferring and transforming
                    credit risks. It is based on a financial structure that we call a
                    “collateralized pension claim obligation” (CPCO). The CPCOs (and
                    possibly corporate entities) would trade pension claims to optimize
                    diversification and balance their assets according to a number of
                    characteristics (age, industry, geography, etc.). Just as loans or mortgages are
                    pooled and tranched in traditional collateralized debt obligations, pension
                    claims would be pooled and tranched in a CPCO.For example, suppose that, for any of several reasons, a beneficiary became
                    reconciled to the idea that he would never collect the full face value of his
                    pension claim and was uncomfortable with the specific risk of the plan sponsor.
                    In this case, the pension beneficiary could trade in his claim to the CPCO.In this way, the CPCO would accumulate claims on many companies and would become
                    naturally diversified. In exchange, the beneficiary would receive a claim on the
                    CPCO. These claims would be organized in tranches. The senior tranche would be
                    almost riskless because it would be protected by the other tranches. Mezzanine
                    tranches of intermediate risk would offer lower, weaker guaranteed levels of
                    income against a higher expected income, with the realized future income to be
                    tied to the future value of the CPCO’s assets. The equity tranche of the
                    CPCO would be provided by speculative funds.A participant would receive a claim on the CPCO tranche (or a mix of CPCO
                    tranches) that she could select according to her affinity for risk and within
                    the context of her overall wealth. Should the participant’s risk
                    preference change, she could exchange her claim against that of another tranche
                    that better reflected her new risk–return profile.Once a market for pension pools has been developed, designing a benchmark to be
                    used for asset manager evaluation and compensation would be straightforward.
Journal: Financial Analysts Journal
Pages: 46-54
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4406
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4406
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:63:y:2007:i:1:p:46-54




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Author-Name: Lawrence N. Bader
Author-X-Name-First: Lawrence N.
Author-X-Name-Last: Bader
Author-Name: Jeremy Gold
Author-X-Name-First: Jeremy
Author-X-Name-Last: Gold
Title: The Case against Stock in Public Pension Funds
Abstract: 
 The case against equity investment by U.S. corporate pension funds has been well
                    documented for a quarter century. The public sector has ignored or dismissed
                    that case because of differences between taxation and accounting between the
                    private and public sectors, the differing interests of shareholders and
                    taxpayers, and the presumption that public plans last forever. Despite these
                    differences, shifting public pension fund investments from equities to bonds
                    adds value for local taxpayers. It also minimizes the risks of intergenerational
                    taxpayer conflicts, undercharges to employees’ compensation packages for
                    the value of the pensions, employee claims on pension surplus, and higher
                    governmental borrowing costs.The case against equity investment by corporate pension funds has been well
                    documented for a quarter century. The public plan sector has ignored or
                    dismissed that case because of differences in taxation and accounting between
                    public and corporate pension plans, the differing interests of shareholders and
                    taxpayers, and the presumption that public plans last forever.Despite these differences, we show that in a transparent environment, shifting
                    public pension fund investments from equities to bonds adds value for local
                    taxpayers. Equity investment does not reduce the economic (risk-adjusted) cost
                    of a pension plan. It does, however, enable violations of intergenerational
                    fairness. The current generation of taxpayers may benefit by anticipating risk
                    premiums without bearing risk while imposing uncompensated risk on future
                    generations. Any apparent savings from the higher expected returns of equities
                    vis-à-vis bonds result from simply ignoring the risks or passing them on
                    to future generations.In some instances, the beneficiaries of equity investment may be the employees
                    rather than current taxpayers—that is, employees receive credit for the
                    risk premiums while taxpayers bear the risks. Such problems arise when sponsors
                    anticipate risk premiums in determining the charges to employees’
                    compensation packages for the value of their pensions or when employees are
                    successful in pressing claims on any pension surplus.As in corporate pension plans, equity investment wastes the tax shelter available
                    to the taxpayers who bear the pension costs. Because individual federal tax
                    rates are lower on equity returns than on bond returns, individual taxpayers
                    should prefer to use the pension fund tax shelter for their bond exposure while
                    holding equities in their own unsheltered personal portfolios.The transparency in public pension accounting needed to support our arguments
                    does not yet exist. The current opacity of governmental pension finance,
                    together with the lack of advocacy for future taxpayer generations, creates
                    strong incentives for the status quo. The financial world is changing, however,
                    and governmental plan sponsors and their investment managers should prepare. The
                    private sector is moving irreversibly toward greater transparency, and the
                    arguments for all-bond investment in corporate pension plans are gaining
                    traction. It is only a matter of time before the same trends develop in
                    governmental plans. Sponsors who anticipate those trends will be able to adjust
                    with smooth transitions rather than disruptive course corrections.
Journal: Financial Analysts Journal
Pages: 55-62
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4407
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4407
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:63:y:2007:i:1:p:55-62




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Author-Name: Ralph Goldsticker
Author-X-Name-First: Ralph
Author-X-Name-Last: Goldsticker
Title: A Mutual Fund to Yield Annuity-Like Benefits
Abstract: 
 The shift away from defined-benefit pension plans is eliminating life annuities
                    received upon retirement. Retiree incomes are becoming increasingly dependent
                    upon retirees’ investment returns and savings consumption rates. The
                    traditional solution, for retirees to purchase annuities, is expensive (because
                    insurance companies must be compensated for bearing systematic investment and
                    actuarial risks) and leaves the investor exposed to the risk of issuer default.
                    The alternative investment vehicle proposed here would allow retirees to
                    diversify life-expectancy risk but retain aggregate investment and actuarial
                    risks. Participants would thus save the cost of the risk premiums for
                    transferring those risks to an insurance company. As a result, the payments to
                    participants from this alternative should be significantly higher than payments
                    from a purchased annuity.The shift away from defined-benefit (DB) pension plans is eliminating life
                    annuities received upon retirement. As a consequence, both longevity risk and
                    investment risk are being transferred from employers to employees. Thus, retiree
                    incomes are becoming increasingly dependent on retirees’ investment
                    returns and the rate at which they choose to consume their savings.The traditional way to eliminate these risks is to purchase a life annuity.
                    Annuities diversify retirees’ life-expectancy risks—but at a cost.
                    The insurance company must charge enough to be compensated for bearing the
                    systematic investment and actuarial risks in the annuity contracts. In addition,
                    annuities leave retirees with credit risk—the risk that the insurance
                    company will default.As an alternative to annuities, I propose an investment vehicle that has features
                    of both mutual funds and tontines (a financial arrangement in which participants
                    share in the arrangement’s advantages until all but one has died or
                    defaulted, at which time the whole goes to that survivor). The vehicle would
                    allow retirees to diversify their individual life-expectancy risk but through a
                    structure that retains the aggregate investment and actuarial risks. By
                    retaining the systematic risks, participants save the risk premiums associated
                    with transferring them to an insurance company. As a result, the payments from
                    the mutual fund/tontine hybrid should be significantly higher than those from a
                    purchased annuity. In addition, a mutual fund–type structure imposes no
                    default risk.Consider a mutual fund/tontine hybrid that is offered to a single age- and
                    gender-specific cohort (e.g., 65-year-old men). Because the distribution of the
                    participants’ life expectancies and the expected rate of return on assets
                    are known, calculating an annual, fixed annuity payment that can be paid to each
                    participant as long as they survive is straightforward. The tontine-like
                    characteristic arises when participants die; at that time, all claims on assets
                    remaining in the fund are lost. The assets are retained in the fund and used to
                    make payments to surviving participants in the future. Unlike payments from a
                    purchased annuity, however, the fund’s payments are not contractually
                    fixed. Each year, the assumptions are updated and the “annuity”
                    payments recalculated. The payments will vary as a result of differences between
                    realized and expected returns, and between forecasted and realized actuarial
                    experience.To evaluate the potential benefit of this structure, I compared the monthly
                    payment quoted for a single-premium, immediate life annuity with one calculated
                    for the fund/tontine structure. Purchasing an annuity with a $1 million
                    investment would provide a monthly payment of $6,460 for the 65-year-old
                    retiree. By investing $1 million in the mutual fund/tontine hybrid (using a 4.5
                    percent interest rate assumption and current U.S. mortality tables), I found the
                    retiree could expect to receive monthly payments of $7,925. That is 123 percent
                    of the purchased annuity.Tontines could be structured to meet various investment objectives by investing
                    in fixed-income securities, combining bonds with stocks, or adding in Treasury
                    Inflation-Protected Securities to produce an inflation-linked annuity. Also, the
                    assets of more than one cohort could be pooled. That feature makes the tontine
                    an attractive vehicle to annuitize cash-balance pension plans.The most important parameters required to estimate the “fair”
                    payments are the expected return on assets and the expected mortality
                    distribution. These parameters would not be known with certainty. As a result,
                    when setting the tontine’s payment level, in addition to forecasting
                    investment returns, the tontine’s sponsor would need to forecast
                    longevity drift (changes in the longevity of the general population) and adverse
                    selection (those who choose to participate living longer than the general
                    population).Although tontines are not legal today, laws can be changed. The coming
                    demographic wave of Baby Boomer retirees, combined with the steady disappearance
                    of DB pension plans, creates a demand for new approaches to help retirees manage
                    their finances. Properly structured tontine-like vehicles can make an important
                    contribution to meeting that objective.
Journal: Financial Analysts Journal
Pages: 63-67
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4408
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4408
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:63:y:2007:i:1:p:63-67




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Author-Name: João F. Cocco
Author-X-Name-First: João F.
Author-X-Name-Last: Cocco
Author-Name: Paolo F. Volpin
Author-X-Name-First: Paolo F.
Author-X-Name-Last: Volpin
Title: Corporate Governance of Pension Plans: The U.K. Evidence
Abstract: 
 For this study of the governance of defined-benefit pension plans in the United
Kingdom, the governance measure was equal to the proportion of trustees of the
pension plan in 2002 who were also executive directors of the sponsoring
company. The findings indicate that pension plans of indebted companies with a
higher proportion of insider than independent trustees invest a higher
proportion of pension plan assets in equities and that the sponsors contribute
less to the plan and have a larger dividend payout ratio. This evidence supports
the agency view that insider trustees act in the interests of shareholders of
the sponsor, not necessarily in the interests of pension plan members.Many companies have promised their employees defined-benefit (DB) pensions. The
large increases in life expectancy that have occurred since the 1970s and the
decline in interest rates that are used to calculate the present value of
pension liabilities have led to significant increases in corporate pension
liabilities. As a result, many DB corporate pension plans now show substantial
deficits.In the United Kingdom, which is the focus of this article, DB pension plans are
set up in trusts with trustees responsible for the trust assets
and management. More precisely, the trustees must decide how to invest the
assets of the pension plan and must put in place a schedule of contributions for
the sponsoring companies. These powers, combined with the size and deficit of
the pension plans, mean that the actions of pension plan trustees have important
implications not only for pension plan members (or beneficiaries) but also for
the value and behavior of sponsors.The law specifies that the trustees of the pension plan may be directors of
sponsoring companies, which may lead to conflicts of interest between the
executive and trustee roles. In this article, we study such conflicts of
interest.We focus on two alternative hypotheses. The first is that the presence of
insiders is a source of agency problems because it allows insider trustees to
favor shareholders of the company over members of the pension plan. A company
with a DB pension plan can be considered to own a put option: If the assets (the
company and DB assets) fall short of the pension fund liabilities, the company
has the option of giving those assets to the DB beneficiaries as payment.
Because the value of a put option increases with the risk of the underlying
assets, insider trustees may have an incentive to increase the riskiness of the
assets (the company and the DB plan assets) beyond what is optimal for the
members of the pension plan by, for example, investing the pension plan assets
in equities.Agency problems may also be reflected in the contributions paid into the pension
plan. Pension plan liabilities are similar to long-term debt, and pension plan
members are debtholders of the company. Insider trustees who favor shareholders
of the company over debtholders (i.e., pension plan members), however, may have
an incentive to reduce company contributions to the plan.The second hypothesis is that insider trustees facilitate an efficient management
of tax liabilities, which may be positive for both
shareholdersand pension plan members. More precisely,
companies may be able to generate tax savings if they integrate their financial
and pension investment policies: If a company increases leverage, uses the
proceeds to fund the pension plan, and invests those funds in bonds, it may
generate tax savings without affecting financial risk. The reason is that the
increase in leverage generates a debt tax shield while the return on bonds held
in the pension plan is tax exempt.To test these hypotheses, we collected information for 2002 and 2003 on U.K.
companies that had DB pension plans. We found evidence that supports the agency
hypothesis that insider trustees act in the interests of shareholders of the
sponsoring company, not necessarily in the interests of pension plan members.
More precisely, we found that pension plans of the more-leveraged companies with
a higher proportion of insider trustees invest a higher proportion of the
pension plan assets in equities than do other plans and, in this way, make
riskier investments. Also, we provide evidence, consistent with the
risk-shifting effect, that the presence of insider trustees allows companies to
reduce contributions to the plan.
Journal: Financial Analysts Journal
Pages: 70-83
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4409
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4409
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:63:y:2007:i:1:p:70-83




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Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Author-Name: Anthony Bova
Author-X-Name-First: Anthony
Author-X-Name-Last: Bova
Title: P/Es and Pension Funding Ratios
Abstract: 
 Some evidence supports the intriguing conjecture that P/Es in the U.S. market may
                    decline in times of both significantly lower, as well as significantly higher,
                    real interest rates. The P/E response pattern would then resemble a tent that
                    angles downward at both ends. For pension liabilities defined in real terms,
                    very low real rates would then lead to a clifflike falloff in the funding ratio
                    from the decline in equity valuations combined with surging liability costs.
                    This article explores the risk implications of such a low-rate scenario and the
                    equity valuations that could give rise to such a tent pattern.A number of historical studies have exhibited generally declining P/Es for U.S.
                    stocks as a function of higher nominal interest rates. A different perspective
                    emerges when real (inflation-adjusted) rates are substituted for nominal rates.
                    We provide a histogram based on monthly samples for the 1978–2004 period
                    to study the P/E pattern related to real rates. The P/Es were computed from
                    12-month forward earnings projections and the real rates were derived by
                    subtracting concomitant inflation from 10-year U.S. Treasury rates. A tentlike
                    pattern emerges in which, in contrast to the typical decreasing pattern of P/Es
                    with nominal interest rates, P/Es decline in times of both significantly lower,
                    as well as significantly higher, real interest rates. When real rates are used,
                    the highest P/Es lie within a “sweet spot” of 2–3 percent and
                    then fall off for both higher and lower rate levels. In this article, with due recognition of the many empirical limitations, we
                    proceed on an admittedly conjectural basis to explore the potential implications
                    such a tent pattern has for the asset/liability management of pension funds and
                    for some aspects of asset valuation in general.A potential explanation for the tent pattern relates to the interaction of real
                    rates and growth prospects. For real rates in the 2–3 percent sweet spot,
                    economic and profit growth can be presumed to be reasonably normal, reflecting a
                    comfortable balance between funding needs and capital availability. As growth
                    and demand for funds push real rates beyond 3 percent, however, valuations begin
                    to be impaired by the increasing cost of funds. This reasoning would explain the
                    P/E decline with higher interest rates—whether nominal or real.For the infrequent events when real interest rates fall significantly below 2
                    percent, a feasible explanation for the lower P/Es is more challenging.
                    Circumstances can certainly be envisioned, however, in which low real rates are
                    associated with poor economic conditions and dour prospects for future profit
                    growth. In such a situation, money may be readily available but P/E valuations
                    could still be severely depressed by a mixture of dismal growth prospects,
                    elevated risk prospects, and perhaps, a reduced tolerance for market risk.
                    Although such a hypothetical situation is grim, these conditions are not unknown
                    within the recent history of global markets. A P/E tent pattern would have particularly intriguing implications for the
                    asset/liability management of defined-benefit (DB) pension funds. Consider a
                    pension fund that can be simplistically modeled as having 12-year duration
                    relative to real rates. Now, suppose that, with real rates at 3 percent, this
                    liability is 100 percent funded with a portfolio consisting of 60 percent equity
                    and 40 percent 5-year-duration bonds. Suppose also that the tent pattern is a
                    snapshot of the movement of equity prices as real rates change.On the one hand, as real rates move to levels higher than the 2–3 percent
                    sweet spot, the 60 percent equity component of the asset portfolio would decline
                    (in accordance with the right side of the tent). The 40 percent bond component
                    would also decline, so the total portfolio would be under considerable stress.
                    On the other hand, at rates lower than the 2–3 percent sweet spot, the
                    equity component would again decline but there would be some offset from
                    increasing bond values. The net effect would be a somewhat flat tent.In contrast to the asset/liability offset seen under rising rates, the scenario
                    of falling rates would lead to a severe deterioration in the funding ratio
                    driven by a “perfect storm” of asset deterioration and rising
                    liability values. Thus, the overall pattern for the funding ratio would be a
                    surprisingly high degree of stability at higher interest rates but a horrendous
                    falling off at lower rates.The key point is that the “left-hand scenario” below the sweet spot
                    may represent the ultimate “black hole” for investors subject to
                    some form of long-term liability. Such an environment, especially if persistent
                    over time, would exert a gravitational pull to produce a host of adverse
                    events—low-growth prospects, reduced risk tolerance, a move to lower-risk
                    assets, increased risk premiums, adverse correlations across alternative asset
                    classes, reduced annuity value per investable dollar, deteriorated funding
                    ratios, a pullback of automatic-rebalancing strategies (together with a loss of
                    volatility smoothing), and so on. That is the bad news.The good news is that such events are rare and that, for the most part, real
                    interest rates and the associated market conditions are localized within or near
                    the sweet spot. In addition, when events push toward the extreme right or left
                    sides of the tent diagram, natural counterbalancing forces of recovery and/or
                    societal intervention act to speed a return back toward the sweet spot. In
                    particular, the right-hand scenario, with its excessively high cost of capital,
                    is inherently self-correcting. The more troublesome left-hand scenario is
                    apparently extremely rare and rarely persistent.
Journal: Financial Analysts Journal
Pages: 84-96
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4410
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4410
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:63:y:2007:i:1:p:84-96




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Author-Name: Victor F. Morris
Author-X-Name-First: Victor F.
Author-X-Name-Last: Morris
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: The Battle for the Soul of Capitalism (a review)
Abstract: 
 John Bogle (“Saint Jack”), founder and former chairman and CEO of the          Vanguard Group, describes implications of the transformation of U.S. market participants          from individual investors owning stocks directly to investment intermediaries.
Journal: Financial Analysts Journal
Pages: 97-99
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4411
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4411
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:63:y:2007:i:1:p:97-99




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Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Neural Networks in Finance: Gaining Predictive Edge in the Markets (a review)
Abstract: 
 This excellent handbook addresses the criticisms of neural networks, shows how the technique can be resurrected to solve forecasting problems, and may facilitate the resurgence of NN modeling.
Journal: Financial Analysts Journal
Pages: 101-102
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4413
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4413
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Handle: RePEc:taf:ufajxx:v:63:y:2007:i:1:p:101-102




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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and                    issue.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 1
Volume: 63
Year: 2007
Month: 1
X-DOI: 10.2469/faj.v63.n1.4415
File-URL: http://hdl.handle.net/10.2469/faj.v63.n1.4415
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Author-Name: Tom Arnold
Author-X-Name-First: Tom
Author-X-Name-Last: Arnold
Author-Name: John H. Earl
Author-X-Name-First: John H.
Author-X-Name-Last: Earl
Author-Name: David S. North
Author-X-Name-First: David S.
Author-X-Name-Last: North
Title: Are Cover Stories Effective Contrarian Indicators?
Abstract: 
 Headlines from featured stories in Business
                        Week,Fortune, and Forbes were
                    collected for a 20-year period to determine whether positive stories are
                    associated with superior future performance and negative stories are associated
                    with inferior future performance for the featured company.
                    “Superior” and “inferior” were determined in comparison
                    with an index or another company in the same industry and of the same size.
                    Statistical testing implied that positive stories generally indicate the end of
                    superior performance and negative news generally indicates the end of poor
                    performance.For this study, we identified feature stories from the cover headlines
                        inBusiness Week, Fortune,
                        andForbes for a 20-year period (1983–2002) to
                    determine whether positive cover stories are associated with superior future
                    performance and whether negative cover stories are associated with inferior
                    future performance (where “superior” and “inferior” were
                    defined in comparison with an index or with another company in the same industry
                    and of the same size). The feature stories were categorized according to a
                    five-point scale (1 = very positive, 2 = optimistic, 3 = neutral, 4 =
                    pessimistic past but a better future predicted, and 5 = pessimistic with the
                    potential for management turnover and/or litigation).Our statistical testing implies, as expected, that positive business magazine
                    cover stories follow significantly positive performance and negative stories
                    follow significantly negative performance. In both cases, however, the
                    appearance of a company on a cover apparently signals the end of the extreme
                    performance. We found for these companies going forward weak evidence that
                    optimistic (Category 2) cover headlines are an indicator for momentum on a
                    six-month horizon after publication. Negative cover headlines do not provide a
                    good signal for momentum or contrarian strategies when performance is measured
                    against an index or on a size/industry-adjusted basis, despite a popular belief
                    that such cover headlines are a contrarian signal. Indeed, we found that
                    companies that were the subject of negative cover headlines tended to have
                    positive holding-period returns after publication of the magazine, but the
                    positive returns were not abnormally positive when adjusted for an index or for
                    size and industry. Consequently, if an investor is short the stock that is the
                    subject of a negative cover story, the investor should consider covering the
                    short position because the stock has hit “bottom.”
Journal: Financial Analysts Journal
Pages: 70-75
Issue: 2
Volume: 63
Year: 2007
Month: 3
X-DOI: 10.2469/faj.v63.n2.4520
File-URL: http://hdl.handle.net/10.2469/faj.v63.n2.4520
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:63:y:2007:i:2:p:70-75




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Author-Name: Richard Sias
Author-X-Name-First: Richard
Author-X-Name-Last: Sias
Title: Causes and Seasonality of Momentum Profits
Abstract: 
 With Januaries (a month in which lagged “losers” typically outperform
                    lagged “winners”) excluded, the average monthly return to a momentum
                    strategy for U.S. stocks was found to be 59 bps for non-quarter-ending months
                    but 310 bps for quarter-ending months. The pattern was stronger for stocks with
                    high levels of institutional trading and was particularly strong in December.
                    The results suggest that window dressing by institutional investors and tax-loss
                    selling contribute to stock return momentum. Investors using a momentum strategy
                    should focus on quarter-ending months and securities with high levels of
                    institutional trading.Stocks exhibit return momentum: Lagged “winners” (i.e., securities in
                    the top performance decile based on returns over the previous six months) tend
                    to subsequently outperform lagged “losers” (i.e., securities in the
                    bottom lagged six-month performance decile). Both tax-loss selling in December
                    and window dressing by institutional investors in quarter-ending months may
                    contribute to stock return momentum. In the case of tax-loss selling, investors
                    (both individual investors and some institutional investors) may favor selling
                    lagged losers in December to realize taxable losses and may avoid selling lagged
                    winners in December to forestall recognizing taxable gains. This behavior may
                    contribute to return momentum in December. In the case of institutional
                    investors, their window-dressing behavior also may contribute to momentum-profit
                    seasonality. At quarter-end, and especially year-end, institutional investors
                    may want to abandon lagged losers to avoid reporting “embarrassing”
                    stocks in their end-of-quarter or end-of-year holdings. Similarly, managers may
                    buy lagged winners to appear as if they held respectable or
                    “winning” stocks throughout the period.This study found that the profitability of momentum strategies in the past 20
                    years arose primarily from the last month of each quarter, which is consistent
                    with the hypothesis that year-end tax-motivated trading and institutional window
                    dressing contribute to stock return momentum. Momentum profits were, on average,
                    negative when quarter-ending months (March, June, September, and December) were
                    excluded from the sample. January, a month when lagged losers typically
                    outperform lagged winners, explains part of the negative momentum profits for
                    non-quarter-ending months. Even after excluding January from the sample,
                    however, momentum profits from quarter-ending months averaged more than five
                    times the momentum profits from non-quarter-ending months.The seasonal pattern was particularly strong in stocks with high levels of
                    institutional trading and in December. The momentum-profit seasonality and the
                    relationship between this seasonality and institutional trading suggest that
                    tax-loss selling and institutional window dressing play substantial roles in
                    driving stock return momentum. Investors attempting to exploit return momentum
                    should thus focus their efforts on quarter-ending months and on securities with
                    high levels of institutional trading.
Journal: Financial Analysts Journal
Pages: 48-54
Issue: 2
Volume: 63
Year: 2007
Month: 3
X-DOI: 10.2469/faj.v63.n2.4521
File-URL: http://hdl.handle.net/10.2469/faj.v63.n2.4521
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Handle: RePEc:taf:ufajxx:v:63:y:2007:i:2:p:48-54




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Author-Name: Jing Liu
Author-X-Name-First: Jing
Author-X-Name-Last: Liu
Author-Name: Doron Nissim
Author-X-Name-First: Doron
Author-X-Name-Last: Nissim
Author-Name: Jacob Thomas
Author-X-Name-First: Jacob
Author-X-Name-Last: Thomas
Title: Is Cash Flow King in Valuations?
Abstract: 
 Contrary to the common perception that operating cash flows are better than
                    accounting earnings at explaining equity valuations, recent studies suggest that
                    valuations derived from industry multiples based on reported earnings are closer
                    to traded prices than those based on reported operating cash flows. The question
                    addressed in the article is whether the balance tilts in favor of cash flows
                    when the following are considered: (1) forecasts rather than reported numbers,
                    (2) dividends rather than operating cash flows, (3) individual industries rather
                    than all industries combined, and (4) companies in non-U.S. markets. In all
                    cases studied, earnings dominated operating cash flows and dividends.Even though many finance academics and practitioners believe that operating cash
                    flows are better than accounting earnings at explaining equity valuations, the
                    evidence from recent studies suggests the opposite. For example, we previously
                    investigated the performance of industry multiples based on a comprehensive list
                    of value drivers for a sample of U.S. companies. Performance was measured as the
                    ability of valuations derived from industry multiples to approach traded prices,
                    and the value drivers considered included forward earnings; reported earnings;
                    book value of equity; sales; earnings before interest, taxes, depreciation, and
                    amortization; and various cash flow measures. Our results suggested that
                    earnings clearly outperform other value drivers.In this study, we focused on a comparison of cash flows and earnings because of
                    the prominence of these two measures in practice but we expanded our analysis in
                    four directions to see whether cash flows outperform earnings in other contexts.
                    First, we considered forecasts of cash flows in addition to
                    reported numbers. Because analysts exclude in their forecasts the one-time items
                    that tend to blur the relationship between reported numbers and value, moving
                    from reported numbers to forecasts should improve the performance for both cash
                    flows and earnings. The open question was whether the improvement in performance
                    for cash flow forecasts would be large enough to overcome the initial
                    performance gap between reported earnings and cash flows. Second, we broadened
                    the definition of cash flows to consider both dividends and operating cash
                    flows. Even though many companies do not pay dividends, we considered that
                    dividends might outperform earnings for the subset of dividend-paying companies.
                    Third, we compared the performance of earnings with the performance of cash
                    flows within industries to determine whether for a subset of industries,
                    dividends or operating cash flows would outperform earnings.Fourth, we considered nine markets in addition to the United States: Australia,
                    Canada, France, Germany, Hong Kong, Japan, South Africa, Taiwan, and the United
                    Kingdom. To the extent that factors such as accounting rules and the
                    informativeness of dividends vary across markets, that variation could result in
                    across-market variation in the performance of earnings, operating cash flows,
                    and dividends.Our main finding is that valuations based on industry multiples using earnings
                    forecasts are remarkably accurate. About half the companies had valuations that
                    were within 20 percent of traded prices for the three markets where earnings
                    forecasts performed well (Australia, the United Kingdom, and the United States)
                    and were within 30 percent of traded prices for the three markets where earnings
                    forecasts were the least informative (Germany, Japan, and Taiwan). In effect,
                    the lead that reported earnings exhibit over reported operating cash flows and
                    dividends increased when we considered forecasts. Although the earnings multiple
                    was outperformed by operating cash flows or dividends in some
                    industries—and in one market (Japan), where the performance of dividends
                    approached that of earnings—the dominance of earnings multiples was very
                    evident. Overall, our results suggest that proponents of using cash flow
                    multiples consider using earnings multiples instead, especially if earnings
                    forecasts are available.
Journal: Financial Analysts Journal
Pages: 56-68
Issue: 2
Volume: 63
Year: 2007
Month: 3
X-DOI: 10.2469/faj.v63.n2.4522
File-URL: http://hdl.handle.net/10.2469/faj.v63.n2.4522
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Handle: RePEc:taf:ufajxx:v:63:y:2007:i:2:p:56-68




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Author-Name: Stéphanie Desrosiers
Author-X-Name-First: Stéphanie
Author-X-Name-Last: Desrosiers
Author-Name: Natacha Lemaire
Author-X-Name-First: Natacha
Author-X-Name-Last: Lemaire
Author-Name: Jean-François L’Her
Author-X-Name-First: Jean-François
Author-X-Name-Last: L’Her
Title: Residual Income Approach to Equity Country Selection
Abstract: 
 The predictive power for country selection of expected returns estimated through
                    the residual income model is examined through analysis of 19 developed-country
                    indices for 1988–2005. Zero-investment strategies based on a ranking or
                    optimization methodology—expected returns and conditional country risk
                    estimates—posted significant positive performance over various holding
                    periods. Risk-adjusted returns remained significant after control for four world
                    risk factors—market, size, the book-to-market ratio, and
                    momentum—constructed through a country stratification methodology based on
                    stock constituents. The results were robust to various long-term growth
                    estimates and to different country-universe subsamples and remained robust after
                    transaction costs were taken into account.Ample evidence exists that country versions of company characteristics have a
                    certain degree of predictive power for future country returns. Although these
                    variables do allow ranking strategies, however, they do not allow optimization
                    strategies. We favor the use of expected returns over the use of these variables
                    for selecting countries in a global equity strategy.We examined the suitability of using expected returns derived from the residual
                    income model (RIM) in global equity country selection. This model has the
                    advantage of relying on analysts’ forward-looking information, and it
                    allowed us to translate accounting numbers computed within different
                    country-specific accounting standards into a harmonious measure of expected
                    return. The model provides a reliable and consistent measure of the implicit
                    expected rates of return among countries.According to the RIM, the intrinsic value of the market index is equal to the sum
                    of the book value of the market index plus the present value of abnormal
                    earnings. Abnormal earnings are equal to the difference between forecast
                    earnings and normal earnings, where normal earnings represent the charge for the
                    cost of capital. We inferred the implicit expected return (discount rate) from
                    the equality between the intrinsic value and the market price of the index.Our sample comprised 19 developed countries and spanned the period
                    1988–2005. We first created zero-investment portfolios by following a
                    ranking strategy in which the long portfolio contained the most attractive
                    countries with respect to expected returns obtained via the RIM and the short
                    portfolio contained the least attractive countries. We then examined an
                    optimization strategy based on conditional risk estimates in addition to the
                    implicit expected return estimates.Both strategies posted significantly positive excess returns over the period. The
                    ranking strategy provided an annual average raw return of 8.3 percent with an
                    annualized standard deviation of 8.6 percent over one-month holding periods. The
                    optimization strategy provided a slightly lower annual average raw return (8.1
                    percent) but also a lower annualized standard deviation (7.2 percent). Although
                    a one-month horizon produced the best results, three-, six-, and twelve-month
                    holding periods all produced significantly positive returns.The strategies’ results held when we controlled for four world risk
                    factors—market, size, the book-to-market ratio, and momentum. The alpha
                    coefficients dropped only slightly from those of the raw returns.In further tests, we assessed the robustness of the strategies to various
                    parameters. First, we tested other proxies for the estimate of the abnormal
                    long-term growth rate in the RIM. In our original calculations, we assumed that
                    abnormal earnings grew at the long-term expected inflation rate as measured by
                    the historical inflation rate observed over the previous year. In the robustness
                    tests, we used short-term interest rates and consensus inflation forecasts as
                    proxies for the long-term growth rate of earnings. Returns from the strategies
                    remained positive and significant for both these proxies.We also showed the robustness of the strategies to various universe
                    subsamples—the developed countries ex the United States, the subsample
                    composed of the MSCI Europe/Australasia/Far East Index ex Japan, and the 12
                    largest and most liquid markets.Finally, we tested the results’ robustness to transaction costs.
                    Conservative transaction costs did not undermine the statistical and economical
                    significance of the results.Considering our results, the use of the residual income model for country
                    allocation seems promising.We documented basic zero-investment strategies for applying the model, but there
                    are many ways of implementing such strategies. For example, an investor could
                    tilt global equity portfolios toward countries with higher expected returns and
                    avoid countries with lower expected returns. All variants of the basic
                    zero-investment strategies would add value over a passive benchmark.
Journal: Financial Analysts Journal
Pages: 76-89
Issue: 2
Volume: 63
Year: 2007
Month: 3
X-DOI: 10.2469/faj.v63.n2.4523
File-URL: http://hdl.handle.net/10.2469/faj.v63.n2.4523
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:63:y:2007:i:2:p:76-89




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Author-Name: Ira G. Kawaller
Author-X-Name-First: Ira G.
Author-X-Name-Last: Kawaller
Title: Interest Rate Swaps: Accounting vs. Economics
Abstract: 
 With interest rate swaps being the most widely used of all financial derivative
                    contracts, financial analysts and engineers should be keenly interested in any
                    regulations that could influence how these tools are used. This article
                    addresses one such regulatory aspect—namely, the accounting rules. In
                    certain cases, these rules can result in financial reports that do not
                    accurately represent the economic intent of derivative transactions. This essay
                    strives to explain this disconnect and suggest (1) how accounting standard
                    setters might consider adjusting their requirements or, independently of that
                    adjustment, (2) how companies might want to accommodate to the current
                    rules.In June 1998, the Financial Accounting Standards Board (FASB) issued new
                    accounting rules for derivatives and hedging transactions—Statement of
                    Financial Accounting Standards (FAS) No. 133, Accounting for Derivative
                        Instruments and Hedging Activities. Even now, after more than eight
                    years of experience with the standard, it remains controversial. For hedgers who
                    use derivatives directly related to some associated economic exposure, under the
                    “regular” accounting rules, the derivative’s results and the
                    hedged item’s income effects are often recognized in earnings in different
                    calendar periods. For these hedgers, the resulting income volatility obscures
                    the economics of the hedging activity. The FASB accommodated to this perspective
                    by providing for “special hedge accounting’ procedures, in which
                    these two income effects may be recorded concurrently, but special hedge
                    accounting is not automatic, and qualifying for it requires satisfying a host of
                    preconditions.One special accommodation was made for the use of interest rate swaps. This
                    “shortcut” method was authorized for use when swaps are designed to
                    perfectly address the risk being hedged. In these instances, shortcut treatment
                    minimizes some of the obligations relating toeffectiveness
                    testing and measurement. However, a number of reporting entities have applied
                    the shortcut procedure but apparently not satisfied the requirements to do
                    so—because of technical violations or, perhaps, more willful
                    misrepresentations. Therefore, auditing firms have taken to broadly discouraging
                    their clients from applying the shortcut method.The implications of applying hedge accounting without following the shortcut
                    treatment has little consequence for hedgers who use swaps to convert from
                    floating-rate exposures to fixed-rate exposure (i.e., cash flow hedgers).
                    However, for hedgers who seek to do the opposite (i.e., fair value hedgers who
                    want to convert from fixed to floating rates), forgoing the shortcut procedure
                    means that they cannot realize an accounting result that accurately represents
                    the economics of the hedge. Moreover, without shortcut treatment, there is even
                    a chance that hedge accounting could, at some point, be disallowed—even if
                    the ideal swap is being used.The primary objective of this article is to motivate a reassessment of the
                    shortcut rules, with the hope of encouraging the FASB to liberalize some of the
                    prerequisite requirements. I also suggest ways in which reporting entities can
                    accommodate to the rules as they currently stand.
Journal: Financial Analysts Journal
Pages: 15-18
Issue: 2
Volume: 63
Year: 2007
Month: 3
X-DOI: 10.2469/faj.v63.n2.4524
File-URL: http://hdl.handle.net/10.2469/faj.v63.n2.4524
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Author-Name: Doron Avramov
Author-X-Name-First: Doron
Author-X-Name-Last: Avramov
Author-Name: Gergana Jostova
Author-X-Name-First: Gergana
Author-X-Name-Last: Jostova
Author-Name: Alexander Philipov
Author-X-Name-First: Alexander
Author-X-Name-Last: Philipov
Title: Understanding Changes in Corporate Credit Spreads
Abstract: 
 New evidence is reported on the empirical success of structural models in
                    explaining changes in corporate credit risk. A parsimonious set of common
                    factors and company-level fundamentals, inspired by structural models, was found
                    to explain more than 54 percent (67 percent) of the variation in credit-spread
                    changes for medium-grade (low-grade) bonds. No dominant latent factor was
                    present in the unexplained variation. Although this set of factors had lower
                    explanatory power among high-grade bonds, it did capture most of the systematic
                    variation in credit-spread changes in that category. It also subsumed the
                    explanatory power of the Fama and French factors among all grade classes.We provide new evidence on the empirical success of structural models in
                    explaining corporate credit-risk changes. The basic factors used in the model
                    were a set of common factors—the equity market return, change in prospects
                    for company growth (proxied by change in the price-to-book ratio, or P/B),
                    change in aggregate idiosyncratic equity volatility, the slope of the term
                    structure, and change in the spot rate—and a set of company-level
                    characteristics—the stock return (as a proxy for leverage), stock
                    momentum, change in idiosyncratic equity volatility, and change in the P/B. We
                    also examined the three Fama–French factors (for beta, size, and
                    value–growth) and whether Federal Reserve Board policy was expansionary or
                    recessionary.Studying 2,375 U.S. corporate bonds that were diverse in credit quality (ranging
                    from AAA to D) in the 1990–2003 period, we found that a structural model
                    with our set of factors was impressively successful in explaining credit-spread
                    changes in the medium- and low-grade bond segments. Specifically, we found the
                    model explained more than 54 percent of individual-bond credit-spread changes in
                    the medium-grade group and 67 percent of changes in the low-grade group. In the
                    highest-grade group, the explanatory power was about 36 percent.Explanatory power differs among bond classes partly because of the different
                    roles played by company-level fundamentals, such as volatility, leverage, and
                    growth opportunities. These variables are particularly important in the
                    low-grade segment but play little role in the high-grade segment. Moreover, the
                    common factors captured twice as much variation in the low-grade group as in the
                    high-grade group.No dominant latent factor was present in the unexplained variation.
                    Principal-components analysis applied to bond portfolios revealed no latent
                    factor in the residual variation of low- or medium-grade portfolios but a strong
                    latent factor in high-grade portfolios. Analysis of individual regression
                    residuals revealed no variation, however, common to all the credit-risk groups,
                    which provides solid evidence that structural models capture essentially all
                    systematic variation in individual credit-spread changes for all credit-risk
                    classes.We provide new evidence that idiosyncratic volatility and the P/B are important
                    in empirical corporate bond pricing. The P/B and idiosyncratic volatility are
                    both driven by uncertainty about a company’s future profitability, which
                    affects default probability in a structural model framework. We show that
                    changes in idiosyncratic volatility and the P/B at both the aggregate and
                    company level are economically and statistically significant in explaining the
                    time-series variation in corporate credit-spread changes.Our parsimonious set of variables subsumes the explanatory power of the
                    Fama–French factors, which have traditionally been used in equity pricing.
                    We found the Fama–French factors on their own to be significant and to
                    explain about 26 percent of the variation in credit-spread changes, but when
                    added to our proposed set of structural model variables, the Fama–French
                    factors lost significance and did not increase overall explanatory power. This
                    finding suggests that structural model factors capture the systematic risk in
                    credit-spread changes better than do the Fama–French factors.
Journal: Financial Analysts Journal
Pages: 90-105
Issue: 2
Volume: 63
Year: 2007
Month: 3
X-DOI: 10.2469/faj.v63.n2.4525
File-URL: http://hdl.handle.net/10.2469/faj.v63.n2.4525
File-Format: text/html
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Author-Name: C. Terry Grant
Author-X-Name-First: C. Terry
Author-X-Name-Last: Grant
Author-Name: Gerry H. Grant
Author-X-Name-First: Gerry H.
Author-X-Name-Last: Grant
Author-Name: William R. Ortega
Author-X-Name-First: William R.
Author-X-Name-Last: Ortega
Title: FASB’s Quick Fix for Pension Accounting Is Only First Step
Abstract: 
 Hidden liabilities, understated expenses, and discretionary management
                    assumptions make pension accounting controversial. Previous accounting standards
                    allowed companies with underfunded pension plans to accumulate pension
                    liabilities off the balance sheet while frequently reporting a net pension asset
                    on the balance sheet. A new standard improves transparency by requiring that the
                    pension’s funded status be reported on the balance sheet. In assessing the
                    impact of the new standard, this study finds that it creates profound reductions
                    in owners’ equity for many U.S.-listed companies. Pension cost smoothing
                    and three primary pension assumptions—the expected rate of return on plan
                    assets, discount rate, and expected rate of increase in employee
                    compensation—continue to be controversial.Hidden liabilities, understated expenses, and discretionary management
                    assumptions make pension accounting highly controversial. Previous accounting
                    standards allowed companies to accumulate pension liabilities off the balance
                    sheet by relegating actual pension assets and liabilities to financial statement
                    footnotes. Financial reporting transparency was further inhibited because
                    pension-related items recognized in the financial statements often did not
                    portray the company’s true financial position. Indeed, many companies with
                    underfunded pension plans have reported net pension assets on their balance
                    sheets. For example, in 2004, General Motors’ pension plans were
                    underfunded by more than $7.5 billion, but GM reported a net pension asset of
                    almost $35 billion as a result of allowable income smoothing and amortization
                    techniques established under Statement of Financial Accounting Standards (FAS)
                    No. 87, Employers’ Accounting for Pensions.A new FASB pension standard, FAS 158, Employers’ Accounting for
                        Defined-Benefit Pension and Other Postretirement Plans, which is
                    effective for public companies with fiscal years ending after 15 December 2006,
                    will greatly improve the transparency of financial reporting by requiring
                    companies to report the actual funded status of their pension plans on the
                    balance sheet. Nevertheless, many pension accounting deficiencies—in
                    particular, income-smoothing techniques used to amortize actuarial gains and
                    losses—will remain for at least three years until a more comprehensive
                    pension rule can be issued. In addition, three primary pension
                    assumptions—the expected rate of return on plan assets, discount rate, and
                    expected rate of increase in employee compensation—continue to be a source
                    of controversy and a target of regulators.We explain previous pension accounting and evaluate the effects of FAS 158. We
                    examine pension accounting assumptions for S&P 100 Index companies over the
                    eight-year period of 1997–2004. The use of aggressive rate assumptions can
                    greatly affect the quality of earnings and thus cloud the transparency of
                    financial reporting. Because many provisions established under FAS 87 will
                    continue to affect computation of pension cost, the importance of these
                    assumptions does not diminish under FAS 158. The varying market conditions over
                    the eight-year period allow a comprehensive assessment of the reasonableness of
                    managements’ pension rate assumptions.We also explain the profound balance sheet impact FAS 158 will have. We estimate
                    that the new rule will reduce owners’ equity an average of $2.2 billion
                    for S&P 100 companies. When we expanded the sample to S&P 500 Index
                    companies, we found the average reduction to owners’ equity to be $767
                    million. Our results indicate that such declines in owners’ equity because
                    of FAS 158 are robust across all major industries represented by S&P 500
                    companies. As a result of the new pension standard, some companies will report
                    negative owners’ equity; many companies could face the risk of debt
                    covenant violations.
Journal: Financial Analysts Journal
Pages: 21-35
Issue: 2
Volume: 63
Year: 2007
Month: 3
X-DOI: 10.2469/faj.v63.n2.4526
File-URL: http://hdl.handle.net/10.2469/faj.v63.n2.4526
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Author-Name: Jagadeesh Gokhale
Author-X-Name-First: Jagadeesh
Author-X-Name-Last: Gokhale
Author-Name: Kent Smetters
Author-X-Name-First: Kent
Author-X-Name-Last: Smetters
Title: Do the Markets Care about the $2.4 Trillion U.S. Deficit?
Abstract: 
 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.
                    The opinions and conclusions expressed in this article are solely those
                        of the authors and do not necessarily represent the opinions of the Cato
                        Institute or the Wharton School.
                Our calculations show that 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. The major culprits are
                    Social Security and Medicare.Although the 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?We discuss four hypotheses that might explain the market’s indifference to
                    our looming financial crises: First, market participants believe that explicit
                    government debt is “real” whereas unfunded liabilities are not (a
                    belief that is not tolerated if a corporation expresses it). Second,
                    Stein’s Law says, “That which cannot go on forever
                    won’t.” Policy makers and market participants interpret the law to
                    mean someone in the future will somehow figure out how to pay the piper. Third,
                    the future is too uncertain to be predictable, so market participants are taking
                    a wait-and-see attitude just when they should be worried. Finally, the market
                    believes foreigner investors will bail us out—despite the fact that those
                    investors have their own, similar problems.The common belief that capital markets cannot fail is precisely the reason why
                    they can—and why an Argentina-type disaster can happen in the United
                    States. The financial shortfalls that the federal government faces are
                    unprecedented, as investors will eventually figure out. Hopefully, policymakers
                    will have the wits and political will to address these shortfalls soon and avoid
                    a situation in which investors suddenly realize the shortfalls’
                    implications and attempt to exit the fixed-income market all at once.
Journal: Financial Analysts Journal
Pages: 37-47
Issue: 2
Volume: 63
Year: 2007
Month: 3
X-DOI: 10.2469/faj.v63.n2.4527
File-URL: http://hdl.handle.net/10.2469/faj.v63.n2.4527
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: Investment Policy: Bridle of Want
Abstract: 
 Investors desire return, but successful investment requires more than the                        desire; it needs an investment policy grounded in investor capacities to                        bear risk, to hold illiquid assets, and to exploit security mispricing
Journal: Financial Analysts Journal
Pages: 8-8
Issue: 2
Volume: 63
Year: 2007
Month: 3
X-DOI: 10.2469/faj.v63.n2.4528
File-URL: http://hdl.handle.net/10.2469/faj.v63.n2.4528
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Author-Name: Bruce Alan Ackermann
Author-X-Name-First: Bruce Alan
Author-X-Name-Last: Ackermann
Title: “Value Destruction and Financial Reporting Decisions”: A Comment
Abstract: 
 This material comments on “Value Destruction and Financial Reporting                    Decisions”.
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 2
Volume: 63
Year: 2007
Month: 3
X-DOI: 10.2469/faj.v63.n2.4529
File-URL: http://hdl.handle.net/10.2469/faj.v63.n2.4529
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “Corporate Governance of Pension Plans: The U.K.                        Evidence” by João F. Cocco and Paolo F.                    Volpin in the January/February 2007 issue of the FAJ.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 2
Volume: 63
Year: 2007
Month: 3
X-DOI: 10.2469/faj.v63.n2.4531
File-URL: http://hdl.handle.net/10.2469/faj.v63.n2.4531
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issue.
Journal: Financial Analysts Journal
Pages: 112-112
Issue: 2
Volume: 63
Year: 2007
Month: 3
X-DOI: 10.2469/faj.v63.n2.4532
File-URL: http://hdl.handle.net/10.2469/faj.v63.n2.4532
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: Editor’s Corner
Abstract: 
 The cloning of hedge funds sprang from efforts to measure hedge fund performance.                    A clone offers the systematic return of a hedge fund for a lower fee. The                    question is: Why would anyone want to pay an active fee for an intentionally                    passive investment product?
Journal: Financial Analysts Journal
Pages: 6-7
Issue: 3
Volume: 63
Year: 2007
Month: 5
X-DOI: 10.2469/faj.v63.n3.4681
File-URL: http://hdl.handle.net/10.2469/faj.v63.n3.4681
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Author-Name: Harry Klaristenfeld
Author-X-Name-First: Harry
Author-X-Name-Last: Klaristenfeld
Title: “A Mutual Fund to Yield Annuity-Like Benefits”: A Comment
Abstract: 
 This material comments on “A Mutual Fund to Yield Annuity-Like                    Benefits”.
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 3
Volume: 63
Year: 2007
Month: 5
X-DOI: 10.2469/faj.v63.n3.4682
File-URL: http://hdl.handle.net/10.2469/faj.v63.n3.4682
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Author-Name: Keith Wallace
Author-X-Name-First: Keith
Author-X-Name-Last: Wallace
Title: “Corporate Governance of Pension Plans: The U.K. Evidence”: A Comment
Abstract: 
 This material comments on “Corporate Governance of Pension Plans: The                    U.K. Evidence”.
Journal: Financial Analysts Journal
Pages: 10-11
Issue: 3
Volume: 63
Year: 2007
Month: 5
X-DOI: 10.2469/faj.v63.n3.4684
File-URL: http://hdl.handle.net/10.2469/faj.v63.n3.4684
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “Are Cover Stories Effective Contrarian Indicators?” by          Tom Arnold, CFA, John H. Earl, Jr., CFA, and David S. North in the March/April 2007 issue          of the FAJ.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 3
Volume: 63
Year: 2007
Month: 5
X-DOI: 10.2469/faj.v63.n3.4685
File-URL: http://hdl.handle.net/10.2469/faj.v63.n3.4685
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Author-Name: Randall A. Heron
Author-X-Name-First: Randall A.
Author-X-Name-Last: Heron
Author-Name: Erik Lie
Author-X-Name-First: Erik
Author-X-Name-Last: Lie
Author-Name: Tod Perry
Author-X-Name-First: Tod
Author-X-Name-Last: Perry
Title: On the Use (and Abuse) of Stock Option Grants
Abstract: 
 Recently, a significant number of companies have come under public and regulatory
                    scrutiny for backdating stock option grants. This article discusses factors that
                    influenced the dramatic increase in stock option compensation and summarizes the
                    academic research that led to the discovery of backdating. The information
                    gained in this early stage of investigation provides some insight into the
                    number of companies and potential costs of option backdating. Increased
                    transparency and timely disclosure should curtail grant-date manipulation, but
                    the credibility of the disclosure system requires active enforcement of the
                    rules and standards. Investors need accurate, complete disclosures of executive
                    compensation to hold boards of directors accountable for executive
                    compensation.The structure and form of compensation for executive officers of publicly traded
                    companies have changed dramatically since the early 1990s; the number and value
                    of stock options granted to executive officers exploded during this period.
                    Stock options can be used to align the financial interests of managers and
                    shareholders, provide retention incentives, and compensate employees without any
                    immediate cash outflow. Critics of stock options, however, have argued that the
                    historical accounting treatment of stock options and the possible tax advantages
                    for stock options relative to cash-based compensation have contributed to an
                    excessive use of option-based compensation.Although companies are now required under Statement of Financial Accounting
                    Standards No. 123 (revised 2004), Share-Based Payment (SFAS
                    123R) to expense stock options by using option-pricing methodologies designed to
                    capture the underlying economic, or “fair,” value of the option
                    grant, a new controversy over stock option grants has arisen as a significant
                    number of companies have been identified as likely to have backdated stock
                    option grants.Backdating is the practice of selecting option grant dates on a retroactive basis
                    to reflect a lower stock price than the stock price on the date the actual
                    granting decision occurred. With the benefit of hindsight, we can see that
                    companies that grant backdated options are effectively granting in-the-money
                    options. The accounting rules in place prior to SFAS 123R did not require
                    companies to expense stock options as long as the options were not granted in
                    the money.We present summary data that illustrate how the structure of CEO pay packages
                    changed during the 1996–2005 period and the increased emphasis on options.
                    We then discuss the academic research leading to the discovery that executive
                    option grants were being backdated and provide graphs demonstrating the return
                    patterns around the time of option grants prior to and following the adoption of
                    SOX. We also discuss how the backdating scandal surfaced in the media and was
                    followed by an explosion of interest in 2006.Although the industry is in the early stages of learning about backdating
                    practices, we provide some evidence as to the breadth of the practice and the
                    potential economic costs for companies involved in it. By November 2006, more
                    than 170 companies had been mentioned as having potential backdating problems,
                    and that number is likely to substantially increase. Also, from early
                    information, we find that the costs of investigating and fixing backdating
                    problems are likely to be material for many companies.We conclude with a discussion of additional measures that are being taken and
                    should be taken to prevent or limit abuses of option granting, such as
                    backdating, in the future. Companies are now required to expense option grants
                    at fair value for accounting purposes, and new U.S. SEC rules for compensation
                    disclosure require companies to provide greater details regarding the timing of
                    option grants than were required in the past. Increased transparency combined
                    with timely disclosure should curtail manipulation of option grant dates, but
                    the credibility of the disclosure system still requires active enforcement of
                    the rules and standards in place. Ultimately, investors need to use the more
                    accurate and complete disclosure of executive compensation in general, and
                    option grants in particular, to hold boards of directors accountable for the
                    compensation paid to executives.
Journal: Financial Analysts Journal
Pages: 17-27
Issue: 3
Volume: 63
Year: 2007
Month: 5
X-DOI: 10.2469/faj.v63.n3.4686
File-URL: http://hdl.handle.net/10.2469/faj.v63.n3.4686
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Author-Name: Denise Dickins
Author-X-Name-First: Denise
Author-X-Name-Last: Dickins
Author-Name: Robert Houmes
Author-X-Name-First: Robert
Author-X-Name-Last: Houmes
Title: Executive Compensation: Much Ado about Nothing?
Abstract: 
 Recent concerns about the level of executive compensation led to revisiting the
                    question of whether highly compensated corporate employees earn their pay.
                    Several measures of company performance indicate that companies with the most
                    highly compensated employees perform only in a manner consistent with other
                    companies. Our results provide support for those who have recently expressed
                    dismay over compensation levels.Recent concerns about the level of executive compensation led us to revisit the
                    question of whether highly compensated individuals earn their pay. Using data
                    for S&P 500 Index companies during the 1997–2004 period and several
                    measures of company performance, we found on a fairly consistent basis that for
                    both market-based and income-based performance measures, companies with the
                    highest levels of compensation report future performance that is, at best, only
                    consistent with the performance of other companies. In some periods, based on at
                    least one measure of performance, our analysis suggests that the performance of
                    companies who reported the greatest amount of compensation may have been
                    significantly worse than the performance of other companies. These results were
                    consistent even under the assumption that executives’ pay should vary
                    positively with company size. We also found that irrespective of performance,
                    executives at the largest companies were paid the most.In short, recent concerns over the reported amounts of executive compensation
                        maynot be much ado about nothing. These findings not only
                    provide support for the U.S. SEC’s recent adoption of rules expanding
                    companies’ disclosures about executive compensation (Release No. 33-8655),
                    they also lead to this question: If companies’ future performance is
                    unrelated to the level of executive compensation, why should companies give
                    managers above-average salaries, bonuses, and stock-based awards?
Journal: Financial Analysts Journal
Pages: 28-31
Issue: 3
Volume: 63
Year: 2007
Month: 5
X-DOI: 10.2469/faj.v63.n3.4687
File-URL: http://hdl.handle.net/10.2469/faj.v63.n3.4687
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Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: Local Ethics in a Global World
Abstract: 
 Ethics, fairness, trust, and freedom from corruption are parts of social capital,
                    and social capital matters in financial markets. Investors consider not only the
                    information they receive but also their trust in the accuracy of the information
                    and the fairness of the markets in which to trade. Deficiencies in ethics and
                    fairness mark all countries. But surveys of the perception among students and
                    finance professionals of the fairness of insider trading in eight countries
                    indicate that deficiencies are more pronounced in some countries than in others.
                    Five factors are discussed that affect social capital: culture, globalization,
                    income, education, and law enforcement.Ethics, fairness, trust, and freedom from corruption are all parts of social
                    capital, and social capital matters in financial markets because in considering
                    the trade-off between risk and return, investors base decisions not only on
                    available information but also on how much they trust the accuracy of the
                    information and on the fairness of markets.Deficiencies in ethics and fairness mark all countries, but such deficiencies are
                    more pronounced in some countries than in others. Previous research has found,
                    for example, that levels of corruption vary by country. The scores of India,
                    Turkey, Tunisia, and Italy on the Corruption Perception Index are lower than
                    those of Australia, the Netherlands, the United States, and Israel. This article
                    presents the findings of a survey of perceptions of the fairness of insider
                    trading on the part of finance professionals and college students in eight
                    countries. The rankings generally followed the corruption rankings. Finance
                    professionals and college students in India, Turkey, Tunisia, and Italy perceive
                    insider trading to be fairer than do finance professionals and students in
                    Australia, the Netherlands, the United States, and Israel.Why are levels of corruption higher in some countries than in others? Why is
                    insider trading considered fairer in some countries than in others? These are
                    the questions I try to answer in this article. I discuss five factors that
                    affect social capital: culture, globalization, income, education, and law
                    enforcement.Social capital, including a sense of fairness, is generally higher in
                    economically developed countries, where incomes are high and markets play a
                    prominent role, than in less economically developed countries. A potent tool to
                    increase both income and fairness is globalization. When an Italian family
                    business puts most of its production in Vietnam and China, it increases income
                    in Vietnam and China. And it increases trust and fairness because extending
                    business beyond one’s family requires extension of trust and fairness
                    beyond one’s family.Education, including education about the law, is useful in tilting the behavior
                    of people toward fairness. The surveys reported in the article show that finance
                    professionals in all countries perceive insider trading as less fair than do
                    college students. This difference is probably a result of continuing moral and
                    legal education. Nevertheless, perceptions of the fairness of insider trading
                    vary greatly from country to country, even among finance professionals. The
                    global reach of companies and institutions can be a force for changing
                    perceptions, especially in countries where insider trading and other trading
                    violations are generally perceived as fair.Education is useful but not powerful enough to reinforce social capital. People
                    know that the law mandates paying taxes and agree that they should pay their
                    taxes honestly. But when asked what deters them from cheating, most people point
                    to enforcement—the fear of an IRS audit. Even the best moral and legal
                    education will not persuade some people to refrain from insider trading when
                    tempted by gaining seemingly easy thousands or millions of dollars. Law
                    enforcement, aided by technology (such as computer logs of trading and video
                    cameras on floors of exchanges), must supplement education. Companies and
                    institutions can do their share by advocating vigorous enforcement of the law
                    and rigorously enforcing their own codes of ethics.
Journal: Financial Analysts Journal
Pages: 32-41
Issue: 3
Volume: 63
Year: 2007
Month: 5
X-DOI: 10.2469/faj.v63.n3.4688
File-URL: http://hdl.handle.net/10.2469/faj.v63.n3.4688
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Handle: RePEc:taf:ufajxx:v:63:y:2007:i:3:p:32-41




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Author-Name: Zvi Bodie
Author-X-Name-First: Zvi
Author-X-Name-Last: Bodie
Author-Name: Jonathan Treussard
Author-X-Name-First: Jonathan
Author-X-Name-Last: Treussard
Title: Making Investment Choices as Simple as Possible, but Not Simpler
Abstract: 
 Target-date funds (TDFs) for retirement, also known as life-cycle funds, are
                    being offered as a simple solution to the investment task of participants in
                    self-directed retirement plans. A TDF is a “fund of funds”
                    diversified across stocks, bonds, and cash with the feature that the proportion
                    invested in stocks is automatically reduced as time passes. Empirical evidence
                    suggests that a simple TDF strategy would be an improvement over the choices
                    currently made by many uninformed plan participants. This article explores a way
                    to achieve even greater improvement for people who are very risk averse and have
                    high exposure to market risk through their labor.Many participants in self-directed retirement plans [401(k)s, IRAs, and so forth]
                    do not know enough about investing to choose rationally among alternatives.
                    Others may know enough but find the task unpleasant or too time-consuming.
                    Target-date funds (TDFs), also known as life-cycle funds, are being offered as a
                    simple solution to these participants’ needs.A TDF is a “fund of funds” diversified across stocks, bonds, and cash
                    with the feature that the proportion invested in stocks is automatically reduced
                    as time passes. Empirical evidence suggests that a simple TDF strategy would be
                    an improvement over the choices currently made by many uninformed plan
                    participants. Therefore, in 2006 the U.S. Department of Labor proposed that TDFs
                    be considered a “safe harbor” investment alternative for employers
                    to offer as the default in their defined-contribution plans. The prediction is
                    that many plan sponsors will adopt TDFs as their default option in the near
                    future. We explore in this article one way to achieve an even greater
                    improvement by a simple procedure for taking account of two characteristics in
                    addition to an individual’s target retirement date and age—namely,
                    human capital risk and risk aversion.We use a compact continuous-time optimization model with a single market
                    portfolio of risky assets and a single asset that is safe for an individual with
                    a given target date. People start saving for retirement with an initial wealth
                    consisting of their financial assets and human capital. Human capital is the
                    present value of their future labor income. Human capital is normally the
                    largest single asset in the early part of the working life of most people, and
                    it declines in relative importance as people age and accumulate other assets. We
                    assume that human capital is nontradable but perfectly correlated with the
                    market portfolio of all risky assets. The beta of human capital is its
                    volatility relative to the market portfolio of risky assets. For example, if the
                    individual has human capital of $1,000,000 and β = 0.4, then the human
                    capital is equivalent to a portfolio that has $400,000 invested in the risky
                    asset and $600,000 invested in the safe asset. We consider a range of human
                    capital betas from 1.0 to –0.5.The individual’s preferences are represented by an expected utility
                    function of wealth at the date of retirement characterized by a parameter of
                    relative risk aversion, γ. Research suggests that the normal range for
                    gamma is from 1 at the low end (people who are willing to take substantial risk
                    to achieve higher potential consumption) to 10 at the high end (people who crave
                    security).To quantify the welfare resulting from any investment strategy, we rely on the
                    concept of certainty-equivalent wealth. The certainty-equivalent wealth
                    associated with a TDF strategy is defined as the certain dollar amount that
                    provides the individual with the same level of welfare as the expected utility
                    from the TDF strategy. To measure the reduction in welfare caused by adopting
                    the TDF instead of the optimal strategy for a particular person, we use the
                    ratio of the TDF’s certainty-equivalent wealth to the optimal
                    strategy’s certainty-equivalent wealth. A ratio of 1 (or 100 percent)
                    implies that no welfare losses are incurred as a result of adopting the TDF
                    strategy, so the individual would be a natural TDF holder. The lower the value
                    of the ratio, the greater the reduction in welfare from using the TDF
                    portfolio.We show that the TDF strategy may be far from optimal for people who, although of
                    the same age as the natural TDF holder, differ from the natural TDF holder in
                    their risk aversion or exposure to human capital risk. To bring such plan
                    participants much closer to their optimal strategy, it is enough to add a second
                    simple investment alternative—a safe fund matched to the
                    participant’s time horizon. Participants with the same time horizon can
                    then consider their risk aversion and human capital risk in choosing (or being
                    advised to choose) either the TDF or the safe target-date fund. We find that
                    people who are very risk averse and who have a high exposure to market risk
                    through their labor income would experience a substantial gain in welfare from
                    being offered a safe target-date fund rather than a risky one.Recent empirical research suggests that human capital betas change over
                    one’s working career. They are typically quite high during the early years
                    when human capital represents the largest part of total wealth for most people.
                    Unlike the linear TDFs currently offered to participants in 401(k) plans, the
                    proportion of the portfolio invested in risky assets should be a hump-shaped
                    function of age to reflect the gradual change of human capital from
                    predominantly “stocklike” to mostly “bondlike” over the
                    life cycle.
Journal: Financial Analysts Journal
Pages: 42-47
Issue: 3
Volume: 63
Year: 2007
Month: 5
X-DOI: 10.2469/faj.v63.n3.4689
File-URL: http://hdl.handle.net/10.2469/faj.v63.n3.4689
File-Format: text/html
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Author-Name: Eugene F. Fama
Author-X-Name-First: Eugene F.
Author-X-Name-Last: Fama
Author-Name: Kenneth R. French
Author-X-Name-First: Kenneth R.
Author-X-Name-Last: French
Title: Migration
Abstract: 
 Migration of stocks across size and value portfolios contributes to the size and
                    value premiums in average stock returns. The size premium is almost entirely
                    generated by the small-capitalization stocks that earn extreme positive returns
                    and thus become big-cap stocks. The value premium comes from (1) value stocks
                    that improve in type because their companies are acquired by other companies or
                    because they earn high returns and migrate to a neutral or growth portfolio, (2)
                    growth stocks that earn low returns and thus move to a neutral or value
                    portfolio, and (3) the slightly higher returns on value stocks that do not
                    migrate compared with the returns on growth stocks that do not migrate.We examine a breakdown of average returns focused directly on migration. At the
                    end of each June for 1926 through 2005, we form six value-weight portfolios on
                    size (market capitalization) and price-to-book ratio (P/B). We then split each
                    portfolio into four migration groups: Same (stocks that stay in the same
                    portfolio when portfolios are rebalanced annually), dSize (small-cap stocks that
                    become big-cap stocks and big-cap stocks that become small-cap stocks), Plus
                    (stocks that move toward growth or are acquired by another company), and Minus
                    (stocks that move toward value, that are delisted for cause, or whose book
                    equity goes negative). We examine how much each group contributes to excess
                    returns for the six portfolios.A migration group’s contribution to a portfolio’s excess return
                    depends on both the group’s excess return and its weight in the portfolio.
                    For example, a group return close to the market return contributes little to a
                    portfolio’s excess return even when the group is a large share of the
                    portfolio. Conversely, a group with a high excess return may not have much
                    effect on a portfolio’s excess return if the group has little weight in
                    the portfolio.Size premium. The higher average returns of
                    small-cap stocks are primarily a result of one type of migration: small-cap
                    stocks that become big. Specifically, price appreciation moves a stock’s
                    market cap from below to above the NYSE median from one year to the next.
                    Big-cap stocks that become small have strong negative average excess returns,
                    but they contribute little to the size premium. This perhaps surprising result
                    arises because, unlike stocks that move from small to big, stocks that become
                    small account for tiny fractions of the market capitalization of big-cap
                    portfolios. Small- and big-cap stocks that improve in type from one year to the
                    next (move toward growth or merge into other firms) have high average excess
                    returns, but improvements in type make similar contributions to small- and
                    big-cap stock returns. As a result, they are a minor factor in the size premium.
                    Stocks that deteriorate in type or stay in the same portfolio from one year to
                    the next actually lean against the size premium; that is, they contribute more
                    to returns on portfolios of big-cap stocks. In the end, the size premium in
                    average returns for 1927–2006 traces almost entirely to the high average
                    excess returns (more than 50 percent) earned by the 8–12 percent of the
                    market capitalization of small-cap stocks that moves to a big-cap portfolio from
                    one year to the next.Value premium. Three of the four migration groups
                    (Same, Plus, and Minus) contribute to the value premiums in the average returns
                    of 1927–2006. Stocks that stay in the same portfolio from one year to the
                    next contribute a modest 1.0 percent (or 1 percentage point) to the value
                    premium for small-cap stocks and 1.7 percent to the premium for big-cap stocks.
                    These contributions to the value premium trace to the fact that value stocks
                    that do not migrate have higher average returns than growth stocks that do not
                    migrate.In contrast, differences in transition frequencies for value and growth stocks
                    largely drive the contributions of Plus and Minus migration to value premiums.
                    Without changing size groups, there is little room for growth stocks to improve
                    in type or for value stocks to deteriorate. Thus, Plus transitions are common
                    for value stocks but rare for growth stocks, and Minus transitions are common
                    for growth stocks but rare for value stocks. As a result, Plus transitions,
                    which are accompanied by high returns, contribute about 3.5 percent (3.5
                    percentage points) more per year to the excess returns of small-cap and big-cap
                    value portfolios than they do to the matching growth portfolios. Similarly,
                    Minus transitions and their low returns are a bigger drag on the excess returns
                    of growth portfolios. The impact is particularly large for the spread between
                    small-cap value and small-cap growth returns. Minus transitions contribute 5.1
                    percent per year to the 1927–2006 small-cap value premium, versus 1.2
                    percent for big-cap stocks.One type of migration acts to lower the small-cap value premium. Small-cap value
                    and growth stocks have high returns when they move to a big-cap portfolio; the
                    1927–2006 average excess returns exceed 60 percent per year and are about
                    the same for growth and value stocks. But migration to a big-cap portfolio from
                    one year to the next is more common among small-cap growth stocks (on average,
                    11.8 percent of market cap) than among small-value stocks (8.5 percent). As a
                    result, moves from small to big add 2.9 percent per year more to the average
                    return on the small-cap growth portfolio and so work against the value
                    premium.
Journal: Financial Analysts Journal
Pages: 48-58
Issue: 3
Volume: 63
Year: 2007
Month: 5
X-DOI: 10.2469/faj.v63.n3.4690
File-URL: http://hdl.handle.net/10.2469/faj.v63.n3.4690
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Author-Name: Raman Vardharaj
Author-X-Name-First: Raman
Author-X-Name-Last: Vardharaj
Author-Name: Frank J. Fabozzi
Author-X-Name-First: Frank J.
Author-X-Name-Last: Fabozzi
Title: Sector, Style, Region: Explaining Stock Allocation Performance
Abstract: 
 The importance of asset allocation policy in stock/bond portfolios is widely
                    recognized. Drawing a parallel for equity-only portfolios, this study analyzed
                    the importance of allocation by economic sector and by size and style in purely
                    U.S. stock portfolios and the importance of regional allocation policy in
                    international stock portfolios. The study found that allocation policy explains
                    one-third to nearly three-quarters of among-fund variation in returns, nearly 90
                    percent of across-time variation, and more than 100 percent of the level of
                    stock portfolio returns.The importance of asset allocation policy in balanced stock and bond portfolios
                    has been the subject of several studies. The first two studies, published in
                        theFinancial Analysts Journal in 1986 and 1991, reported
                    that asset allocation explains more than 90 percent of the variation in a
                    typical portfolio’s performance. Subsequently, researchers have shown
                    that, although more than 90 percent of managed portfolio return variability over
                    time is indeed explained by policy benchmarks, only about 40 percent of the
                    variability among managed portfolios is explained by policy
                    differences.Prior studies analyzed the importance of allocation among broad asset classes,
                    but we focused on equity allocations. We examined what part of a U.S.
                    large-capitalization or small-cap equity fund’s performance is explained
                    by its allocation policy for economic sectors (we used the Global Industry
                    Classification Standard sectors—consumer discretionary, health care,
                    industrials, and so on) or market segments as characterized by size and style as
                    to a value orientation versus a growth orientation. We also examined what part
                    of an international equity fund’s performance is explained by its
                    allocation policy toward world regions.After determining fund policy allocations through style analysis, we regressed
                    total returns on policy returns both in a time-series sense and cross-sectional
                    sense. The R2s
                    of these regressions were used to infer the importance of policy allocations. We
                    also calculated the difference between the gross policy return and total return
                    (both annualized for either a 10-year period of 1995–2004 or a 5-year
                    period of 2000–2004) and compared that difference with reasonable
                    estimates of replication costs.We found that the answer to what role allocation policy plays in returns has
                    three parts. First, allocation policy explains nearly 90 percent of the monthly
                    or quarterly return variability over time. Second, for large-cap and small-cap
                    U.S. funds, allocation policy explains about one-third of monthly or quarterly
                    return variation among funds. For these funds over a recent 5-year period,
                    allocation policy explained close to three-quarters of the return variation in
                    compound annual returns. And for international funds, allocation among regions
                    explains about one-fourth of monthly or quarterly return variation among funds.
                    Finally, policy returns generally exceeded total returns even after accounting
                    for reasonable estimates of the cost for passive replication of the policy mix.
                    Thus, generally more than 100 percent of fund return level is explained by the
                    policy allocation.
Journal: Financial Analysts Journal
Pages: 59-70
Issue: 3
Volume: 63
Year: 2007
Month: 5
X-DOI: 10.2469/faj.v63.n3.4691
File-URL: http://hdl.handle.net/10.2469/faj.v63.n3.4691
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Author-Name: Ilya Figelman
Author-X-Name-First: Ilya
Author-X-Name-Last: Figelman
Title: Interaction of Stock Return Momentum with Earnings Measures
Abstract: 
 Examination of the interaction of stock return momentum with various earnings
                    measures finds that large-capitalization companies with poor past returns and
                    high return on equity (ROE) significantly underperform the market and companies
                    with poor past returns and low ROE. Thus, the profitability of high-ROE
                    companies with poor past returns may have peaked. In addition, companies with
                    poor past returns and poor earnings quality (as measured by accruals)
                    significantly underperform the market and companies with poor past returns and
                    good earnings quality. Therefore, the market may not fully recognize
                    manipulation of earnings. The findings are consistent with the explanation that
                    momentum is driven by slow reaction to news.This article examines the interaction of stock return momentum with various
                    measures of earnings. I had two goals in mind. First, such an analysis could
                    help investors and portfolio managers understand the dynamics of the stocks in
                    their portfolios and thus enhance portfolio performance. Second, and as
                    important, the analysis deepens the profession’s theoretical understanding
                    of the intermediate-term momentum phenomenon.I computed the historical performance of 25 bivariate stock quintile portfolios.
                    Stocks were placed in the first set of quintiles based on their past
                    year’s return and in a second set of quintiles based on an earnings
                    measure. The universe is the S&P 500 Index, and the historical time period
                    is 1970 to 2004. The earnings measures that I report are trailing return on
                    equity, change in ROE, and earnings quality (as measured by balance sheet
                    accruals). I also used as earnings measures forecast ROE, change in forecast
                    ROE, P/E, and price-to-book ratio (results reported in the appendix). Results
                    for a one-month holding period are reported (with results for a six-month
                    holding period available online).I found that large-cap companies with poor past returns and high ROEs not only
                    significantly underperform the market but also underperform companies with poor
                    past returns and low ROEs. (Similar results were found for forecast ROE, change
                    in ROE, and change in forecast ROE.) This finding suggests that the
                    profitability of companies with high ROEs and poor past returns may have already
                    peaked. In addition, I found that companies with poor past returns and poor
                    earnings quality significantly underperform the market and companies with poor
                    past returns and good earnings quality. This finding implies that company
                    managers’ manipulation of earnings may not be fully recognized by the
                    market, which enhances the momentum effect. These findings are consistent with
                    the behavioral explanation that the momentum phenomenon is driven by the
                    market’s slow reaction to news.
Journal: Financial Analysts Journal
Pages: 71-78
Issue: 3
Volume: 63
Year: 2007
Month: 5
X-DOI: 10.2469/faj.v63.n3.4692
File-URL: http://hdl.handle.net/10.2469/faj.v63.n3.4692
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Author-Name: Anne M. Anderson
Author-X-Name-First: Anne M.
Author-X-Name-Last: Anderson
Author-Name: Edward A. Dyl
Author-X-Name-First: Edward A.
Author-X-Name-Last: Dyl
Title: Trading Volume: NASDAQ and the NYSE
Abstract: 
 Historically, reported trading volume has been overstated for NASDAQ stocks
                    relative to NYSE stocks. Because NASDAQ volume may be overcounted, many
                    researchers use an adjustment factor to make it comparable to NYSE volumes.
                    Today, electronic communication networks account for about 75 percent of the
                    trading volume for NASDAQ stocks. Many believe that the increased level of
                    trading on ECNs and changes to the order-handling rules have lessened the
                    discrepancy between the exchanges. To investigate, this study examined the
                    relationship between reported trading volume to shares outstanding for a matched
                    sample of NYSE and NASDAQ companies. The evidence indicates that the discrepancy
                    has not diminished but widened.Historically, reported trading volume has been overstated for stocks on NASDAQ (a
                    dealer market) vis-à-vis stocks on the NYSE (an auction market). Market
                    practitioners know that NASDAQ volume may be double-counted, so they frequently
                    use an adjustment factor of 50 percent or so to make it comparable to NYSE
                    volumes. Electronic communications networks (ECNs), however, now account for
                    about 75 percent of the trading in NASDAQ stocks, which should make the NASDAQ
                    resemble an auction market.Reported trading volume matters for two reasons. First, various U.S. securities
                    regulations are based on trading volume. For example, U.S. SEC Rule 144 limits
                    an individual’s sales of restricted common stock during a three-month
                    period to either the average weekly trading volume in the stock during the
                    preceding four weeks or 1 percent of the shares outstanding. Second, reported
                    trading volume matters because trading volume is an important measure, for
                    portfolio managers and other practitioners, of a stock’s liquidity.
                    Practitioners need to know when trading volume is “real” and when it
                    is overcounted as a result of dealer trades and, therefore, misleading.
                    Moreover, some firms, deciding that reported volume figures in the two markets
                    are now roughly equivalent, have already stopped adjusting for the historical
                    difference in reported volume. We looked for evidence that the way volume is
                    reported has indeed become equivalent in the two markets.Thus, we examined the structure of reported trading volumes on the NYSE and
                    NASDAQ before and after the changes that occurred from 1997 to 2002.
                    Specifically, we compared trading during 1990–1996 with trading during
                    2003–2005 to determine whether any meaningful change has occurred in the
                    relationship between reported trading volume in the two markets from the former
                    period to the latter period.We related reported trading volume on the NYSE and NASDAQ to the number of shares
                    outstanding for a group of comparable companies trading on the two exchanges; we
                    controlled for nonlinearity, stock price level, and volatility. We used the
                    regression model to investigate the proposition that the widely acknowledged
                    discrepancy between reported trading volumes for NYSE and NASDAQ stocks that
                    existed before 1997 has diminished or vanished because of such recent
                    developments as the change in order-handling rules for NASDAQ stocks and the
                    increasing role of electronic order books in trading NASDAQ stocks.
                    Surprisingly, we found no evidence that the discrepancy has either narrowed or
                    vanished. On the contrary, our results suggest that the discrepancy may have
                    widened, perhaps because of increased interdealer trading. We also found that
                    the association between volatility and reported trading volume has increased
                    dramatically in recent years for both NYSE and NASDAQ stocks.The absence of any basic change in the relative structure of reported trading
                    volume between NASDAQ and the NYSE is a major puzzle in view of the fact that
                    the majority of the trading in NASDAQ-listed securities has been via electronic
                    order books in recent years. One auction market should look much like another,
                    but we see no signs of convergence between NASDAQ and the NYSE with regard to
                    the structure of trading volume.
Journal: Financial Analysts Journal
Pages: 79-86
Issue: 3
Volume: 63
Year: 2007
Month: 5
X-DOI: 10.2469/faj.v63.n3.4693
File-URL: http://hdl.handle.net/10.2469/faj.v63.n3.4693
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 88-88
Issue: 3
Volume: 63
Year: 2007
Month: 5
X-DOI: 10.2469/faj.v63.n3.4695
File-URL: http://hdl.handle.net/10.2469/faj.v63.n3.4695
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: Editor’s Corner
Abstract: 
 In the realm of institutional management, although asset allocation models                    abound, most institutions periodically conduct investment policy studies, and                    policy statements exist, a wide gap exists between theory and practice in                    investment policy research. Signs of the gap lie in the failure to integrate in                    portfolio policy the pension/endowment portfolio with the                    institution’s other assets and liabilities, in what appears to be                    herding in portfolio allocations, and in the misallocation of resources to                    active management rather than policy research. In short, practitioners lack a                    professional method for investment policy development.
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4742
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4742
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Author-Name: Robert M. Braun
Author-X-Name-First: Robert M.
Author-X-Name-Last: Braun
Title: “Do the Markets Care about the $2.4 Trillion U.S. Deficit?”: A Comment
Abstract: 
 This material comments on “Do the Markets Care about the $2.4 Trillion                    U.S. Deficit?”
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4743
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4743
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Author-Name: Jerry H. Tempelman
Author-X-Name-First: Jerry H.
Author-X-Name-Last: Tempelman
Title: “Do the Markets Care about the $2.4 Trillion U.S. Deficit?”: A Comment
Abstract: 
 This material comments on “Do the Markets Care about the $2.4 Trillion                    U.S. Deficit?”Editor’s Note: The views expressed in this letter are those of                    the author and not necessarily those of the Federal Reserve Bank of New York or                    the Federal Reserve System. 
Journal: Financial Analysts Journal
Pages: 11-11
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4744
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4744
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Author-Name: Thomas J. Healey
Author-X-Name-First: Thomas J.
Author-X-Name-Last: Healey
Title: “Are Cover Stories Effective Contrarian Indicators?”: A Comment
Abstract: 
 This material comments on “Are Cover Stories Effective Contrarian                    Indicators?”
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4745
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4745
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Author-Name: Bruce I. Jacobs
Author-X-Name-First: Bruce I.
Author-X-Name-Last: Jacobs
Author-Name: Kenneth N. Levy
Author-X-Name-First: Kenneth N.
Author-X-Name-Last: Levy
Title: 20 Myths about Enhanced Active 120–20 Strategies
Abstract: 
 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.Enhanced active equity strategies, including 120–20 and 130–30
                    portfolios, have become increasingly popular as managers and investors search
                    for new ways to expand the alpha opportunities available from active management.
                    Enhanced active portfolios have short positions equal to some percentage of
                    capital (generally 20 percent or 30 percent but possibly 100 percent or more)
                    and an equal percentage of leveraged long positions. They are facilitated by
                    modern prime brokerage structures, which allow the proceeds
                    from short sales to be used to purchase long equity positions.Enhanced active equity strategies differ in some fundamental ways from other
                    active equity strategies, both long-only and long–short strategies. As a
                    result, the financial community has formed some misconceptions about these
                    strategies.Some investors think, for example, that allowing a portfolio to sell short offers
                    little incremental advantage over long-only portfolios. But an active long-only
                    portfolio, although it can overweight any security by enough to achieve a
                    significant positive active weight, cannot underweight many securities by enough
                    to achieve significant negative active weights. Only about 15 stocks in the
                    Standard & Poor’s 500, Russell 1000, or Russell 3000 indices have
                    index weights greater than 1 percent. Thus, meaningful underweights of many
                    securities can be achieved only if short selling is
                    allowed.Other investors believe that constraints on short selling do not affect a
                    portfolio’s ability to overweight attractive securities. But a
                    120–20 portfolio can sell short and use the proceeds to purchase
                    additional long positions, thereby taking more and/or larger active overweight
                    positions than a long-only portfolio can take with the same amount of capital.
                    Furthermore, the incremental overweights and underweights permit more
                    diversification than a long-only portfolio allows, which should result in
                    greater consistency of performance. Moreover, and more subtly, the long-only
                    portfolio manager may not be able to establish desired overweights in some
                    attractive securities because without short selling, related securities cannot
                    be underweighted by enough to counterbalance the risk exposures that would be
                    created by the overweights.Some investors might think that an enhanced active equity portfolio offers less
                    flexibility to overweight and underweight securities than an equitized
                    market-neutral long–short portfolio, which has fully active weights
                    through its market-neutral portion and full exposure to the equity market
                    through an overlay. It can be shown, however, that enhanced active and equitized
                    market-neutral portfolios are equivalent, with identical active weights and
                    identical market exposure. The enhanced active portfolio is more compact,
                    however, and uses less leverage than the equitized portfolio. Furthermore,
                    because it obtains its market exposure with individual security positions, it
                    can attain exposures to benchmarks even if liquid overlays are not
                    available.Enhanced active equity portfolios are sometimes portrayed as much more risky than
                    long-only portfolios because they contain short positions. But whether a
                    portfolio achieves an underweight by holding a security at less than the
                    security’s benchmark weight or by not holding the security at all or
                    whether it extends the underweight by selling the security short, the portfolio
                    is in a risky position in terms of potential value added or lost relative to the
                    benchmark. And although losses on short positions are theoretically unlimited,
                    because a security’s price can rise without limit, this risk can be
                    minimized in practice by diversification and rebalancing.Finally, some confusion exists as to where enhanced active strategies fit in an
                    asset allocation framework. Enhanced active portfolios share some
                    characteristics with hedge funds and other alternative investments. They have
                    the same equity benchmarks as comparable long-only portfolios, however, while
                    enjoying the potential of improving upon the performance of long-only portfolios
                    by virtue of their ability to extend portfolio overweights and underweights.
                    They are thus an enhanced form of active equity management.
Journal: Financial Analysts Journal
Pages: 19-26
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4746
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4746
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Author-Name: Jinliang Li
Author-X-Name-First: Jinliang
Author-X-Name-Last: Li
Author-Name: Robert Mooradian
Author-X-Name-First: Robert
Author-X-Name-Last: Mooradian
Author-Name: Wei David Zhang
Author-X-Name-First: Wei David
Author-X-Name-Last: Zhang
Title: Is Illiquidity a Risk Factor? A Critical Look at Commission Costs
Abstract: 
 A quarterly time series of the aggregate commission rate for NYSE trading over
                    1980–2003 allowed an investigation of the information conveyed by this
                    liquidity risk metric and analysis of its critical role in the generation of
                    stock returns. The aggregate commission rate was found to be highly correlated
                    with other illiquidity metrics, such as the bid–ask spread. The rate is
                    significantly and positively related to the excess returns of the stock market
                    portfolio and has significant explanatory power for the cross-sectional
                    variation in stock returns. An analysis of size-based portfolios indicates that
                    returns become more sensitive to the aggregate commission rate with declining
                    market capitalization.Knowledge of market microstructure has grown explosively in recent years.
                    Important insights on such topics as limit-order placement strategy for intraday
                    trading, the choice between an automated or floor trading system, and the link
                    between the pricing of IPOs and the activity of secondary-market dealers are of
                    interest to portfolio managers and investment advisers.A topic with considerable relevance to practitioners is the role of liquidity as
                    a factor in asset pricing and portfolio risk. The market microstructure
                    literature suggests that trading costs reflect asymmetric information and market
                    liquidity. One study showed that expected returns are an increasing function of
                    illiquidity. Illiquidity, as measured by bid–ask spreads, commands higher
                    expected returns to compensate for the higher transaction costs investors incur
                    in a less liquid market. Significant changes in asset values have been
                    documented when assets are moved from a less liquid trading system to a more
                    liquid one. Recently, researchers have suggested that liquidity is an important
                    marketwide risk factor in pricing stocks. Holding illiquid financial assets
                    involves nondiversifiable risk, and traders demand premiums for taking such
                    risk. Therefore, variation in liquidity may be closely associated with varying
                    expected returns.In this study, we developed a reliable quarterly time series of the aggregate
                    commission rate for NYSE trading for the period 1980–2003. We show in the
                    article that the aggregate commission rate exhibits a strong correlation with
                    the other frequently studied illiquidity metrics. We document a strong and
                    positive relationship between aggregate stock returns and commission costs. And
                    we demonstrate a significant cross-sectional relationship between betas
                    associated with the aggregate commission rate and average returns.The impact of the aggregate commission rate on market returns survived a number
                    of robustness checks in our study and was found to be significant both
                    statistically and economically. Using 10 size-based portfolios, we show that a
                    statistically significant annualized liquidity premium associated with going
                    long the smallest-capitalization portfolio and shorting the largest-cap
                    portfolio is 2.02 percentage points, which suggests that the relationship
                    between time-series betas on the commission rate and the cross-sectional
                    difference in asset returns is not only statistically significant but also
                    economically important. Our results also show that a change of 1 standard
                    deviation in the illiquidity factor corresponds to a 4.68 percentage point
                    change in quarterly aggregate market returns.Cross-sectional variation in expected returns among securities arises because of
                    differences in trading costs. The aggregate commission rate exhibits significant
                    explanatory power for the cross-sectional variation of average returns, after
                    traditional asset-pricing factors have been controlled for. We found that the
                    sensitivities of returns of size-based portfolios to marketwide liquidity risk
                    are significant and decrease with increasing size of the stock in the
                    portfolios. Our results show that an increase of 1 standard deviation in the
                    illiquidity factor is associated with a 3.08 percentage point increase in the
                    spread between the returns of the portfolios of the smallest-cap and the
                    largest-cap portfolios, after the market, value versus growth, and momentum
                    factors have been controlled for.For hedge fund managers who take advantage of mispriced securities and other
                    marker inefficiencies, our study provides compelling evidence that transaction
                    costs should be accurately accounted for in a successful trading strategy. Our
                    findings support the hypothesis that marketwide liquidity is an important risk
                    factor and significantly affects expected returns.
Journal: Financial Analysts Journal
Pages: 28-39
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4747
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4747
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:63:y:2007:i:4:p:28-39




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Author-Name: Alistair Byrne
Author-X-Name-First: Alistair
Author-X-Name-Last: Byrne
Author-Name: David Blake
Author-X-Name-First: David
Author-X-Name-Last: Blake
Author-Name: Andrew Cairns
Author-X-Name-First: Andrew
Author-X-Name-Last: Cairns
Author-Name: Kevin Dowd
Author-X-Name-First: Kevin
Author-X-Name-Last: Dowd
Title: Default Funds in U.K. Defined-Contribution Plans (corrected)
Abstract: 
 Most defined-contribution (DC) pension plans give members a degree of choice as
                    to the investment strategy for their contributions. For members unable or
                    unwilling to choose their own investment strategies, many plans also offer a
                    default fund. This article analyzes the U.K. “stakeholder” DC plans,
                    which must by law offer a default fund. The default funds are typically risky
                    but vary substantially among the providers in their strategic asset allocation
                    and in their use of life-cycle plans that reduce risk as planned retirement
                    approaches. A stochastic simulation model demonstrates that the differences can
                    have a significant effect on the distribution of potential pension outcomes.Most defined-contribution (DC) pension schemes give their members a degree of
                    choice as to the investment strategy to be followed with their contributions.
                    Many schemes also offer a default fund for members who are unable or unwilling
                    to choose their own investment strategies. Previous research has shown that
                    where a default fund exists, the majority of members adopt it. Therefore, the
                    plan provider’s choice of default fund may have a significant effect on
                    the welfare of plan members.Given the importance of the default fund decision by the pension scheme provider,
                    we analyzed the range of default funds offered by U.K. “stakeholder”
                    pension schemes. These schemes/plans are personal pension arrangements provided
                    by financial institutions that operate on a DC basis. By law, they must offer a
                    default fund. The requirement to have a default fund and the public availability
                    of data on most schemes’ default funds allowed this study of what
                    financial institutions think are appropriate investment strategies for so-called
                    uninformed pension scheme members. We also analyzed the fees charged for the
                    funds.We found the default funds to vary substantially in their strategic asset
                    allocations and in their use of life-style profiles, which switch a
                    member’s assets to fixed-income investments (and cash) as the planned
                    retirement date approaches. We used a stochastic simulation model to demonstrate
                    that the differences can have a significant effect on the likely distribution of
                    pension outcomes. Our analysis of fees found significant variation among the
                    funds with, for example, fees for passively managed funds not always being less
                    than fees for active funds.Our findings raise important questions about how providers choose their default
                    funds and about whether the choice is correlated with the characteristics of
                    scheme members. The findings also suggest that employers need to take care in
                    selecting a default fund because, in many cases, it will be the fund used by
                    most of their scheme members. The variety of default fund approaches we document
                    means that leaving the choice of default fund to the scheme provider may not
                    result in an appropriate outcome for scheme members.
Journal: Financial Analysts Journal
Pages: 40-51
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4748
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4748
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Handle: RePEc:taf:ufajxx:v:63:y:2007:i:4:p:40-51




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Author-Name: John Watson
Author-X-Name-First: John
Author-X-Name-Last: Watson
Author-Name: Mark McNaughton
Author-X-Name-First: Mark
Author-X-Name-Last: McNaughton
Title: Gender Differences in Risk Aversion and Expected Retirement Benefits
Abstract: 
 Women are generally considered more risk averse than men. Controlling for age,
                    income, and education, this study examined the impact of gender on the
                    superannuation (retirement) fund risk preferences of staff in the Australian
                    university sector. The findings suggest that women choose more conservative
                    investment strategies than men and that lower income (which affects the amount
                    members contribute to their superannuation funds) is the primary contributor to
                    the lower projected retirement benefits of women. Providing members with a
                    choice among risk levels in their retirement investments should significantly
                    benefit male and female retirees.Concern has been growing that many retirees will have insufficient assets in
                    retirement to meet their expected retirement liabilities (in particular, housing
                    and health care) and life-style desires (for example, travel). This concern has
                    fuelled considerable public policy debate and has led to significant
                    superannuation fund (retirement fund) reforms in Australia and elsewhere.An important decision facing an individual contributing to a retirement plan (in
                    addition to how much to contribute) is how best to invest the contributions to
                    derive the maximum long-term benefit. As both history and theory advise, higher
                    returns generally come at the cost of higher risks; therefore, individuals who
                    choose to bear lower risk will generally earn lower returns—in the long
                    run.Considerable empirical evidence suggests that women are more risk averse than men
                    and are, therefore, likely to choose lower risk/lower return investment
                    strategies. Research also suggests that women, because they usually earn less
                    than men over their working lives, are likely to be less wealthy when they
                    retire. The potential effects of these differences on the differential
                    retirement benefits of men and women is compounded by the fact that women
                    typically have longer life spans over which their retirement benefits must be
                    allocated and also tend to retire earlier than men.This study aims to contribute to the existing literature in two ways. First, we
                    sought to determine, in the Australian context, whether women are indeed more
                    risk averse than men in their choices of superannuation investments. This study
                    also illustrates the potential impact that increased risk aversion (and
                    differences in working-life income) is likely to have on the retirement benefits
                    of women compared with the benefits available to men.The dataset we used was provided by the superannuation fund UniSuper, the sole
                    superannuation fund provider for staff (academic and general) at Australian
                    universities during the period of the study, 1 July 1997 to 30 June 2003. When
                    UniSuper began allowing members to choose their investment plans/strategies, all
                    existing members (and, subsequently, new members) were asked to select a plan
                    from among seven ranging from a cash investment to a very risky all-equity plan.
                    The dataset contained details on 32,061 members who had selected an investment
                    plan in the sample period.After controlling for age (negatively related to risk taking) and income
                    (positively related to risk taking), we found the differences in investment
                    choices of the average male and female UniSuper member to be statistically
                    significant, but the dollar impact of the difference on expected retirement
                    benefits was small (approximately AU$16,000 in total over a 35-year period from
                    age 30 to age 65). Of far greater importance for expected retirement benefits
                    was the difference in the average incomes (and thus superannuation
                    contributions) of the men and women. This difference resulted in the average
                    male UniSuper member having almost AU$195,000 more in expected retirement
                    benefits at age 65 than the average female.Furthermore, we found that the average expected superannuation investment return
                    for both male and female UniSuper members has been substantially greater since
                    members have been given a choice of investment strategy than it was under the
                    previous scheme in which no choice was available.
Journal: Financial Analysts Journal
Pages: 52-62
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4749
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4749
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Handle: RePEc:taf:ufajxx:v:63:y:2007:i:4:p:52-62




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Author-Name: Alina Lerman
Author-X-Name-First: Alina
Author-X-Name-Last: Lerman
Author-Name: Joshua Livnat
Author-X-Name-First: Joshua
Author-X-Name-Last: Livnat
Author-Name: Richard R. Mendenhall
Author-X-Name-First: Richard R.
Author-X-Name-Last: Mendenhall
Title: Double Surprise into Higher Future Returns
Abstract: 
 Post-earnings-announcement drift is the well-documented ability of earnings
                    surprises to predict future stock returns. Despite nearly four decades of
                    research, little has been written about the importance of how earnings surprise
                    is actually measured. We compare the magnitude of the drift when historical
                    time-series data are used to estimate earnings surprise with the magnitude when
                    analyst forecasts are used. We show that the drift is significantly larger when
                    analyst forecasts are used. Furthermore, we show that using the two models
                    together does a better job of predicting future stock returns than using either
                    model alone.One of the most puzzling characteristics of the stock market is that earnings
                    surprises seem to predict future stock return performance. That is, when
                    companies announce quarterly earnings that exceed market expectations, on
                    average, the stocks of those companies exhibit higher-than-normal return
                    performance for weeks, even months, following the earnings announcement. The
                    opposite is true for stocks of companies whose earnings fall short of market
                    expectations; they tend to perform poorly. This well-documented phenomenon is
                    normally referred to as either “post-earnings-announcement drift” or
                    “the SUE (standardized unexpected earnings) effect.” The drift was
                    first noticed almost 40 years ago, but a constant stream of research from 1968
                    to the present has confirmed the anomaly.A question that has been largely ignored in the drift literature is: What is the
                    best way to measure the earnings surprise? If the drift represents a slow market
                    reaction to the information in earnings announcements, the way in which that
                    information is assessed may be vital to the magnitude of the drift. Most prior
                    SUE studies estimated the earnings surprise as the difference between reported
                    EPS and a time-series earnings forecast (usually deflated by price or past
                    earnings variability). But another prominent measure of earnings surprise is the
                    difference between reported earnings and financial analysts’ forecasts of
                    earnings.Research has shown that analyst forecast errors are a better measure of earnings
                    surprise than time-series errors—at least in terms of initial stock market
                    reaction. This finding makes sense because analysts have access to a broader and
                    more timely set of information than simply the pattern of past earnings.
                    Although analyst forecast errors may be superior measures of surprise, research
                    has also shown that this measure does not completely subsume time-series errors
                    in explaining the immediate stock price reaction to earnings.Time-series errors may capture a component of the earnings surprise that is not
                    caught by analyst forecast errors because of some analyst bias. For example,
                    analysts may be hesitant to make low earnings forecasts for several reasons. One
                    is the fear of alienating company managers and risking the analyst’s
                    ability to obtain information from the company in the future.Another reason that the information in time-series errors may not be subsumed by
                    those of analysts is that time-series errors calculated from Compustat data rely
                    on earnings that reflect GAAP whereas analyst tracking services, such as Thomson
                    Corporation’s I/B/E/S, tend to use “Street” earnings figures
                    that exclude some expenses required by GAAP.Whatever the reasons, neither model subsumes the other as a measure of earnings
                    surprise. Therefore, we estimated the magnitude of the drift by using a
                    time-series model, by using analyst forecasts, and by combining the two.We show that for companies followed by professional security analysts, using
                    analyst forecast errors to define earnings surprise leads to greater
                    predictability of future stock returns than does using time-series forecast
                    errors. Return predictability can be further enhanced by combining the two
                    measures of drift. These findings proved to be robust to a range of
                    specifications.Although analyst forecasts are not available for all companies, those companies
                    for which they are available tend to be more liquid than other companies.
                    Therefore, investors will generally find it easier and less expensive to exploit
                    any mispricings among these stocks than among other stocks.This study can be beneficial for practitioners and academics alike. Professional
                    investors can use the results to improve their selection of stocks. Instead of
                    using the earnings surprise based on either analyst forecasts
                    or time-series forecasts, they can, by using both measures, focus on a
                    restricted set that has extreme surprises. For academics, the findings have
                    implications that may be useful in understanding how stock market participants
                    process information and how that information is incorporated in stock
                    prices.
Journal: Financial Analysts Journal
Pages: 63-71
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4750
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4750
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Handle: RePEc:taf:ufajxx:v:63:y:2007:i:4:p:63-71




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Author-Name: Shinhua Liu
Author-X-Name-First: Shinhua
Author-X-Name-Last: Liu
Title: Currency Derivatives and Exchange Rate Forecastability
Abstract: 
 By incorporating new information generated by currency derivatives trading,
                    underlying exchange rates should be less forecastable than previously and the
                    underlying currency markets should, therefore, be more efficient. This
                    hypothesis was tested, for the first time, for the period 1982 through 1997 on a
                    clean sample of three major types of currency derivatives launched in two
                    prominent markets. Various statistical tests indicate that following the
                    introduction of the derivative contracts, the underlying exchange rates became
                    more random and the currencies involved tended thus to be priced more
                    efficiently, which supports the hypothesis.The Chicago Mercantile Exchange (CME) introduced currency futures in 1972, and
                    the Philadelphia Stock Exchange (PHLX) pioneered option trading on major
                    currencies in 1982. Derivatives trading on currencies has attracted interest
                    from academics, practitioners, and regulators, as documented in existing
                    studies. So far, studies have focused on the impact of derivatives trading on
                    the volatility of spot exchange rates, and the results have been mixed. No study
                    has examined the impact of derivatives trading on the pricing efficiency in the
                    underlying currency market, which is an important market quality, or the impact
                    of derivatives trading on the forecastability of underlying exchange rates, a
                    characteristic of enormous importance to market participants.When derivatives trading commenced, pricing efficiency of underlying exchange
                    rates could have been enhanced through a number of conceivable channels. First,
                    prior to the CME initiation of currency futures, the bulk of currency trading
                    was in London time; any London overnight move tended to wash out on the next
                    trading day in London. The CME market should thus have improved liquidity in the
                    U.S. time zone and, therefore, improved market liquidity and efficiency around
                    the clock. Second, enormous growth has occurred in OTC currency derivatives
                    since the early 1970s, when major currencies began to float. It has been claimed
                    that the creation of currency futures was instrumental in encouraging the rapid
                    expansion of OTC trading and, in turn, in ameliorating the pricing efficiency in
                    the underlying markets. Third, the advent of exchange-traded currency
                    derivatives should have reduced nonrandom runs or clustering in the exchange
                    rates and, therefore, increased market efficiency because currency market
                    participants had previously been forced to pursue trend-following strategies
                    (portfolio insurance) to protect themselves against adverse moves in exchange
                    rates. Fourth, the introduction of currency options made the market more
                    complete and, therefore, more efficient because the second moment (volatility)
                    of the exchange rate distribution became directly priced. Finally, formal models
                    of rational expectations predict higher pricing efficiency in an underlying
                    market when derivatives are listed because of increased information flow.The intention of this study was to investigate for the first time the effect of
                    derivatives trading on pricing efficiency in the underlying currency market. I
                    used a clean sample of currency derivatives launched by the CME and the PHLX
                    from 1982 to 1997. A major advantage of using these currency derivatives is that
                    multiple major derivative contracts, including futures, options, and futures
                    options, on the same currencies were often introduced simultaneously. Such
                    intensive and comprehensive listings presented a unique opportunity to test the
                    efficiency effects of derivatives trading and thus deliver a robust verdict on
                    the hypothesis presented earlier.Using a nonparametric runs test, I found that following the derivatives listings,
                    returns to the sample currencies, on average, become significantly more random.
                    This increased randomness was also detected in two robustness tests. This
                    finding suggests that, to the extent that randomness proxies for efficiency,
                    efficiency increased in the spot market following the commencement of
                    derivatives trading. Moreover, the increased randomness meant decreased
                    predictability in exchange rates, an implication of interest to market
                    participants.
Journal: Financial Analysts Journal
Pages: 72-78
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4751
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4751
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 80-80
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4753
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4753
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Author-Name: Tom Arnold
Author-X-Name-First: Tom
Author-X-Name-Last: Arnold
Author-Name: John H. Earl
Author-X-Name-First: John H.
Author-X-Name-Last: Earl
Author-Name: David S. North
Author-X-Name-First: David S.
Author-X-Name-Last: North
Title: “Are Cover Stories Effective Contrarian Indicators?”: Author Response
Abstract: 
 This material comments on “Are Cover Stories Effective Contrarian                    Indicators?”
Journal: Financial Analysts Journal
Pages: 14-14
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4754
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4754
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Author-Name: Zvi Bodie
Author-X-Name-First: Zvi
Author-X-Name-Last: Bodie
Author-Name: Jonathan Treussard
Author-X-Name-First: Jonathan
Author-X-Name-Last: Treussard
Title: “Making Investment Choices as Simple as Possible, but Not Simpler”: Author Response
Abstract: 
 This material comments on “Making Investment Choices as Simple as                    Possible, but Not Simpler”.
Journal: Financial Analysts Journal
Pages: 14-16
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4756
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4756
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Author-Name: Jeffrey J. Diermeier
Author-X-Name-First: Jeffrey J.
Author-X-Name-Last: Diermeier
Title: “Making Investment Choices as Simple as Possible, but Not Simpler”: CFA Institute Response
Abstract: 
 This material comments on “Making Investment Choices as Simple as                    Possible, but Not Simpler”.
Journal: Financial Analysts Journal
Pages: 16-17
Issue: 4
Volume: 63
Year: 2007
Month: 7
X-DOI: 10.2469/faj.v63.n4.4757
File-URL: http://hdl.handle.net/10.2469/faj.v63.n4.4757
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: Editor’s Corner
Journal: Financial Analysts Journal
Pages: 8-8
Issue: 5
Volume: 63
Year: 2007
Month: 9
X-DOI: 10.2469/faj.v63.n5.4832
File-URL: http://hdl.handle.net/10.2469/faj.v63.n5.4832
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Author-Name: John Benson
Author-X-Name-First: John
Author-X-Name-Last: Benson
Title: “Executive Compensation: Much Ado about Nothing?”: A Comment
Abstract: 
 This material comments on “Executive Compensation: Much Ado about          Nothing?”.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 5
Volume: 63
Year: 2007
Month: 9
X-DOI: 10.2469/faj.v63.n5.4833
File-URL: http://hdl.handle.net/10.2469/faj.v63.n5.4833
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Author-Name: Samuel Lum
Author-X-Name-First: Samuel
Author-X-Name-Last: Lum
Title: “Do the Markets Care about the $2.4 Trillion U.S. Deficit?”: A Comment
Abstract: 
 This material comments on “Do the Markets Care about the $2.4 Trillion U.S. Deficit?”.
Journal: Financial Analysts Journal
Pages: 12-14
Issue: 5
Volume: 63
Year: 2007
Month: 9
X-DOI: 10.2469/faj.v63.n5.4835
File-URL: http://hdl.handle.net/10.2469/faj.v63.n5.4835
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material refers to “Human Capital, Asset Allocation, and Life Insurance,” by Peng Chen, CFA, Roger G. Ibbotson, Moshe A. Milevsky, and Kevin X. Zhu, in the January/February issue of the Financial Analysts Journal.
Journal: Financial Analysts Journal
Pages: 15-15
Issue: 5
Volume: 63
Year: 2007
Month: 9
X-DOI: 10.2469/faj.v63.n5.4836
File-URL: http://hdl.handle.net/10.2469/faj.v63.n5.4836
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Author-Name: William F. Sharpe
Author-X-Name-First: William F.
Author-X-Name-Last: Sharpe
Title: Expected Utility Asset Allocation
Abstract: 
 Most asset allocation analyses use the mean–variance approach for analyzing the
          trade-off between risk and expected return. Analysts use quadratic programming to find
          optimal asset mixes and the characteristics of the capital asset pricing model to
          determine reasonable optimization inputs. This article presents an alternative approach in
          which the goal of asset allocation is to maximize expected utility, where the utility
          function may be more complex than that associated with mean–variance analysis.
          Inputs for the analysis are based on the assumption of asset prices that would prevail if
          there were a single representative investor who desired to maximize expected utility.Most asset allocation analyses use the mean–variance approach for analyzing the
          trade-off between risk and expected return. The investor is assumed to care only about the
          expected return and standard deviation of return of his or her portfolio. This approach
          makes it possible to use quadratic programming to find optimal asset mixes. An analogous
          assumption is made when determining inputs for the optimization phase. A key step is a
          reverse optimization, in which asset prices are assumed to be those that would prevail if
          there were a single investor who cared only about portfolio mean and variance and thus the
          conditions of the capital asset pricing model (CAPM) were met. In some cases, such
          assumptions are modified to take into account an investor’s views about deviations
          of asset prices from those consistent with mean–variance equilibrium.This article presents an alternative approach. In the optimization phase, the goal is to
          select an asset allocation that maximizes expected utility when the utility function may
          be more complex than that associated with mean–variance analysis. In the reverse
          optimization phase, inputs for the asset allocation analysis are found that are consistent
          with the assumption that asset prices are those that would prevail if there were a single
          representative investor who desired to maximize expected utility and, again, the utility
          function might be more complex than that associated with mean–variance analysis and
          the CAPM.The article provides algorithms for efficiently performing the computations for both the
          optimization and reverse optimization analyses. It also shows that the approach can be
          considered a generalization of the usual mean–variance analysis because the results
          obtained when quadratic utility functions are used will be the same as those produced by
          using standard mean–variance analyses.Although only experience with practical applications can determine the extent to which
          this more general approach could actually improve investment decisions, it offers the
          prospect for dealing with a number of aspects of asset allocation and doing so in a single
          integrated manner. It may well provide better asset allocations than mean–variance
          analysis in at least some circumstances.
Journal: Financial Analysts Journal
Pages: 18-30
Issue: 5
Volume: 63
Year: 2007
Month: 9
X-DOI: 10.2469/faj.v63.n5.4837
File-URL: http://hdl.handle.net/10.2469/faj.v63.n5.4837
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Author-Name: David T. Brown
Author-X-Name-First: David T.
Author-X-Name-Last: Brown
Author-Name: Gideon Ozik
Author-X-Name-First: Gideon
Author-X-Name-Last: Ozik
Author-Name: Daniel Scholz
Author-X-Name-First: Daniel
Author-X-Name-Last: Scholz
Title: Rebalancing Revisited: The Role of Derivatives
Abstract: 
 Portfolio rebalancing trades off tracking error against the transaction costs associated
          with avoiding tracking error. Prior analytical work derived optimal rebalancing strategies
          that minimize the expected transaction costs required to achieve a given level of tracking
          error. Using these strategies results in the same level of tracking error as naive
          strategies often observed in practice but with much lower transaction costs. Additional
          (substantial) reductions in expected transaction costs can be obtained by using
          derivatives to synthetically rebalance a portfolio. The design of an
          efficient synthetic rebalancing program, however, is complicated. This article describes
          the key elements in such a complex design.Portfolio rebalancing strategies trade tracking error off against the transaction costs
          associated with avoiding tracking error. Prior analytical work derived optimal rebalancing
          strategies that minimize the expected transaction costs required to achieve a given level
          of tracking error by rebalancing the portfolio back to a no-trade region. Applying Monte
          Carlo simulation models, we show that using these strategies results in the same level of
          tracking error as naive strategies often observed in practice but with much lower
          transaction costs.Rebalancing portfolio positions by using derivatives (synthetic
            rebalancing) is potentially even more efficient than using the cash market for
          rebalancing because the cost of trading derivatives is considerably lower than the cost of
          trading cash assets. The design of an efficient synthetic rebalancing program is
          complicated, however, because the costs and tracking-error implications of using
          derivatives depend on how long the derivative positions are maintained. We show the key
          elements of the design of an efficient synthetic rebalancing program.The expected transaction costs of using synthetic rebalancing are less than the expected
          transaction costs of using strategies limited to the cash market that approximate the
          optimal strategies derived in the literature. When the desired tracking-error target is
          small, synthetic rebalancing can achieve the same level of tracking error for less than
          half the cost of cash-market-only rebalancing. As the tracking-error target increases, the
          expected transaction-cost savings from synthetic rebalancing decline. Synthetic
          rebalancing is particularly attractive when the desired tracking error is small because
          derivative positions are expected to be maintained for longer periods of time when the
          tracking-error tolerance is large.Using Monte Carlo simulation models to analyze rebalancing strategies, we document that
          substantial reductions in expected transaction costs can be obtained by using derivatives
          to synthetically rebalance a portfolio.When a portfolio receives cash inflows or is required to make periodic cash payments, an
          efficient rebalancing strategy allows the portfolio to hold some cash. When cash flows
          arrive, gaining the desired exposure by overlaying at least some of the cash with
          derivative positions is more efficient than investing the entire cash flow directly into
          the underweighted asset classes. Investing the cash flow into cash assets generally moves
          the asset allocations inside the no-trade region. The overlay strategy avoids trading
          cash-market asset classes inside the no-trade region, which (as previous literature has
          shown) is inefficient. The numerical optimization procedure determines the most efficient
          allowable cash position and no-trade region.Editor’s Note: David Brown consults from time to time for NISA
            Investment Advisors, LLC, which provides investment advisory services that include
            services relating to the strategies discussed in this article.
Journal: Financial Analysts Journal
Pages: 32-44
Issue: 5
Volume: 63
Year: 2007
Month: 9
X-DOI: 10.2469/faj.v63.n5.4838
File-URL: http://hdl.handle.net/10.2469/faj.v63.n5.4838
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Author-Name: Robert Fernholz
Author-X-Name-First: Robert
Author-X-Name-Last: Fernholz
Author-Name: Cary Maguire
Author-X-Name-First: Cary
Author-X-Name-Last: Maguire
Title: The Statistics of Statistical Arbitrage
Abstract: 
 Hedge funds sometimes use mathematical techniques to “capture” the short-term
          volatility of stocks and perhaps other types of securities. This sort of strategy
          resembles market making and is sometimes considered a form of statistical arbitrage. This
          study shows that for the universe of large-capitalization U.S. stocks, even quite naive
          techniques can achieve remarkably high information ratios. The methods used are quite
          general and should be applicable also to other asset classes.Market makers in financial markets generate profits by buying low and selling high over
          short time intervals. This process occurs naturally because, as market makers, they offer
          a stock for sale at a higher price than they are willing to pay for it and because the
          more urgent buyers and sellers have to accept the market makers’ terms. Market
          making, particularly that of NYSE specialists, has been studied in the normative context
          of academic finance. This article describes a market-making type of trading strategy.High-speed trading strategies similar to market making have putatively been used by hedge
          funds in recent years—a type of strategy sometimes referred to as “statistical
          arbitrage” (or “stat arb” in the abbreviated patois of the Street).
          Statistical arbitrage of this nature can be studied in the context of portfolio behavior
          and is thus amenable to the methods of stochastic portfolio theory. We use these methods
          to examine the potential profitability of such a strategy applied to large-capitalization
          U.S. stocks, but the methodology is quite general and should be applicable also to other
          asset classes.Dynamic stock portfolios can be constructed that behave like market makers.
          Equal-weighted portfolios are dynamic portfolios in which each of the stocks has the same
          constant weight. In an equal-weighted portfolio, if a stock rises in price relative to the
          others, it generates a sell trade in the stock, and if the price declines, it generates a
          buy. Hence, such a portfolio sells on upticks and buys on downticks, the way a market
          maker would.We estimate the return and risk parameters of equal-weighted portfolios and use these
          parameters to determine the efficacy of statistical arbitrage in the universe of large-cap
          U.S. stocks. In the absence of trading commissions and with adequate order flow, we find
          that a hedged strategy that is long an equal-weighted portfolio that is rebalanced at 1.5
          minute intervals and short an equal-weighted portfolio that is rebalanced only at the open
          and close of trading during the day can generate an annual information ratio as high as
          32.Editor’s Note: INTECH markets unique mathematical investment processes
              that attempt to capitalize on the random movement of stock prices.
Journal: Financial Analysts Journal
Pages: 46-52
Issue: 5
Volume: 63
Year: 2007
Month: 9
X-DOI: 10.2469/faj.v63.n5.4839
File-URL: http://hdl.handle.net/10.2469/faj.v63.n5.4839
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Author-Name: Stephen E. Wilcox
Author-X-Name-First: Stephen E.
Author-X-Name-Last: Wilcox
Title: The Adjusted Earnings Yield
Abstract: 
 The earnings yield, determined by the ratio of reported earnings to price, is frequently
          used to predict real return. Complications characterize the predictions, however, because
          reported earnings are not real. This research identifies an adjusted earnings yield that
          ensures that real return can be determined as a ratio of current-period prices. From
          freely accessible and publicly disseminated data, an adjusted-earnings-yield series is
          created for the U.S. equity market. Statistical tests indicate that this measure is a much
          better predictor of future real returns than are other popular valuation measures.The earnings yield, determined as the ratio of reported earnings to price, is frequently
          used by analysts to predict real equity returns. This approach has advantages,
          particularly when share buybacks and other actions affecting shareholder returns are a
          significant use of earnings. Complications do exist, however, because reported earnings
          are not real and are invariably affected by past and expected changes in the price level.
          The research reported here identified anadjusted earnings yield as an
          intuitively appealing approach to estimating real expected return.An accounting adjustment and a debt adjustment are both necessary to convert reported
          earnings into a measure of real profitability. The accounting adjustment converts reported
          earnings into a current-cost (or replacement-cost) accounting system. The debt adjustment
          corrects for the impact that inflation has on the real value of creditor claims. Adjusted
          earnings are, then, the sum of reported earnings, the accounting adjustment, and the debt
          adjustment. The adjusted earnings yield, determined as the ratio of adjusted earnings to
          equity value, ensures that real return is determined as a ratio of current-period
          prices.Using freely accessible and publicly disseminated data, I created an
          adjusted-earnings-yield series for the U.S. equity market. I used a predictive regression
          model to test the hypothesis that this valuation measure is superior to other commonly
          used valuation measures as a predictor of future real equity returns. Statistical tests
          confirm that it is, indeed, a better measure, particularly when the goal is to forecast
          near-term real returns.The article also provides evidence that the accounting and debt adjustments made to
          reported earnings are each important considerations if the goal is to accurately forecast
          real equity returns. Results of the predictive regression models indicate that the
          coefficient estimate for the accounting adjustment variable is statistically significant
          for all the time horizons considered and the coefficient estimate for the debt adjustment
          variable is statistically significant at longer time horizons. Although the regression
          results suggest that the accounting adjustment is the more important adjustment, the debt
          adjustment was actually found to be more highly positively correlated with future real
          returns, and the difference increases with the length of the investment horizon.An explanation commonly offered for the low real returns of the 1970s and the high real
          returns of the 1980s and 1990s is that investors were simply behaving irrationally. The
          results of this study suggest, however, that a plausible, albeit only partial, explanation
          of why real returns varied as they did is that market participants rationally recognized
          that traditional measures of market valuation, such as P/E or the earnings yield, were
          misstating the true worth of equities. The variation in real returns appears to be
          somewhat more rational once the accounting and debt adjustments are considered.The adjusted earnings yield suffices as a stand-alone measure of real expected return,
          and investors should be most concerned with its level. As of the third quarter of 2006,
          the adjusted-earnings-yield series developed for the U.S. equity market was predicting a
          real return of 6.1 percent. But forecasts change quarterly with the arrival of new data,
          and the current economy raises some concerns. Recent trends in fixed capital investment
          and borrowing suggest a slowing of the U.S. economy, which may adversely affect share
          prices.
Journal: Financial Analysts Journal
Pages: 54-68
Issue: 5
Volume: 63
Year: 2007
Month: 9
X-DOI: 10.2469/faj.v63.n5.4840
File-URL: http://hdl.handle.net/10.2469/faj.v63.n5.4840
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Author-Name: Robin M. Greenwood
Author-X-Name-First: Robin M.
Author-X-Name-Last: Greenwood
Author-Name: Nathan Sosner
Author-X-Name-First: Nathan
Author-X-Name-Last: Sosner
Title: Trading Patterns and Excess Comovement of Stock Returns
Abstract: 
 In April 2000, 30 stocks were replaced in the Nikkei 225 Index. The unusually broad index
          redefinition allowed for a study of the effects of index-linked trading on the excess
          comovement of stock returns. A large increase occurred in the correlation of trading
          volume of stocks added to the index with the volume of stocks that remained in the index,
          and opposite results occurred for the deletions. Daily index return betas of the additions
          rose by an average of 0.45; index return betas of the deleted stocks fell by an average of
          0.63. Theoretical predictions for changes in autocorrelations and cross-serial
          correlations of returns of index additions and deletions were confirmed. The results are
          consistent with the idea that trading patterns are associated with short-run excess
          comovement of stock returns.There is abundant evidence that security prices can move together either too little or
          too much to be justified by fundamentals. What could be causing this comovement if not
          fundamentals? Empirical studies have uncovered a variety of common factors in returns,
          such as size, value, and industry factors. In academic literature, debate is ongoing as to
          whether these factors are related to fundamental risk or, alternatively, reflect
          mispricing driven by investor demand. Providers of commercial risk models have stayed away
          from this debate and include a broad set of factors to explain common variation in asset
          returns.We argue that one driver of comovement of returns is commonality in trading activity. We
          tested this hypothesis by using an unusual index redefinition of the Nikkei 225 Index in
          April 2000 in which 30 stocks were replaced. Upon inclusion in an index, a stock becomes
          exposed to the trading shocks experienced by other stocks in the index. Whenever index
          funds experience inflows or outflows, they trade index stocks as a basket. Also, index
          arbitrageurs delta-hedge their index derivative positions, which requires simultaneous
          trading in the basket of the underlying securities. Consistent with these observations, we
          documented a large and significant increase in the correlation of trading volume of the 30
          stocks added to the Nikkei 225 with the trading volume of stocks that remained in the
          index, and we found the opposite results for the deleted companies.We investigated whether the change in trading activity has consequences for returns. We
          found that after the Nikkei redefinition, the daily return betas of the additions with
          respect to the stocks that remained in the index rose by an average of 0.45 but the daily
          index return betas of the deletions fell by an average of 0.63. Thus, index membership
          alone explained a surprising amount of the comovement among stock returns.We also made predictions about changes in autocorrelations and cross-serial correlations
          for added and deleted stocks following index redefinition. These predictions, which are
          not featured in existing research, were motivated by the idea that pricing effects from
          shocks to correlated investor demand should eventually subside. That is, although security
          returns of index stocks should comove excessively in the short run, at longer horizons,
          returns should revert to reflect fundamentals. We found strong support for these
          predictions. A particularly interesting result is that following index redefinition, daily
          return autocorrelations of additions decreased whereas return autocorrelations of
          deletions increased, which suggests that additions (deletions) become more (less) exposed
          to transitory index-trading shocks. Taken together, our results suggest that commonality
          in trading baskets induces significant excess comovement of stock returns.Our findings have important implications for modeling risk in equity markets. Index
          membership is likely to be an important common factor even after accounting for industries
          and fundamental factors. This aspect is especially important in risk models geared toward
          daily returns—in that the effects of correlated index trading tend to subside as the
          return horizon increases. Our results also imply that short-term shocks to index demand
          add to the transaction costs of index investing.
Journal: Financial Analysts Journal
Pages: 69-81
Issue: 5
Volume: 63
Year: 2007
Month: 9
X-DOI: 10.2469/faj.v63.n5.4841
File-URL: http://hdl.handle.net/10.2469/faj.v63.n5.4841
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Author-Name: Mirko Cardinale
Author-X-Name-First: Mirko
Author-X-Name-Last: Cardinale
Title: Corporate Pension Funding and Credit Spreads
Abstract: 
 This study empirically tested whether pension information derived from accounting
          disclosures is priced in corporate bond spreads. The model was tested on corporate bond
          data of U.S. companies for the 2001–04 period. Unfunded pension liabilities are
          incorporated in credit spreads, and the sensitivity of market spreads to deficits is
          greater than the sensitivity to ordinary long-term debt. This relationship is not,
          however, a linear monotonic function, and the sensitivity of bond spreads to deficits is
          substantially higher for high-yield than for investment-grade bonds. Moreover, the bond
          market prices residual risk even in funded obligations and gives lower weighting to
          off-balance-sheet liabilities.The study described in this article tested empirically whether pension information
          derived from accounting disclosures is priced in corporate bond spreads. The model used
          was built on the literature of structural models of bond spreads initiated in the 1970s. I
          tested it on corporate data and bond data for U.S. companies for the 2001–04
          period.A number of studies have considered the relationship between pension funding and
          corporate financial policy. Although some studies have questioned the value transparency
          of the stock market when it comes to processing information derived from pension
          accounting data (that is, whether stock prices correctly incorporate pension liabilities
          in the valuation of companies), no previous work has investigated the extent to which
          traded corporate bonds incorporate pension liabilities in the implicit assessment of
          company creditworthiness embedded in market spreads. In fact, previous studies of the bond
          market’s response to corporate pension liabilities took an indirect approach by
          calibrating models of credit ratings.The intuition behind the empirical specification in this study was that credit spreads
          are explained by proxies of leverage and volatility of the value of the firm (typically
          proxied by the volatility of the stock price), which is consistent with a structural model
          approach. My analysis was made possible by a unique set of data matching a four-year
          dataset of Fortune 1000 pension and accounting disclosures maintained by Watson Wyatt
          Worldwide with data on corporate spreads supplied by Merrill Lynch & Co. For the
          purpose of the analysis, the sensitivity of market spreads to pension liabilities was
          captured by separating out pension leverage arising from the presence of a defined-benefit
          plan from ordinary leverage arising from corporate debt. Pension leverage was then further
          broken down into a funded component backed by pension assets and an unfunded component
          representing the plan deficit.Consistent with previous studies on credit ratings, I found that the U.S. corporate bond
          market takes into account the presence of unfunded pension liabilities. The effect was
          strongest for below-investment-grade (high-yield) securities. I also found the sensitivity
          of spreads to pension deficits to be much larger than their sensitivity to ordinary
          long-term debt. In the baseline econometric specification, the pension deficit coefficient
          was twice as large as the coefficient associated with ordinary long-term debt for the
          investment-grade sample and more than three times larger for the high-yield sample.The article also provides evidence suggesting that the relationship between pension
          deficits and spreads is rather more complex than a linear monotonic function; therefore, a
          linear regression model can provide only a first-order approximation. Moreover, although
          the market does seem to take reported pension deficits into account, it also appears to
          consider additional factors when incorporating corporate pension fund information in a
          credit-risk framework. In particular, the market apparently takes into account residual
          risk even in funded obligations and gives a lower weighting to off-balance-sheet
          liabilities. The evidence as to whether liability duration and plan asset allocation are
          also priced as separate risk factors is not conclusiveThe results of this study suggest that fixed-income portfolio managers should explicitly
          incorporate plan deficits and other pension fundamentals in their models of corporate
          credit spreads. And managers should assess the impact of pension variables as risk factors
          separate from ordinary leverage. Such an exercise appears to be most important for
          high-yield securities.Editor’s Note: This article is the result of work carried out
            while the author was senior economist at Watson Wyatt Worldwide, Reigate, United
            Kingdom.
Journal: Financial Analysts Journal
Pages: 82-101
Issue: 5
Volume: 63
Year: 2007
Month: 9
X-DOI: 10.2469/faj.v63.n5.4842
File-URL: http://hdl.handle.net/10.2469/faj.v63.n5.4842
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issue.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 5
Volume: 63
Year: 2007
Month: 9
X-DOI: 10.2469/faj.v63.n5.4844
File-URL: http://hdl.handle.net/10.2469/faj.v63.n5.4844
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: Editor’s Corner
Abstract: 
 The rise in patents on “intangible” intellectual property is                    accompanied by confusion in patent law—new, complex rules in the                    United States for granting patents, recent rulings by U.S. courts, publicity                    focused on patent law, and a crowd of patent “experts”                    issuing conflicting views. As the financial industry grapples with this area, we                    need thoughtful discussion of the conflicts that will lead to reasoned outcomes                    regarding patent applications in the industry.
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 6
Volume: 63
Year: 2007
Month: 11
X-DOI: 10.2469/faj.v63.n6.4921
File-URL: http://hdl.handle.net/10.2469/faj.v63.n6.4921
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “Default Funds in U.K. Defined-Contribution                        Plans,” by Alistair Byrne, CFA, David Blake, Andrew                    Cairns, and Kevin Dowd, in the July/August 2007 issue of the Financial                        Analysts Journal.
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 6
Volume: 63
Year: 2007
Month: 11
X-DOI: 10.2469/faj.v63.n6.4922
File-URL: http://hdl.handle.net/10.2469/faj.v63.n6.4922
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Author-Name: Robert A. Prentice
Author-X-Name-First: Robert A.
Author-X-Name-Last: Prentice
Title: Ethical Decision Making: More Needed Than Good Intentions
Abstract: 
 The flourishing field of behavioral finance indicates that people often do not
                    engage in optimal decision making when investing. The same cognitive biases and
                    mental heuristics that cause suboptimal investing may also cause people to make
                    unethical decisions. For that reason, good intentions are necessary, but they
                    are not sufficient for finance professionals who desire to act ethically.
                    Insights presented in this article can assist the well-intentioned to do the
                    right thing in difficult circumstances.The aim of this article is to underline for finance professionals that, although
                    good intentions are essential to ethical behavior, they are not sufficient. Even
                    well-intentioned people can stumble into ethical minefields if they do not keep
                    their ethical antennae up and guard against errors in judgment that are commonly
                    made—errors that, indeed, people are often predisposed to
                    make. The first part of the article describes many of the cognitive biases and
                    decisional heuristics (mental shortcuts) that can create ethical traps. These
                    concepts form the basis of behavioral finance and have been addressed in
                    relation to their adverse impact on investment decisions. But many people do not
                    fully realize how the same cognitive limitations may also lead to judgments that
                    are unethical. The limitations I discuss are obedience to authority; conformity
                    bias; “incrementalism”; “groupthink”; overoptimism and
                    overconfidence; a self-serving bias we all share; the influence of framing and
                    of sunk costs; the power of the more vivid, tangible, and contemporaneous; and
                    loss aversion.The second major part of the article suggests attitudes and actions that can
                    assist those acting in good faith to minimize, even if not eliminate, their
                    unethical decisions. The first correction is to “debias” ourselves.
                    This step may require playing devil”s advocate with our decisions.
                    Cognitive biases are vigorous phenomena, however, and not easy to neutralize or
                    eliminate. The forces behind the self-serving and optimism biases, for example,
                    not only warp the decision-making process in a particular direction but also
                    make it difficult for a person to debias his or her own decision making. The
                    article describes the necessary elements of debiasing as recognition of bias and
                    its magnitude and direction, motivation to correct it, and the ability to adjust
                    one’s response.The second correction for the finance professional who truly wishes to act
                    ethically is to be vigilant, to think about ethics in every situation. Third,
                    one must watch out for rationalizations. Most white-collar criminals do not view
                    themselves as corrupt, as bad people, or as criminals. Rather, they rationalize
                    their actions as normal in the business world. Finally, ethical behavior may
                    call for courage—the gumption to advocate for pursuing the moral
                    course.The good news is that just as normal people commit most of the evil acts in the
                    world, they also commit most of the heroic acts. Most people who behave
                    heroically do not resemble the characters in action movies. Whether charging a
                    machine gun nest on Iwo Jima or blowing the whistle on Enron, heroic acts are
                    generally performed by ordinary people who exercise vigilance, determination,
                    self-reflection, and a little courage.
Journal: Financial Analysts Journal
Pages: 17-30
Issue: 6
Volume: 63
Year: 2007
Month: 11
X-DOI: 10.2469/faj.v63.n6.4923
File-URL: http://hdl.handle.net/10.2469/faj.v63.n6.4923
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Author-Name: André F. Perold
Author-X-Name-First: André F.
Author-X-Name-Last: Perold
Title: Fundamentally Flawed Indexing
Abstract: 
 Fundamental indexers argue that capitalization weighting is an inferior
                    investment strategy because it necessarily invests more in overvalued stocks and
                    less in undervalued stocks. This article shows that this claim is false.
                    Capitalization weighting does not, by itself, create a performance drag.Proponents of “fundamental indexing” argue that holding stocks in
                    proportion to their market capitalizations is an inferior investment strategy.
                    In their model, the market errs randomly in its pricing of individual stocks,
                    which induces a correlation between misvaluation and market capitalization.
                    Capitalization weighting thus necessarily invests more in overvalued stocks and
                    less in undervalued stocks.I show that this conclusion is false. If the market errs randomly in its pricing
                    of individual stocks and if all one knows about a stock is its market
                    capitalization, then one cannot discern whether that stock is overvalued or
                    undervalued. Cap weighting, therefore, does not, by itself, create a performance
                    drag.Fundamental indexing is an active strategy that tilts the portfolio toward value
                    stocks. Value stocks have done well historically, but we do not know whether
                    these higher returns are compensation for risk or because stock prices do not
                    fully reflect readily available company attributes, such as sales, earnings, and
                    dividends. If the reason is the latter and if this particular inefficiency
                    persists, fundamental indexing may perform well (along with other value-oriented
                    strategies), but the reason will not be an inherent performance bias associated
                    with cap weighting.As with any active strategy, fundamental indexing is not an approach that
                    everyone can follow. Investors who have no skill in evaluating active strategies
                    should hold the cap-weighted market portfolio.
Journal: Financial Analysts Journal
Pages: 31-37
Issue: 6
Volume: 63
Year: 2007
Month: 11
X-DOI: 10.2469/faj.v63.n6.4924
File-URL: http://hdl.handle.net/10.2469/faj.v63.n6.4924
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:63:y:2007:i:6:p:31-37




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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: What Ails Public Pensions?
Abstract: 
 Actuarial convention has the effect of driving equity allocations of public
                    pension plans upward. It also pushes the risk of pension funding onto future
                    generations of taxpayers, which has fostered taxpayer discontent. Yet, pension
                    plans in the public sector have much to offer in terms of design features,
                    benefit security, cost effectiveness, and investment performance. Ideally, they
                    will evolve into quasi-autonomous financial institutions. For this to happen,
                    they will have to (1) mark assets and liabilities to market, (2) implement
                    funding and benefit-improvement disciplines, and (3) cease to pursue social,
                    political, and economic development ends.Statewide pension plans report that, based on actuarial convention, they are 87
                    percent funded. If assets and liabilities are marked to market, however, the
                    funded ratio drops to between 62 percent (on the basis of the projected benefit
                    obligation) and 75 percent (on the basis of the accumulated benefit obligation).
                    Actuarial convention has the effect of pushing the risk of pension funding onto
                    future generations of taxpayers and has driven equity allocations in investment
                    portfolios upward. It also obscures significant wealth transfers that occur
                    routinely among plan participants and various generations of taxpayers. The
                    upshot is that future taxpayers face significant moral hazard in connection with
                    the operation of public pension plans. Taxpayer discontent is behind efforts to
                    replace defined-benefit plans with defined-contribution plans in the public
                    sector.Yet, DB pension plans in the public sector have much to offer in terms of design
                    features, benefit security, cost-effectiveness, and investment performance.
                    Ideally, they will evolve into quasi-autonomous financial
                        institutions. For this to happen, they will have to (1) mark assets
                    and liabilities to market, (2) implement funding and benefit-improvement
                    disciplines, and (3) cease to use plan investments to pursue social, political,
                    or economic-development initiatives.This type of evolution could have interesting ramifications for investment
                    policy. Bond durations would almost certainly lengthen. Genuine risk tolerances
                    could emerge and become operative. As a result, equity allocations, which
                    currently cluster in the range of 72–77 percent, might well become more
                    varied as they reflect genuine differences in risk tolerances.
Journal: Financial Analysts Journal
Pages: 38-43
Issue: 6
Volume: 63
Year: 2007
Month: 11
X-DOI: 10.2469/faj.v63.n6.4925
File-URL: http://hdl.handle.net/10.2469/faj.v63.n6.4925
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Author-Name: Eugene F. Fama
Author-X-Name-First: Eugene F.
Author-X-Name-Last: Fama
Author-Name: Kenneth R. French
Author-X-Name-First: Kenneth R.
Author-X-Name-Last: French
Title: The Anatomy of Value and Growth Stock Returns
Abstract: 
 Average returns on value and growth portfolios are broken into dividends and
                    three sources of capital gain: (1) growth in book equity, primarily from
                    earnings retention, (2) convergence in price-to-book ratios (P/Bs) from mean
                    reversion in profitability and expected returns, and (3) upward drift in P/B
                    during 1927–2006. The capital gains of value stocks trace mostly to
                    convergence: P/B rises as some value companies become more profitable and their
                    stocks move to lower-expected-return groups. Growth in book equity is trivial to
                    negative for value portfolios but is a large positive factor in the capital
                    gains of growth stocks. For growth stocks, convergence is negative: P/B falls
                    because growth companies do not always remain highly profitable with low
                    expected stock returns. Relative to convergence, drift is a minor factor in
                    average returns.Value stocks (with low ratios of price-to-book value) have higher average returns
                    than growth stocks (with high P/Bs). To better understand this value premium, we
                    break average returns on value and growth portfolios in the 1926–2006
                    period into dividends and three sources of capital gain: (1) growth in book
                    equity, primarily from earnings retention; (2) convergence in P/Bs as a result
                    of mean reversion in profitability and expected returns; and (3) upward drift in
                    P/Bs.The contribution of dividends to average returns is higher for value stocks than
                    for growth stocks for our second subperiod, 1964–2006. But the higher
                    dividends of value stocks are special to this period. For the earlier subperiod,
                    1927–1963, the contribution of dividends to average returns is similar for
                    value and growth stocks.Differences in the way capital gains split between growth in book equity and
                    growth in P/B are more consistent for the full sample period than the patterns
                    in dividends. In the year after companies are allocated to
                        value portfolios, they do not do much equity-financed
                    investment and growth in book equity is, on average, minor. Thus, the large
                    average capital gains of value stocks show up as increases in P/B. In contrast,
                    companies invest heavily after they are allocated to growth
                    portfolios, and the growth rate of book equity, on average, exceeds the growth
                    rate of the stock price. Thus, P/B, on average, declines after companies are
                    identified as growth stocks, and the positive average rates of capital gain of
                    growth portfolios trace to increases in book equity that more than offset
                    declines in P/B.We look to standard economic forces to explain the behavior of P/Bs after stocks
                    are characterized as value or growth. When companies are allocated to value and
                    growth portfolios, they tend to be at opposite ends of the profitability
                    spectrum. Growth companies tend to be highly profitable and fast growing,
                    whereas value companies are less profitable and they grow less rapidly, if at
                    all. For growth stocks, high expected profitability and growth combine with low
                    expected stock returns (low costs of equity capital) to produce high P/Bs,
                    whereas for value stocks, low profitability, slow growth, and high expected
                    returns produce low P/Bs.Competition from other companies, however, tends to erode the high profitability
                    of growth stocks, and profitability also declines as these companies exercise
                    their most profitable growth options. Thus, each year, some growth stocks cease
                    to be highly profitable, fast-growing companies that are rewarded by the market
                    with low costs of equity capital (expected stock returns). As a result, the P/Bs
                    of growth portfolios tend to fall in the years after portfolio formation.
                    Conversely, the P/Bs of value portfolios tend to rise in the years after
                    portfolio formation as some value companies restructure, improve in
                    profitability, and are rewarded by the market with lower costs of equity capital
                    and higher stock prices.The tendency of P/Bs to become less extreme after companies are placed in value
                    and growth portfolios is what we call “convergence.” There has also
                    been a general upward drift in P/Bs, however, in the 1927–2006 period.
                    Higher prices relative to book values imply some combination of higher expected
                    cash flows and lower expected stock returns (discount rates for expected cash
                    flows) at the end of the period than at the beginning. We label this the
                    “drift effect” in P/B and average returns.The total increase in P/Bs for the sample period is large, but the contribution
                    of this drift to average returns is modest relative to the contribution of
                    convergence. The differences between average growth rates of P/Bs for value and
                    growth portfolios are thus mostly a result of convergence.
Journal: Financial Analysts Journal
Pages: 44-54
Issue: 6
Volume: 63
Year: 2007
Month: 11
X-DOI: 10.2469/faj.v63.n6.4926
File-URL: http://hdl.handle.net/10.2469/faj.v63.n6.4926
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Author-Name: Louis K.C. Chan
Author-X-Name-First: Louis K.C.
Author-X-Name-Last: Chan
Author-Name: Josef Lakonishok
Author-X-Name-First: Josef
Author-X-Name-Last: Lakonishok
Author-Name: Bhaskaran Swaminathan
Author-X-Name-First: Bhaskaran
Author-X-Name-Last: Swaminathan
Title: Industry Classifications and Return Comovement
Abstract: 
 A company’s industry affiliation is commonly used to construct homogeneous
                    stock groupings for portfolio risk management, relative valuation, and
                    peer-group comparisons. A variety of industry classification systems have been
                    adopted, however, creating disagreements as to companies’ industry
                    assignments. This analysis of the Global Industry Classification System (GICS)
                    and Fama–French system indicates that common movement in returns and
                    operating performance resulting from industry effects is stronger for stocks of
                    large companies than for those of small companies. Also, increasingly fine
                    levels of disaggregation improve discrimination up to six-digit GICS codes,
                    after which the benefits tail off. Stock groupings based on industry exhibit
                    stronger out-of-sample homogeneity than groups formed from statistical cluster
                    analysis.Investors and researchers commonly use a company’s industry affiliation to
                    construct homogeneous stock groupings for the purposes of portfolio risk
                    management, relative valuation, and peer-group comparisons. A variety of
                    industry classification systems have been adopted, however, creating
                    disagreements as to companies’ industry assignments. Academic researchers
                    tend to use industry groups developed by Fama and French, which are initially
                    based on Standard Industrial Classification codes. Investment practitioners
                    favor the Global Industry Classification System (GICS). Little evidence is
                    available on the relative performance of alternative classification procedures
                    in terms of their ability to produce groupings of stocks that share coincident
                    price movements. Moreover, the literature provides scant guidance on choosing
                    the fineness of industry disaggregation.We compare the Fama–French (FF) and GICS industry classification schemes in
                    terms of their capacity to isolate common return movements of stocks within an
                    industry relative to covariation with returns on stocks outside the industry. In
                    addition, we document the gains from successively finer levels of industry
                    partitioning. Finally, we verify that industry groups correspond to collections
                    of economically similar companies in terms of sharing common movements in
                    operating performance (as measured by sales growth) and exhibit stronger
                    out-of-sample return covariation than statistical clusters formed without regard
                    to industry affiliation.Large-cap stocks that belong to the same industry as defined by two-digit GICS
                    codes share a simple mean correlation of 0.38, compared with a mean correlation
                    of 0.26 for stocks drawn from different industries. Measured net of an equally
                    weighted market index, when two-digit codes are used, return correlations for
                    large-cap stocks in an industry average 0.17. The magnitudes of within-industry
                    commonality in movements of raw and excess returns highlight the potential
                    benefit of using industry affiliation as one dimension for managing portfolio
                    risk and tracking error in the case of large companies.For smaller companies, however, the comovement of returns associated with
                    commonality in industry membership is much less pronounced. In part, small-cap
                    stocks’ responses to industry effects may be dominated by their higher
                    idiosyncratic volatility. One implication of these results is that constraints
                    on portfolio weights to limit exposures to industries plays a more important
                    role for large-cap stocks than for small-cap stocks.The FF categories fare as well as four-digit GICS groups in terms of the
                    magnitude of mean within-industry correlations but at a cost in terms of
                    parsimony (48 FF groups are needed versus 24 four-digit GICS groups). Finer
                    levels of disaggregation improve discrimination between within-industry and
                    outside-industry correlations except that the benefits generally tail off beyond
                    six-digit GICS codes. For the large-cap sample, correlations between industry
                    members differ from correlations between nonmember companies by, on average,
                    0.13 at the two-digit GICS level, 0.14 at the four-digit level, 0.17 at the
                    six-digit level, and 0.18 at the eight-digit level.Common industry affiliation also translates into heightened covariation in sales
                    growth. The mean correlation of sales growth for large companies within
                    four-digit GICS industries is 0.22, as opposed to 0.10 for the average
                    outside-industry correlation.Pseudo-industry groups formed from statistical cluster analysis of stock returns
                    do not match the performance of industry classifications on an out-of-sample
                    basis. Both the FF and GICS schemes produce classifications with larger
                    within-group correlations and sharper discrimination over outside-group
                    correlations than grouping by statistical cluster analysis produces.
Journal: Financial Analysts Journal
Pages: 56-70
Issue: 6
Volume: 63
Year: 2007
Month: 11
X-DOI: 10.2469/faj.v63.n6.4927
File-URL: http://hdl.handle.net/10.2469/faj.v63.n6.4927
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Author-Name: Wei-Yin Hu
Author-X-Name-First: Wei-Yin
Author-X-Name-Last: Hu
Author-Name: Jason S. Scott
Author-X-Name-First: Jason S.
Author-X-Name-Last: Scott
Title: Behavioral Obstacles in the Annuity Market
Abstract: 
 As Baby Boomers enter retirement, they will look to the investment industry for
                    ways to generate income from accumulated savings. Why most retirees do not
                    purchase longevity insurance in the form of lifetime annuities is a
                    long-standing puzzle. Mental accounting and loss aversion can explain the
                    unpopularity of annuities by framing them as risky gambles where potential
                    losses loom larger than potential gains. Moreover, behavioral anomalies can
                    explain the prevalence of “period certain” annuities, which
                    guarantee a minimum number of payouts. Finally, investors may prefer
                    “longevity annuities” purchased today to begin payouts in the future
                    to immediate annuities because investors overweight the small probability of
                    living long enough to receive large future payouts.As Baby Boomers enter retirement, they will look to the investment industry for
                    ways to generate retirement income from a stock of accumulated savings. A
                    significant focus for the industry is whether retirees are adequately protected
                    against longevity risk (the risk of outliving their assets). Baby Boomers are
                    less likely to have the high degree of guaranteed lifetime income that was
                    formerly provided by defined-benefit pensions. But a natural replacement for a
                    DB pension is a lifetime income annuity purchased from retirement savings. Why
                    most retirees do not purchase longevity insurance in the form of lifetime
                    annuities is a long-standing puzzle.This study applies the lessons of behavioral finance to understand how
                    well-documented anomalies in decision making under risk may affect the annuity
                    purchase decision, even when longevity risk is the only risk being considered.
                    The investment industry’s success at helping manage retirees’
                    longevity risk will depend heavily on understanding these powerful behavioral
                    influences on the way retirees evaluate annuity products.We demonstrate that mental accounting can explain the unpopularity of annuities
                    because it causes individuals to view annuities as gambling on their own lives.
                    When annuity outcomes are segregated from their impact on total retirement
                    spending, then purchasing an annuity appears to be a gamble that
                        increases overall risk rather than a form of insurance that
                    can reduce risk. Loss aversion exacerbates the distortion by
                    making the potential loss (from not making back the initial investment) loom
                    larger than the potential gain. We also explain the prevalence of “period
                    certain” annuities, which guarantee a minimum number of payouts. These
                    annuities effectively combine a bond portfolio with an annuity that starts
                    payouts in the future, and mental accounting may give the impression that this
                    bond-plus-annuity combination is less risky than an immediate annuity, in which
                    all payouts are subject to mortality risk (uncertainty about the date of
                    death).Finally, we show that a recent innovation in annuity markets—delayed-payout
                    or “longevity” annuities, which are purchased today to begin payouts
                    in the future—may be more desirable than immediate-payout annuities. This
                    behavioral pattern is caused by the overweighting of small probabilities. In the
                    case of longevity annuities, the overweighted small probabilities are associated
                    with large cumulative payouts if one lives long enough to earn back multiple
                    times the initial investment.To combat these behavioral distortions, particularly mental accounting, annuity
                    marketers and financial advisers need to frame annuities in the context of an
                    overall retirement spending plan. Achieving this goal should convince more
                    retirees that the normative economic conclusion is true: They should annuitize
                    some part of their retirement savings. Holding longevity insurance in the form
                    of an annuity should reduce the need for precautionary saving and thus allow
                    annuity holders to consume more in retirement.
Journal: Financial Analysts Journal
Pages: 71-82
Issue: 6
Volume: 63
Year: 2007
Month: 11
X-DOI: 10.2469/faj.v63.n6.4928
File-URL: http://hdl.handle.net/10.2469/faj.v63.n6.4928
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and                    issue.
Journal: Financial Analysts Journal
Pages: 86-86
Issue: 6
Volume: 63
Year: 2007
Month: 11
X-DOI: 10.2469/faj.v63.n6.4931
File-URL: http://hdl.handle.net/10.2469/faj.v63.n6.4931
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: 2007 Report to Readers
Journal: Financial Analysts Journal
Pages: 6-7
Issue: 1
Volume: 64
Year: 2008
Month: 1
X-DOI: 10.2469/faj.v64.n1.1
File-URL: http://hdl.handle.net/10.2469/faj.v64.n1.1
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Author-Name: Mark S. Rzepczynski
Author-X-Name-First: Mark S.
Author-X-Name-Last: Rzepczynski
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Quantitative Management of Bond Portfolios (a review)
Abstract: 
 Offering clear, empirically based solutions to many of the practical challenges
                    of running a bond portfolio (particularly, portfolio structuring), this hefty
                    book is incomparable in depth and breadth as an all-encompassing tool kit for
                    fixed-income managers.
Journal: Financial Analysts Journal
Pages: 85-86
Issue: 1
Volume: 64
Year: 2008
Month: 1
X-DOI: 10.2469/faj.v64.n1.10
File-URL: http://hdl.handle.net/10.2469/faj.v64.n1.10
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Do Economists Make Markets? On the Performativity of Economics (a review)
Abstract: 
 The editors of this book have assembled a highly stimulating volume in which
                    experts in economics, sociology, anthropology, and more explore the idea that
                    the practice of economics does more than observe how the economy works; it also
                    shapes and formats it.
Journal: Financial Analysts Journal
Pages: 86-87
Issue: 1
Volume: 64
Year: 2008
Month: 1
X-DOI: 10.2469/faj.v64.n1.11
File-URL: http://hdl.handle.net/10.2469/faj.v64.n1.11
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and
                    issue.
Journal: Financial Analysts Journal
Pages: 88-88
Issue: 1
Volume: 64
Year: 2008
Month: 1
X-DOI: 10.2469/faj.v64.n1.12
File-URL: http://hdl.handle.net/10.2469/faj.v64.n1.12
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Author-Name: Hollister B. Sykes
Author-X-Name-First: Hollister B.
Author-X-Name-Last: Sykes
Title: “The Adjusted Earnings Yield”: A Comment
Abstract: 
 This material comments on “The Adjusted Earnings Yield”.
Journal: Financial Analysts Journal
Pages: 8-8
Issue: 1
Volume: 64
Year: 2008
Month: 1
X-DOI: 10.2469/faj.v64.n1.2
File-URL: http://hdl.handle.net/10.2469/faj.v64.n1.2
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Author-Name: Roger Clarke
Author-X-Name-First: Roger
Author-X-Name-Last: Clarke
Author-Name: Harindra de Silva
Author-X-Name-First: Harindra
Author-X-Name-Last: de Silva
Author-Name: Steven Sapra
Author-X-Name-First: Steven
Author-X-Name-Last: Sapra
Author-Name: Steven Thorley
Author-X-Name-First: Steven
Author-X-Name-Last: Thorley
Title: Long–Short Extensions: How Much Is Enough?
Abstract: 
 Long–short extension strategies, such as 130–30, allow portfolio
                    managers to reduce the implementation inefficiencies associated with the
                    long-only constraint. Ample research using benchmark-specific and time
                    period–specific numerical analyses indicates that long–short
                    extensions increase expected information ratios. What is lacking is a general
                    theory or mathematical model of long–short extensions based on underlying
                    assumptions about benchmark composition, the security covariance matrix, and the
                    portfolio optimization process. The analytical model developed here identifies
                    the roles various parameters play in determining the size of the
                    long–short extension. The impact of changes in the model parameters over
                    time and across markets is illustrated with the use of historical and current
                    equity benchmark data.Long–short extension ratios, such as 130–30, are an increasingly
                    common way for the investment management industry to describe portfolios that
                    have been released from the long-only constraint. The ratio of a
                    portfolio’s long and short positions to net notional value is often the
                    primary description of the strategy. Unfortunately, managers and their clients
                    may not understand the underlying parameters associated with the value of the
                    long–short ratio beyond generally recognizing that the size of the
                    extension (e.g., 30 percent) and active risk are positively related. This study
                    develops a mathematical model to identify the underlying parameters that
                    determine the size of the long–short extension. The relationships are
                    illustrated with historical data on 500 large-capitalization U.S. stocks and
                    current data on a variety of U.S. and international equity benchmarks.The analytical model enhances perspectives from previous studies that depended on
                    benchmark- and period-specific numerical examples or on insights from
                    simulations. The model assumes a generic security-ranking process, a simple
                    covariance matrix, a single measure of benchmark concentration, and
                    unconstrained portfolio optimization. The model confirms the basic intuition
                    that the size of the long–short extension increases with the active-risk
                    target chosen by the manager and decreases with the estimated costs of shorting.
                    In addition, the model shows that the unconstrained short extension decreases
                    with individual security risk and increases with the following parameters:
                    security correlation, the weight concentration of the benchmark, the number of
                    securities in the benchmark, and the assumed accuracy of security return
                    forecasts.The model provides important perspectives on long–short extension
                    strategies. For example, three of the model parameters—individual security
                    risk, security correlation, and benchmark weight concentration—change over
                    time, which suggests that to maintain a constant level of active risk, the exact
                    size of the long–short extension should be allowed to vary. Application of
                    the analytical model to a variety of U.S. and international benchmarks indicates
                    that the number of securities and the weight concentration of the chosen
                    benchmark have a substantial impact on the size of the unconstrained
                    long–short extension.Note: Analytic Investors applies a disciplined quantitative
                        process to manage a variety of equity strategies for institutional and
                        individual investors.
Journal: Financial Analysts Journal
Pages: 16-30
Issue: 1
Volume: 64
Year: 2008
Month: 1
X-DOI: 10.2469/faj.v64.n1.4
File-URL: http://hdl.handle.net/10.2469/faj.v64.n1.4
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:64:y:2008:i:1:p:16-30




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Author-Name: Paul D. Kaplan
Author-X-Name-First: Paul D.
Author-X-Name-Last: Kaplan
Title: Why Fundamental Indexation Might—or Might Not—Work
Abstract: 
 Some proponents of fundamental indexation claim that the strategy is based on a
                    new theory in which market prices of stocks deviate from fair values. A key
                    assumption in this approach is that fundamental weights are unbiased estimators
                    of fair value weights that are statistically independent of market values. This
                    article demonstrates that, except in trivial cases, this assumption is
                    internally inconsistent because the sources of the “errors” are
                    also determinants of market values. The article shows under what conditions
                    fundamental weights are better—or worse—estimators of fair value
                    weights than are market value weights, thereby demonstrating that the new theory
                    is merely a conjecture. A formula is developed for the value bias inherent in
                    fundamental weighting, and two approaches to combining fundamental and market
                    values are discussed.Some proponents of fundamental indexation claim that their strategy is based on a
                    revolutionary new paradigm, the “noisy-market hypothesis,” in which
                    market prices of stocks deviate from their fair values. Skeptics are quick to
                    argue that fundamental indexation is nothing more than value investing in a
                    different guise. Proponents claim that their approach is different from value
                    investing because it takes advantage of the noise in stock prices rather than
                    value premiums. Researchers have already shown, however, that noise in stock
                    prices can serve as the rationale for value investing.Proponents of fundamental indexation assert that fundamental weights can be
                    unbiased estimators of the unobservable fair value weights, with
                    “errors” that are statistically independent of market values.
                    Referring to this assertion as the “independence assumption,” I
                    demonstrate that it is internally inconsistent. The so-called errors are
                    actually restatements of the fair value multiples of the stocks
                    in question. (The fair value multiple is the ratio of the unobservable fair
                    value of a stock to some observed measure of the stock’s fundamental
                    value.) For example, if the fundamental weights are based on earnings, the
                    “errors” in the fundamental weights are restatements of the fair
                    P/Es of the stocks.A stock’s fair value multiple, by definition, reflects investors’
                    assessments of the stock’s risk and future growth prospects. Ideally,
                    such factors should be fully taken into account in portfolio construction.
                    Because they are unobservable, however, they must be either taken into account
                    through proxies or ignored. Market-cap weighting takes risk and expected growth
                    into account by using the market values of stocks as proxies for their
                    unobservable fair values. If market prices contain noise, market-cap weights
                    contain errors. Fundamental-weighting schemes introduce weighting errors of a
                    different type by ignoring risk and expected growth. The superior weighting
                    scheme is the one with the less egregious type of error.In this article, I demonstrate that, except in trivial cases, fundamental weights
                    cannot be unbiased estimators of fair value weights with errors that are
                    statistically independent of market values because the sources of those errors,
                    risk and expected growth, are also determinants of market values. I carry out
                    this demonstration formally by showing that the errors are restatements of fair
                    value multiples and that fair value multiples are correlated with market values
                    unless all stocks have the same fair value multiple.I also show under what conditions fundamental weights are better than market
                    value weights as estimators of fair value weights and under what conditions they
                    are worse. Specifically, in order for fundamental weighting to be superior to
                    market value weighting, the valuation errors that the market makes must be more
                    variable across stocks than the variability of fair value multiples. Conversely,
                    if the market’s value errors across stocks are less variable than fair
                    value multiples, weighting by market value will be superior to weighting by
                    fundamental value. Thus, the case for fundamental indexation is a conjecture
                    about unobservable variables rather than a theory.I next show in a precise fashion that fundamental weighting is inherently value
                    biased by developing a formula for the bias. According to this formula, the
                    yield on a fundamentally weighted index exceeds the yield on a
                    market-value-weighted index of the same stocks by the ratio of the variance of
                    yield across the stocks in the index to the yield on the market-weighted
                    index.Finally, I discuss two approaches to combining fundamental data and market value
                    data to form weights that yield better portfolios than could be obtained by
                    using only one or the other.Note: Morningstar develops and licenses equity indices; it
                        may use commercially some of the methods discussed in this article.
Journal: Financial Analysts Journal
Pages: 32-39
Issue: 1
Volume: 64
Year: 2008
Month: 1
X-DOI: 10.2469/faj.v64.n1.5
File-URL: http://hdl.handle.net/10.2469/faj.v64.n1.5
File-Format: text/html
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Author-Name: Jason S. Scott
Author-X-Name-First: Jason S.
Author-X-Name-Last: Scott
Title: The Longevity Annuity: An Annuity for Everyone?
Abstract: 
 As of 2005, U.S. individuals had an estimated $7.4 trillion invested in IRAs and
                    employer-sponsored retirement accounts. Many retirees will thus face the
                    difficult problem of turning a pool of assets into a stream of retirement
                    income. Purchasing an immediate annuity is a common recommendation for retirees
                    trying to maximize retirement spending. The vast majority of retirees, however,
                    are unwilling to annuitize all their assets. This research demonstrates that a
                    “longevity annuity,” which is distinct from an immediate annuity in
                    that payouts begin late in retirement, is optimal for retirees unwilling to
                    fully annuitize. For a typical retiree, allocating 10–15 percent of wealth
                    to a longevity annuity creates spending benefits comparable to an allocation to
                    an immediate annuity of 60 percent or more.As of 2005, Americans had an estimated $7.4 trillion invested in IRAs and
                    employer-sponsored retirement accounts. Many retirees will face the difficult
                    problem of turning a pool of assets from these accounts into a stream of
                    retirement income. Purchasing an immediate annuity is a common recommendation,
                    from academics and practitioners, for retirees who are trying to maximize
                    retirement spending. The vast majority of retirees, however, are unwilling to
                    annuitize all of their assets. Yet, many retirees may be willing to annuitize a
                    portion of their assets if the benefit is sufficiently large. In this article, I
                    extend the theory by answering a key question in that case: Which annuity should
                    I buy with only a fraction of my assets? Specifically, I demonstrate that a new
                    type of annuity, a longevity annuity, is optimal for retirees unwilling to fully
                    annuitize.Longevity annuities are essentially immediate annuity contracts without the
                    initial payouts. That is, a longevity annuity involves an up-front premium with
                    payouts that begin in the future. For example, an age-85
                    longevity annuity can be purchased at age 65 with payouts commencing only when
                    and if the purchaser reaches age 85.To motivate the desirability of longevity annuities, this paper begins with a
                    fundamental question: What makes insurance valuable? Insurance is generally
                    valuable because it lowers the cost of risk management. But not all insurance is
                    created equal. Some insurance contracts are better able to lower the cost of
                    risk management than others. The desirability of any given insurance contract
                    depends critically on the likelihood of an insurance payout. For low-probability
                    events, an insurance company can pool the risk across policyholders and offer a
                    substantial discount to each policyholder relative to the cost of
                    self-insurance. For high-probability events, the discount relative to
                    self-insurance is substantially smaller.Longevity insurance follows these same basic insurance principles. For a
                    65-year-old retiree, little risk-pooling benefit is to be gained by insuring
                    age-66 income. Because the majority of age-65 individuals live to age 66,
                    insurance can provide only a small benefit relative to self-insurance for this
                    income payment. Living to age 100, however, is a low-probability event, thus
                    insurance can substantially reduce the cost of providing income at age 100. By
                    focusing on later, high-value insurance payments, a longevity annuity can
                    deliver much larger spending benefits per premium dollar than immediate
                    annuities can deliver. For a typical retiree, allocating 10–20 percent of
                    wealth to a longevity annuity increases guaranteed spending in retirement by
                    20–30 percent relative to self-insurance. If an immediate annuity were
                    used instead, a comparable spending boost would require an allocation of 60
                    percent or more.Note: The views expressed herein are those of the author and
                        not necessarily those of Financial Engines.
Journal: Financial Analysts Journal
Pages: 40-48
Issue: 1
Volume: 64
Year: 2008
Month: 1
X-DOI: 10.2469/faj.v64.n1.6
File-URL: http://hdl.handle.net/10.2469/faj.v64.n1.6
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Author-Name: Pornsit Jiraporn
Author-X-Name-First: Pornsit
Author-X-Name-Last: Jiraporn
Author-Name: Yixin Liu
Author-X-Name-First: Yixin
Author-X-Name-Last: Liu
Title: Capital Structure, Staggered Boards, and Firm Value
Abstract: 
 Grounded in agency theory, this study investigates whether staggered boards (in
                    which only a portion of directors are elected at one time) influence capital
                    structure choices. Leverage has been argued and shown to alleviate agency costs.
                    Because staggered boards can entrench inefficient managers, they may motivate
                    managers to adopt a lower level of debt, thereby avoiding the disciplinary
                    mechanisms associated with leverage. The empirical evidence supports this
                    hypothesis, showing that firms with a staggered board are significantly less
                    leveraged than those with unitary boards (in which all board members are elected
                    at one time). The impact of staggered boards on capital structure choices exists
                    both in industrial and regulated firms although it seems to vanish after
                    enactment of the Sarbanes–Oxley Act of 2002. The results show that
                    staggered boards are likely to bring about, and do not merely reflect, lower
                    leverage. Finally, the results demonstrate no significant adverse impact on firm
                    value as a result of excess leverage.Motivated by agency theory, we examine whether staggered boards (in which only a
                    portion of directors are elected at one time) influence capital structure
                    choices. Leverage has been argued and shown to alleviate agency costs. Because
                    staggered boards can entrench inefficient managers, they may motivate managers
                    to adopt a lower level of debt, thereby avoiding the disciplinary mechanisms
                    associated with leverage. The empirical evidence supports this hypothesis; it
                    shows that firms with a staggered board are significantly less leveraged than
                    those with a unitary board (in which all board members are elected at one
                    time).The evidence is robust even after controlling for a large number of firm
                    characteristics. In addition, we controlled for the other provisions in the
                    Governance Index. The impact of staggered boards is several times larger than
                    the effect of the other governance provisions combined. Our results offer an
                    interesting contrast to those in other studies of the Governance Index. This
                    index, which measures the strength of shareholder rights and includes staggered
                    boards as 1 of 24 elements, awards points for elements not in
                    the interest of shareholders. Other studies have found the index to be
                    positively associated with leverage. We found in this study, however, that
                    staggered boards are associated with lower leverage. Our results are consistent
                    with studies reporting that the effect of staggered boards on firm value is many
                    times larger than the effect of the other Governance Index provisions put
                    together.We also found that the impact of staggered boards on capital structure choices
                    exists both in industrial and regulated firms, although it seems to vanish after
                    the enactment of the Sarbanes–Oxley Act of 2002.Cognizant of possible endogeneity, we tested for causality and found that
                    staggered boards are likely to bring about, not merely reflect, lower
                    leverage.Finally, we explored whether firm value is affected by abnormal leverage that can
                    be attributed to the presence of staggered boards. The results demonstrate no
                    significant adverse impact on firm value because of excess leverage.
Journal: Financial Analysts Journal
Pages: 49-60
Issue: 1
Volume: 64
Year: 2008
Month: 1
X-DOI: 10.2469/faj.v64.n1.7
File-URL: http://hdl.handle.net/10.2469/faj.v64.n1.7
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Author-Name: Philippe Jorion
Author-X-Name-First: Philippe
Author-X-Name-Last: Jorion
Title: Risk Management for Event-Driven Funds
Abstract: 
 Many portfolio strategies are “event driven” (i.e., designed to
                    benefit from price movements caused by corporate events, such as a merger).
                    These strategies involve payoffs with discontinuous and skewed distributions
                    that conventional risk methods do not measure well. This article develops
                    methods to measure the forward-looking risk, based on current positions, of
                    portfolios exposed to such discrete events. The method is applied to independent
                    events and to the more realistic case of events that are not independent. For
                    mergers and acquisitions, empirical estimates of deal-break correlations are
                    positive but low, which implies that most of this event risk is idiosyncratic
                    and diversifiable. The methodology allows assessment of the risk and return of
                    various portfolio structures for event-driven funds.Many portfolio strategies are “event driven” (i.e., are intended to
                    benefit from price movements caused by such corporate events as restructurings,
                    bankruptcies, mergers, acquisitions, or other special situations). Such trading
                    strategies involve payoffs that have discontinuous distributions: Either the
                    event happens or not, which is a binary distribution. In a merger and
                    acquisition (M&A) deal, for example, the price of the target may move up to
                    the offer price if the deal succeeds or may drop sharply otherwise. Such
                    distributions pose a particular challenge to risk management because of their
                    discontinuous nature and the asymmetry of their payoffs. I develop new methods
                    to measure the forward-looking risk, based on current positions, of portfolios
                    exposed to such discrete events.Risk measures for event-driven funds cannot rely on traditional risk models. Such
                    models do not take into account the uncertainty generated by the currently
                    unfolding events; in addition, the history of price movements is not directly
                    relevant for measuring risk. Nevertheless, I show that it is perfectly feasible
                    to construct a forward-looking distribution of portfolio profits and losses
                    based on current positions and to summarize the distribution with the usual
                    value-at-risk measure. To do so, the portfolio manager needs to estimate the
                    probability of success for each deal, the payoffs from success and failure, and
                    the joint correlations across deals.Constructing this distribution reveals a number of interesting insights. For
                    instance, the distribution quantile at a high confidence level measures the
                    “economic capital” required to support the portfolio. It, in turn,
                    defines how much leverage is possible and the expected return on capital.When events are independent, the portfolio return follows a binomial
                    distribution, which is analytically tractable. In this case, the spread of the
                    distribution decreases quickly with the number of deals. Indeed, the economic
                    capital required to support a portfolio of 30 independent deals is six times
                    lower than that required for a single-deal portfolio. Thus, this diversified
                    portfolio could be levered six times more than a single-deal position and still
                    maintain the same level of risk while delivering a higher return on capital.In practice, dependencies exist among events. I present empirical estimates of
                    break probabilities and correlations for a large sample of North American
                    M&A deals over the period 1997 through 2006. The deal-break correlation is
                    estimated to be 0.03, which is positive and significantly so. This correlation
                    can be induced by a dependence on market returns. Indeed, the break probability
                    increases when the stock market falls.With nonzero correlations, the portfolio return distribution can be constructed
                    from the binomial expansion technique or from Monte Carlo simulations. The tails
                    of the distributions are shown to be sensitive to the correlation parameter and,
                    although less so, to the break probability. Positive correlations increase the
                    required economic capital, sometimes substantially. Even so, with a correlation
                    of 0.03, a portfolio of 100 deals can be leveraged three times and still have a
                    level of risk similar to that of a 10-deal portfolio with no leverage. Thus,
                    diversifying among deals reduces risk sharply.Armed with these risk measurement tools, the portfolio manager should search for
                    deals that are profitable yet not too correlated with each other.Note: Pacific Alternative Asset Management Company is a
                        fund-of-hedge-funds investment firm offering strategic alternative
                        investment solutions.
Journal: Financial Analysts Journal
Pages: 61-73
Issue: 1
Volume: 64
Year: 2008
Month: 1
X-DOI: 10.2469/faj.v64.n1.8
File-URL: http://hdl.handle.net/10.2469/faj.v64.n1.8
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Author-Name: Lawrence Morgan
Author-X-Name-First: Lawrence
Author-X-Name-Last: Morgan
Title: Combination Hedges Applied to U.S. Markets
Abstract: 
 Financial futures hedges typically use one futures market (e.g., a 10-year-note
                    futures to hedge a position in 10-year U.S. Treasury securities). This article
                    reports tests of combination hedges composed of 10-year-note futures and
                    long-bond futures to hedge 10-year Treasuries and compares combination hedges
                    with the standard one-market hedge. The study applies to the U.S. market an
                    approach developed and tested successfully for the German bond market.
                    Combination hedges are generally found to be superior. Of three methods examined
                    for determining hedge ratios—using yields, option-adjusted modified
                    durations, or non-option-adjusted modified durations—combination hedge
                    ratios derived from option-adjusted modified durations performed best.Futures market practitioners have developed a wide variety of techniques for
                    hedging price and interest rate risk. Typically, the hedge ratios involved are
                    based on the use of one futures instrument. Because the cheapest-to-deliver
                    (CTD) instrument for the futures contract is usually not the issue one hopes to
                    hedge, an inherent mismatch of maturities and durations occurs. This article
                    looks at combination hedges as a solution to the problem. Combination hedges use
                    more than one contract to simulate the duration of the target instrument being
                    hedged. Broadly, the results of the study show that combination hedges are more
                    precise than single-contract hedges.This analysis is based on original work by Heiko Leschhorn reported in the
                        Financial Analysts Journal in 2001 that derived combination
                    hedge ratios based on the relationship between the yields and maturities of the
                    target instrument to be hedged and those of the CTD instruments of the futures
                    contracts used in the combination hedge and then applied the combinations
                    successfully to the German bond market. The current article extends that work to
                    the U.S. Treasury securities market.The futures contracts were chosen so that their maturities or durations bracketed
                    the maturity or duration of the target U.S. Treasury note. In all cases, the
                    hedge ratios of the two combination futures contracts were derived from two
                    things—(1) the ratio of the dollar values of 1 bp of the target instrument
                    and the futures contract and (2) weights that depended on the position of the
                    yield or duration of the target instrument relative to those of the hedge
                    vehicles. For instance, if the duration of the target was two-thirds of the way
                    between the shorter-duration and longer-duration contracts, the longer-duration
                    contract—the one closer to that of the target—would have a larger
                    weight than the shorter-duration contract. The article contains formulas for
                    calculating these weights and hedge ratios.The article reports tests of the efficacy of combination hedges compared with
                    that of single-contract hedges. The hedge target was always the current 10-year
                    U.S. Treasury note (T-note). Single-contract hedges were the 10-year-note,
                    5-year-note, and long-bond futures contracts. Combination hedges combined
                    10-year-note and long-bond futures. Notionally, this combination was a long
                    position in the 10-year T-note and short positions in futures markets to hedge
                    its value.The study covered 27 periods in 1998–2005, each three months long, from one
                    futures delivery month to the next. I describe the results of three tests.
                    First, I report the mean absolute value of the changes in the value of the total
                    hedged position (that is, the long cash and short futures positions together);
                    the smaller the mean absolute value, the more precise and successful the hedge.
                    Second, I report standard deviation of the total value of the hedged position;
                    again, the smaller the standard deviation, the better the hedge. Third, I
                    provide rank scores for the various hedges for each period; in this test, the
                    best hedge in a given period was assigned a rank of 1, the next best received a
                    rank of 2, and so on through 12 hedging strategies; the smaller the sum of the
                    ranks for all periods for a given strategy, the better the strategy.Generally, combination hedges outperformed single-contract hedges as measured by
                    all three tests, although results were not absolutely consistent. Also, among
                    the three methods for constructing combinations, using option-adjusted
                    futures’ modified durations tended to be most attractive.In addition, I examined whether there was any relationship between the success of
                    the strategies and market conditions (direction of yield movements and changes
                    in yield curves), but I found no clear correspondence.I conclude that hedgers can expect moderately more effective hedges by using
                    combinations rather than single contracts.
Journal: Financial Analysts Journal
Pages: 74-84
Issue: 1
Volume: 64
Year: 2008
Month: 1
X-DOI: 10.2469/faj.v64.n1.9
File-URL: http://hdl.handle.net/10.2469/faj.v64.n1.9
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: The Herd Follows the Leader
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.1
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.1
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Author-Name: Ludovic Phalippou
Author-X-Name-First: Ludovic
Author-X-Name-Last: Phalippou
Title: Where Is the Value Premium?
Abstract: 
 The value premium is driven by 7 percent of the stock market. The 93 percent of
                    market capitalization held most by institutional investors is value premium
                    free. In contrast, in stocks held most by individual investors, the value
                    premium, even when the stocks are value weighted, reaches a staggering 185 bps
                    per month. In addition, the value premium is a long-side anomaly. It is a value
                    premium puzzle, not a growth discount puzzle.The premise of this article is that if the value premium is a result of both
                    pricing errors and limited arbitrage, then the value premium should be
                    concentrated in stocks that are both held by relatively less sophisticated
                    investors and expensive to arbitrage. Such a concentration is suggested in the
                    literature but has not been quantified. In this article, I show that, indeed, at
                    least 93 percent of market capitalization is free of a value premium.Using institutional ownership (IO) as a parsimonious way to classify stocks by
                    their mispricing likelihood, I show that the value premium monotonically
                    decreases from a high 185 bps for low-IO stocks to a negligible 13 bps for
                    high-IO stocks. This result also holds when returns are value weighted and,
                    importantly, is driven mainly by the long side. Low-IO value stocks are those
                    with the most abnormal returns. The anomaly is a value premium, not a growth
                    discount, as is sometimes argued. Another way to express this important point is that over the last 20 years (on an
                    equally weighted basis), only 15 percent of the value premium came from the
                    short side. Even if one could not short growth stocks, one could short the
                    S&P 500 Index and be long on value stocks, which would have generated 85
                    percent of the unconstrained value premium.The extreme concentration of the value premium has important practical
                    implications. First, arbitrageurs can expect to face substantial costs when
                    trying to arbitrage the value premium, and those focusing on the stocks most
                    held by institutional investors (the larger, more liquid stocks) will have
                    difficulties generating arbitrage profits. The value premium concentrates where
                    arbitrageurs usually do not go. This reason is also why studies have found that
                    value and growth mutual funds perform the same. Second, studies that select a
                    subsample of stocks that, for instance, either have at least two to five
                    analysts following the stocks or are traded on the NYSE end up with a sample
                    that is almost free of the value anomaly. Such a fact is important to bear in
                    mind when interpreting the results found in such samples.
Journal: Financial Analysts Journal
Pages: 41-48
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.10
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.10
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Author-Name: John J. McConnell
Author-X-Name-First: John J.
Author-X-Name-Last: McConnell
Author-Name: Wei Xu
Author-X-Name-First: Wei
Author-X-Name-Last: Xu
Title: Equity Returns at the Turn of the Month
Abstract: 
 The turn-of-the-month effect in U.S. equities is found to be so powerful in the
                    1926–2005 period that, on average, investors received no reward for
                    bearing market risk except at turns of the month. The effect is not confined to
                    small-capitalization or low-price stocks, to calendar year-ends or quarter-ends,
                    or to the United States: This study finds that it occurs in 31 of the 35
                    countries examined. Furthermore, it is not caused by month-end buying pressure
                    as measured by trading volume or net flows to equity funds. This persistent
                    peculiarity in returns remains a puzzle in search of an answer.See comments and response on this article.Using the DJIA and the S&P 500 Index, prior studies have reported a
                    turn-of-the-month effect in equity returns so prominent that equity returns, on
                    average, are significantly higher at the four-day turn of the month than over
                    other days. We examine this effect in detail. Using CRSP daily returns for the 80-year period of 1926–2005, we found the
                    average daily value-weighted (equal-weighted) U.S. equity market return over the
                    four-day turn of the month to be 0.15 percent (0.22 percent). In comparison, the
                    average daily value-weighted (equal-weighted) market return over the other 16
                    trading days of the month was found to be –0.001 percent (0.04 percent).
                    This pattern is present in various subperiods, including the two most recent
                    decades. Furthermore, this pattern is not confined to small-capitalization or low-price
                    stocks; it is not confined to calendar quarter-ends or year-ends; it is not the
                    result of higher risk at the turn of the month as measured by standard deviation
                    of returns; and it is not confined to the United States—it occurs in 31 of
                    the 35 countries that we examined. We also examined the proposal that the pattern is the result of a
                    “regularity in payment dates” in which the flow of funds into the
                    market at turns of the month push up stock prices. We found no evidence,
                    however, that trading volume or net flows to equity mutual funds are higher at
                    turns of the month than over other days. In the end, we concluded that the turn-of-the-month pattern in equity returns
                    remains a puzzle in search of an answer.
Journal: Financial Analysts Journal
Pages: 49-64
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.11
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.11
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:64:y:2008:i:2:p:49-64




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Author-Name: M. Barton Waring
Author-X-Name-First: M. Barton
Author-X-Name-Last: Waring
Author-Name: Sunder R. Ramkumar
Author-X-Name-First: Sunder R.
Author-X-Name-Last: Ramkumar
Title: Forecasting Fund Manager Alphas: The Impossible Just Takes Longer
Abstract: 
 Expected alpha from active fund managers can be forecasted—as long as one
                    is mindful of the rules of the zero-sum game of investing. Explicit forecasts
                    are preferred over implicit forecasts because sponsors can use explicit
                    forecasts to build optimized portfolios of managers with improved manager
                    weighting. To make explicit alpha forecasts, the investor combines two equations
                    derived from the fundamental law of active management. The elemental variables
                    for the equations are the sponsor’s estimate of the manager’s
                    “goodness” at beating the manager’s benchmark, the
                    sponsor’s assessment of the sponsor’s skill in estimating manager
                    ability, the cross-sectional standard deviation of manager skill, portfolio
                    breadth, implementation efficiency, expected active risk of the portfolio, and
                    fees. Most plan sponsors (by which, we also mean foundations, endowments, individual
                    investors, and anyone else facing the task of evaluating professional investment
                    fund managers) chafe at and resist as undoable the suggestion that they should
                    make explicit alpha forecasts for the active fund managers they hire or consider
                    hiring. But fund manager alphas can and should be
                    forecasted.The game of active management is difficult to win. The zero-sum nature of the
                    game makes winning impossible for most fund managers and plan sponsors. Not
                    everyone can be above average. To win this zero-sum (negative-sum after fees and
                    costs) game, a fund manager must have exceptional skill. And if one is a sponsor
                    considering hiring active fund managers, winning is even more difficult: To
                    justify hiring active managers at all, a sponsor must also have a special
                    skill—a skill for identifying the skillful active managers. So, two kinds
                    of skill are necessary if active management is to be successful for a
                    sponsor—one set of skills at the manager level and one at the sponsor
                    level.Both sponsor skill and fund manager skill can be estimated, quantified, and
                    incorporated into an explicit alpha forecast by using the framework developed in
                    this article. By combining equations for the fundamental law of active
                    management and a new version of the forecasting equation, one can derive a
                    formula for building an alpha forecast out of elemental parts. The formula
                    contains seven variables to be estimated:the sponsor’s forecast of the manager’s
                            “goodness” at beating the manager’s benchmark,
                            expressed as a z-score;the sponsor’s self-assessment of its own ability to select good
                            managers, expressed as an information coefficient for the sponsor;the cross-sectional standard deviation of information coefficients for
                            the manager population (this variable cannot be observed directly, but a
                            reasonable value for it can be inferred);the breadth of the portfolio, where breadth is the number of
                                independent active management decisions made per
                            year by the portfolio manager;the transfer coefficient, or implementation efficiency, of the portfolio,
                            which accounts for the performance drag from constraints (principally
                            the no-shorting constraint);the expected active risk of the portfolio; andfees.The first two variables are difficult to estimate because they involve forming
                    (and then perhaps defending) a belief that one can beat the market. Investors
                    who deeply understand the difficulty involved in beating the market are likely
                    to be reluctant to make forecasts of these two variables; yet, these investors
                    are, paradoxically, the best placed to try to make these forecasts. And the fact
                    is that investors cannot approach the task with an expectation of success if
                    they do not think they have the skill to win.Alpha forecasts made by using this approach will be properly adjusted for
                    differences in risk, differences in fees, and other differences, so the various
                    funds will have alpha estimates that bear reasonable relationships to one
                    another in light of such differences. Ultimately, however, the estimates will be
                    only as good as the sponsor’s estimate of its own skill—which is as
                    it should be.Investors should be encouraged to use the method described in the article for
                    explicit alpha forecasting because it brings discipline and structure to the
                    process of building portfolios of managers and because the forecasts are
                    required for optimizing the structure of the portfolio of managers. An optimized
                    structure gives the most weight to managers who have the highest alphas and the
                    lowest risks, a result that almost never happens by using intuition alone. 
Journal: Financial Analysts Journal
Pages: 65-80
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.12
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.12
File-Format: text/html
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Author-Name: Jose Menchero
Author-X-Name-First: Jose
Author-X-Name-Last: Menchero
Author-Name: Vijay Poduri
Author-X-Name-First: Vijay
Author-X-Name-Last: Poduri
Title: Custom Factor Attribution
Abstract: 
 Portfolio analysts often use one set of decision variables for attributing
                    portfolio returns and a different set for attributing risk. This practice
                    obscures the relationship between the sources of risk and return. This article
                    demonstrates how to align the attribution model with the investment process. The
                    attribution methodology can be applied ex ante or ex
                        post. A factor-based investment process illustrates the general
                    framework. Specifically, active return, tracking error, and the information
                    ratio are attributed to a user-defined set of factors that reflect the
                    manager’s investment decision-making process. A concrete example with
                    actual market data, a style portfolio, and a parsimonious set of custom factors
                    illustrates how to apply the analysis.Portfolio analysts often use one set of decision variables for attributing
                    portfolio returns and an entirely different set for attributing risk. For
                    instance, active return is often decomposed into allocation and selection
                    effects by using a sector-based model whereas tracking error is usually
                    attributed to a set of factors within a fundamental risk model. Unfortunately,
                    this practice obscures the relationship between the sources of portfolio risk
                    and return.In this article, we present a general methodology for aligning the attribution
                    model with the investment process. We begin by decomposing portfolio returns
                    into a set of attribution effects that reflects the investment process. We then
                    show how portfolio risk can be attributed to the same underlying decision
                    variables. The final step in our framework is to combine the return and risk
                    attribution analyses to obtain a decomposition of the risk-adjusted performance,
                    or information ratio. We show that the portfolio information ratio can be
                    expressed as a weighted average of component information ratios. The relevant
                    weights are not the investment weights, however, but the risk weights. The
                    component information ratios are simply the stand-alone information ratios of
                    the attribution effects magnified by the reciprocal of the correlation between
                    the attribution effect and the active return. This “magnification
                    effect” reflects the benefit of diversification. Our attribution
                    framework can be applied on an ex ante or an ex
                        post basis.To illustrate our general framework, we consider an investment process based on a
                    set of custom factors that do not directly correspond to the factors in the risk
                    model. A major challenge is to cleanly attribute returns to the investment
                    factors without the confounding effects (because of colinearity) of the risk
                    factors. One approach is simply to suppress the risk factors. This method has
                    the benefit of cleanly attributing the returns to the custom factors, but it has
                    the disadvantage of not accounting for all of the factor risk, which can be
                    fully explained only by the risk factors. Our solution to this problem is to
                    include the risk factors in the analysis—but only after orthogonalizing
                    them to the custom factors. In this approach, because the
                    “residual” factors are orthogonal to the custom factors, the return
                    and risk attributable to the custom factors can be cleanly explained.
                    Furthermore, all of the factor risk not explained by the custom factors will now
                    be captured by the residual factors.We use a concrete example with actual market data to illustrate how to apply our
                    analysis in practice. We use well-known indices to construct an active portfolio
                    with strong tilts to value and size. We then attribute the portfolio return,
                    risk, and information ratio to the Fama–French factors.
Journal: Financial Analysts Journal
Pages: 81-92
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.13
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.13
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issue.
Journal: Financial Analysts Journal
Pages: 96-96
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.16
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.16
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: Fundamental Disagreement
Abstract: 
 This material refers to the Letters to the Editor commenting on “Fundamental Indexation,” “Why Market-Valuation-Indifferent Indexing Works,” “Fundamentally Flawed Indexing,” and “Why Fundamental Indexation Might—or Might Not—Work.”
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.2
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.2
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Author-Name: Harry M. Markowitz
Author-X-Name-First: Harry M.
Author-X-Name-Last: Markowitz
Title: “Fundamentally Flawed Indexing”: Comments
Abstract: 
 This material comments on “Fundamentally Flawed Indexing.”
Journal: Financial Analysts Journal
Pages: 12-14
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.3
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.3
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Author-Name: Jack Treynor
Author-X-Name-First: Jack
Author-X-Name-Last: Treynor
Title: “Fundamentally Flawed Indexing”: Comments
Abstract: 
 This material comments on “Fundamentally Flawed Indexing.”
Journal: Financial Analysts Journal
Pages: 14-14
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.4
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.4
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Author-Name: André F. Perold
Author-X-Name-First: André F.
Author-X-Name-Last: Perold
Title: “Fundamentally Flawed Indexing”: Author Response
Abstract: 
 This material comments on “Fundamentally Flawed Indexing.”
Journal: Financial Analysts Journal
Pages: 14-17
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.5
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.5
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Author-Name: Jason C. Hsu
Author-X-Name-First: Jason C.
Author-X-Name-Last: Hsu
Title: “Why Fundamental Indexation Might—or Might Not—Work”: A Comment
Abstract: 
 This material comments on “Why Fundamental Indexation Might—or Might Not—Work.”
Journal: Financial Analysts Journal
Pages: 17-18
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.6
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.6
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Author-Name: Paul D. Kaplan
Author-X-Name-First: Paul D.
Author-X-Name-Last: Kaplan
Title: “Why Fundamental Indexation Might—or Might Not—Work”: Author Response
Abstract: 
 This material comments on “Why Fundamental Indexation Might—or Might Not—Work.”
Journal: Financial Analysts Journal
Pages: 18-18
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.7
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.7
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Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Author-Name: Kenneth L. Fisher
Author-X-Name-First: Kenneth L.
Author-X-Name-Last: Fisher
Author-Name: Deniz Anginer
Author-X-Name-First: Deniz
Author-X-Name-Last: Anginer
Title: Affect in a Behavioral Asset-Pricing Model
Abstract: 
  Stocks, like houses, cars, watches, and other products, exude
                    “affect”—that is, they are considered good or bad, beautiful
                    or ugly; they are admired or disliked. Affect plays an overt role in the pricing
                    of houses, cars, and watches, but according to standard financial theory, it
                    plays no role in the pricing of financial assets. This article outlines a
                    behavioral asset-pricing model in which expected returns are high not only when
                        objective risk is high but also when
                        subjective risk is high. High subjective risk comes with
                    negative affect. Investors prefer stocks with positive affect, which boosts the
                    prices of such stocks and depresses their returns.Stocks, like houses, cars, watches, and other products, exude
                    “affect.” Affect is the feeling of good or bad, beautiful or ugly,
                    admired or disliked, and it occurs rapidly and automatically, often without
                    consciousness. Affect plays a role in the pricing models of houses, cars, and
                    watches but, according to standard financial theory, plays no role in the
                    pricing of financial assets.In this article, we outline a behavioral asset-pricing model in which expected
                    returns are high when objective risk is high and also when
                        subjective risk is high. High subjective risk comes with
                    negative affect. Investors prefer stocks with positive affect, and their
                    preference boosts the prices of such stocks and depresses their subsequent
                    returns.The preferences of investors were gathered from surveys conducted by
                        Fortune magazine in 1983–2006 and in additional
                    surveys we conducted in 2007. From the Fortune data, we found
                    that the returns of admired stocks, those highly rated by the
                        Fortune respondents, were lower than the returns of spurned
                    stocks, those rated low. This finding is consistent with the hypothesis that
                    stocks with negative affect have high subjective risk and their extra returns
                    compensate for that risk. We also found that admired companies have higher
                    market capitalizations but lower book-to-market ratios than spurned companies.
                    This finding is consistent with the hypothesis that size and book value to
                    market value are proxies for affect.We gathered supporting evidence from our own surveys. In these surveys, we
                    presented investors with only the names of companies and their industries and
                    asked them to rate the affect of these companies. The questionnaire said,
                    “Look at the name of the company and its industry and quickly rate the
                    feeling associated with it on a scale ranging from bad to good. Don’t
                    spend time thinking about the rating. Just go with your quick, intuitive
                    feeling.” We found a positive correlation between these affect scores and
                    the companies’ Fortune scores. Moreover, we found that
                    positive affect creates a halo over stocks that results in perceptions that they
                    promise high future returns coupled with low risk.
Journal: Financial Analysts Journal
Pages: 20-29
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.8
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.8
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Author-Name: John C. Bogle
Author-X-Name-First: John C.
Author-X-Name-Last: Bogle
Title: Black Monday and Black Swans
Abstract: 
 Investors need to be aware that rare events with an extreme impact that,
                    afterwards, we think we could have predicted—in short, black
                    swans—happen in the markets. Those who are trying to measure risk in the
                    financial markets need to carefully distinguish risk, with its probabilities,
                    from uncertainty, which cannot be measured. We have become increasingly
                    vulnerable to black swans because our financial economy has come to play an
                    ever-larger role in our productive economy.The 20th anniversary of what came to be known as “Black
                    Monday”—19 October 1987—provides a platform for considering,
                    yet again, the role of risk in the financial markets. On that single day, the
                    Dow Jones Industrial Average dropped from 2,246 to 1,738, an astonishing decline
                    of almost 25 percent that is nearly twice the largest previous daily decline of
                    13 percent (24 October 1929). Black Monday was a black swan.In his book The Black Swan: The Impact of the Highly Improbable,
                    Nassim Nicholas Taleb lists three characteristics of a black swan: rarity (it is
                    an outlier), extremeness (it carries an extreme impact), and retrospective
                    predictability (after it happens, human nature enables us to accept it by
                    concocting explanations that make it seem predictable). Black Monday
                    demonstrates that not only can anything happen in the stock market; anything
                    does happen. In this article, I take advantage of the anniversary of Black Monday to explore
                    risk as a measurable aspect of investing and as an uncertainty that is always
                    with us. We speak of “forecasts” and “probabilities,”
                    but the application of the laws of probability to our financial markets is badly
                    misguided. Black swans do occur. Black swans remind us of uncertainty. What other black swans are lurking beyond
                    the horizon, waiting to become part of financial market history? The fact is
                    that the movements of the stock market exhibit a lot of randomness. So, the
                    knowledge that black swans can and do occur holds important lessons for how we
                    think about risk. Black swans are one reason that many theorists warn us to beware of using past
                    Gaussian stock market return patterns and thinking we have defined the bounds by
                    which we can predict the future. Furthermore, changes in the nature and
                    structure of our equity markets—and a radical shift in the
                    participants—are making shocking and unexpected market aberrations ever
                    more probable. Over the past two centuries, the United States has moved from an
                    agricultural economy to a manufacturing economy, to a service economy, and to a
                    financial economy—and a global one at that. The nation is becoming a
                    country where no business actually makes anything. Our financial intermediaries
                    merely trade pieces of paper, swap stocks and bonds back and forth with one
                    another, and pay the financial croupiers a veritable fortune. Moreover, long before the recent wave of complex financial products, observers
                    noted that the financial system is particularly prone to innovation. Indeed, the
                    value of these financial “products”—stock market futures and
                    options—has overwhelmed the total value of the stock market itself. Now,
                    one of the riskiest of derivatives, credit-default swaps, alone totals $45
                    trillion, an amazing ninefold increase over the last three years. These swaps
                    are five times the size of the U.S. national debt and three times U.S. GDP. We
                    have become increasingly vulnerable to black swans because our financial economy
                    has swamped our productive economy.Note: The opinions expressed in this article do not
                        necessarily represent the views of the Vanguard Group’s present
                        management.
Journal: Financial Analysts Journal
Pages: 30-40
Issue: 2
Volume: 64
Year: 2008
Month: 3
X-DOI: 10.2469/faj.v64.n2.9
File-URL: http://hdl.handle.net/10.2469/faj.v64.n2.9
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Author-Name: Jack L. Treynor
Author-X-Name-First: Jack L.
Author-X-Name-Last: Treynor
Title: “Patents on Intangibles” Continued
Journal: Financial Analysts Journal
Pages: 6-6
Issue: 3
Volume: 64
Year: 2008
Month: 5
X-DOI: 10.2469/faj.v64.n3.1
File-URL: http://hdl.handle.net/10.2469/faj.v64.n3.1
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 3
Volume: 64
Year: 2008
Month: 5
X-DOI: 10.2469/faj.v64.n3.15
File-URL: http://hdl.handle.net/10.2469/faj.v64.n3.15
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Author-Name: Alberto L. Dominguez
Author-X-Name-First: Alberto L.
Author-X-Name-Last: Dominguez
Title: “The Pension Problem: On Demographic Time Bombs and Odious Debt”: A Comment on the Letter from Dean LeBaron, CFA
Abstract: 
 This material comments on “‘The Pension Problem: On Demographic Time Bombs and Odious Debt’: A Comment”.
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 3
Volume: 64
Year: 2008
Month: 5
X-DOI: 10.2469/faj.v64.n3.2
File-URL: http://hdl.handle.net/10.2469/faj.v64.n3.2
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Author-Name: Richard Manley
Author-X-Name-First: Richard
Author-X-Name-Last: Manley
Author-Name: Christian Mueller-Glissmann
Author-X-Name-First: Christian
Author-X-Name-Last: Mueller-Glissmann
Title: The Market for Dividends and Related Investment Strategies (corrected)
Abstract: 
 A market for dividends paid on major equity indices and paid by large companies
                    has developed around the world. This market, in a manner similar to that of the
                    U.S. Treasury strip market, allows investors to invest in future dividend cash
                    flows independent of investing in the equities. Since 2004, dividend swaps have
                    been a major profit contributor for multistrategy and macro hedge funds because
                    market-implied dividends have been trading at high discounts and dividend growth
                    has been strong. This article contains a discussion of current instruments and
                    market dynamics, investment strategies and methods of forecasting dividends, and
                    potential benefits and problems in this market.In Europe, the United States, and Asia, a market has developed for dividends paid
                    on major equity indices and by large companies. This market emerged around 1999
                    as banks and dealers started actively trading dividend risks among one another
                    following increasing volumes in equity derivatives globally. For equity
                    derivatives, especially those with long maturities, the dividend assumption can
                    be crucial for competitive pricing and dividend surprises pose a risk. Between
                    2001 and 2003, because of an excess supply of index dividends, market-implied
                    levels of OTC dividend trades were at deep discounts relative to subsequently
                    realized levels and often implied negative or zero future dividend growth. This
                    discount soon stimulated interest in the market from institutional investors,
                    especially hedge funds, and trading volumes have increased considerably since
                    2004. A Greenwich Associates survey of equity derivatives use in Europe for 2007
                    shows growth in the number of investors trading dividend swaps from 16 percent
                    of the surveyed investors in 2006 to 19 percent in 2007. In the United States,
                    the proportion of users increased from 16 percent in 2006 to 20 percent in
                    2007.The dividend market allows investors to invest in future dividend cash flows
                    independent of stocks; in this way, dividend strips are similar to U.S. Treasury
                    strips. Dividends are traded mainly through swaps. Dividend swaps are OTC
                    derivative contracts that enable investors to take a view on the sum of
                    dividends that will be paid by an underlying stock or equity index in a
                    predetermined period. Dividend markets are liquid for indices with a liquid
                    forward/futures market for the price index, which usually occurs because an
                    index is being used as the underlying asset for derivatives and (retail)
                    structured products. Similarly, single-stock dividend swaps are tradable for
                    stocks with sufficiently liquid forward markets and/or options. Despite rapid development in recent years, the dividend market is relatively
                    young and is dominated by hedge funds; because the dividend market is an
                    immature market with limited participation, mispricings are more likely in it
                    than in a mature market. Investors can profit from mispricings of the dividends
                    for indices or single stocks if they are able to forecast dividends of a company
                    or at an index level with higher accuracy than the market. In addition, a risk
                    premium will be priced into the market-implied levels for dividends with long
                    maturities, which provides a positive carry. Because investors can trade
                    ordinary dividends only for a predetermined period, a company’s
                    propensity to pay dividends—both the timing of cash flows and the choice
                    of alternative payouts, such as share repurchases and special
                    dividends—plays a central role in forming views about likely growth in the
                    dividend market. Since 2004, dividend swaps have been a major profit contributor
                    for multistrategy and macro hedge funds because market-implied dividends have
                    been trading at high discounts and dividend growth has been strong.Equities may be more volatile than justified by dividends. Prices are driven not
                    only by expectations for growth in dividends, earnings, or cash flow until
                    perpetuity but also by the equity market risk premium and many additional
                    factors. Dividend swaps or strips allow investing in single future cash flows
                    with a fixed maturity and payouts linked directly to the income statement. As a
                    result, we think the dividend market provides investment opportunities with
                    attractive risk–return trade-offs for fundamental investors. In addition,
                    a well-functioning dividend market should, as does the credit default swap
                    market, serve as an independent reference market for pricing and trading
                    dividend risks in forwards/futures, options, and structured products.Problems of the market are limited liquidity and the additional complexity of
                    forecasting index dividends resulting from changes in index composition and the
                    rules of various index providers. The dividend decision also introduces
                    principal–agent risks if companies do not have a clear, well-communicated
                    dividend policy or if they deviate from it.As liquidity in dividend swap markets increases, as contracts become increasingly
                    standardized, and as regulation permits long-only managers to incorporate more
                    derivative exposure in their funds, we expect the dividend market to develop
                    further. Market participants should have a strong incentive to forecast
                    dividends proactively and eliminate mispricings, which we suspect may result in
                    banks, hedge funds, and institutional investors dedicating more resources to
                    dividend trading and fundamental research.
Journal: Financial Analysts Journal
Pages: 17-29
Issue: 3
Volume: 64
Year: 2008
Month: 5
X-DOI: 10.2469/faj.v64.n3.4
File-URL: http://hdl.handle.net/10.2469/faj.v64.n3.4
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Author-Name: Kuntara Pukthuanthong-Le
Author-X-Name-First: Kuntara
Author-X-Name-Last: Pukthuanthong-Le
Author-Name: Lee R. Thomas
Author-X-Name-First: Lee R.
Author-X-Name-Last: Thomas
Title: Weak-Form Efficiency in Currency Markets
Abstract: 
 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.Trend following was a successful strategy for the major currencies and their
                    associated cross exchange rates during the 1970s and 1980s and, for certain
                    currencies, during the 1990s. Since 2000, however, trend following in the major
                    currencies has yielded poor results, and the results are broadly similar for the
                    major currencies’ cross exchange rates. Practically speaking, trend
                    trading appear to have been unprofitable in recent years, which supports the
                    assertion that the major currency markets have become weak-form efficient after
                    many years of inefficiency.We do not know why currencies trended in the first place. One hypothesis is that
                    early markets were inefficient simply because inefficiency is a characteristic
                    of immature markets. But we bring additional evidence to bear on this open
                    question. First, cross exchange rates show the same pattern as dollar exchange
                    rates—profits in the early years followed by an erosion of profits in
                    later years—making it unlikely that the dollar exchange rate results are a
                    consequence of chance or implicit data mining of the 1972–2000 period. And
                    the results also fail to support the hypothesis that trending was largely a
                    result of central bank intervention. Second, we find that although trending in major currencies has vanished, newly
                    liquid exchange rates have been very profitable for trend traders in recent
                    years. This finding suggests that trending is a feature of all newly trading
                    currencies, and based on the experience of the major currencies, we would expect
                    these profits to vanish in time.
Journal: Financial Analysts Journal
Pages: 31-52
Issue: 3
Volume: 64
Year: 2008
Month: 5
X-DOI: 10.2469/faj.v64.n3.5
File-URL: http://hdl.handle.net/10.2469/faj.v64.n3.5
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Author-Name: Martin Eling
Author-X-Name-First: Martin
Author-X-Name-Last: Eling
Title: Does the Measure Matter in the Mutual Fund Industry?
Abstract: 
 A frequent comment is that investment funds with a nonnormal return distribution
                    cannot be adequately evaluated by using the classic Sharpe ratio. Research on
                    hedge fund data that compared the Sharpe ratio with other performance measures,
                    however, found virtually identical rank ordering by the various measures. The
                    study reported here analyzed a dataset of 38,954 funds investing in seven asset
                    classes over 1996–2005 and found that the previous result is true not only
                    for hedge funds but also for mutual funds investing in stocks, bonds, real
                    estate, funds of hedge funds, commodity trading advisers, and commodity pool
                    operators. In short, choosing a performance measure is not critical to fund
                    evaluation and the Sharpe ratio is generally adequate.The Sharpe ratio measures the relationship between the risk premium (mean excess
                    returns) and the standard deviation of the returns generated by a portfolio,
                    asset, or fund. Hedge funds and other alternative investments are prone to
                    generating returns that have nonnormal distributions. For this reason, a number
                    of researchers have claimed that these funds cannot be adequately evaluated by
                    using the Sharpe ratio. Consideration of this issue has led to the development
                    of numerous new performance measures, including Omega, the Sortino ratio, the
                    Calmar ratio, and the modified Sharpe ratio, all of which are currently being
                    debated in hedge fund literature. Recent research was carried out to compare these new performance measures with
                    the Sharpe ratio by using return data on 2,763 hedge funds. Despite significant
                    deviations of hedge fund returns from a normal distribution, the Sharpe ratio
                    and the other performance measures resulted in virtually identical rank ordering
                    of the hedge funds. These researchers analyzed only hedge funds, however, and
                    thus did not consider whether this result is also true for funds investing in
                    other asset classes.The aim of the study reported here was to address this issue. Combining two large
                    data sets, I analyzed the rankings generated by various performance measures for
                    38,954 investment funds for the 1996–2005 period. This empirical study
                    investigated 11 performance measures: the Sharpe ratio, Omega, the Sortino
                    ratio, Kappa 3, the upside potential ratio, the Calmar ratio, the Sterling
                    ratio, the Burke ratio, the excess return on value at risk, the conditional
                    Sharpe ratio, and the modified Sharpe ratio. I found that the earlier research
                    result is robust in regard to a large number of asset classes, including stocks,
                    bonds, real estate, hedge funds, funds of hedge funds, commodity trading
                    advisers, and commodity pool operators. This finding has serious implications for performance measurement in the
                    investment industry. From a practical point of view, the Sharpe ratio is
                    adequate for analyzing hedge funds and mutual funds. This finding is in accord
                    with other research findings that, despite some undesirable features, the Sharpe
                    ratio is adequate for analyzing performance throughout the investment
                    industry.
Journal: Financial Analysts Journal
Pages: 54-66
Issue: 3
Volume: 64
Year: 2008
Month: 5
X-DOI: 10.2469/faj.v64.n3.6
File-URL: http://hdl.handle.net/10.2469/faj.v64.n3.6
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Handle: RePEc:taf:ufajxx:v:64:y:2008:i:3:p:54-66




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Author-Name: Joshua Livnat
Author-X-Name-First: Joshua
Author-X-Name-Last: Livnat
Author-Name: Germán López-Espinosa
Author-X-Name-First: Germán
Author-X-Name-Last: López-Espinosa
Title: Quarterly Accruals or Cash Flows in Portfolio Construction?
Abstract: 
 Using quarterly and rolling four-quarter data, this study explores the
                    incremental roles of accruals and net operating cash flows in generating
                    abnormal returns for the full population of U.S. listed companies and specific
                    industries. Quarterly net operating cash flow (OCF) is a stronger signal of the
                    next quarter’s returns than are accruals. When rolling four-quarter OCF
                    and accruals were used to construct portfolios held for a whole year, however,
                    OCF dominated accruals only in the first three fiscal quarters. The
                    industry-specific results are consistent with the results for the full
                    population. For most industries, investment managers and financial analysts
                    should focus on OCF more than on accruals.The accruals anomaly, in which a portfolio consisting of long (short) positions
                    in stocks with the lowest (highest) accruals earns average abnormal annual
                    returns of about 10 percentage points, has received considerable attention by
                    academics and practitioners in the past decade. This anomaly may be attributable
                    to the market’s failure to correctly evaluate the quality of earnings by
                    ignoring the information embedded in the breakdown of earnings into net
                    operating cash flows and accruals.Professional investors and analysts may be using either accruals or net operating
                    cash flows in their investment decisions or when they forecast future earnings.
                    Which of the two will yield higher future returns is ultimately an empirical
                    question—with meaningful implications for practitioners. The academic
                    literature on this topic is sparse, relates only to annual
                    accruals and cash flows, and is inconclusive. We address this empirical question
                    in this article.In this study, we extend this literature by exploring two questions:Are quarterly accruals associated with future abnormal returns after the
                            information in net operating cash flows has been controlled for?Is the accruals anomaly stronger in certain industries, and as a related
                            question, do net operating cash flows overshadow accruals as a signal
                            for portfolio selection in some industries?In our study, we analyzed U.S. stocks on a quarterly basis for the
                    1993–2006 period. Our results show that quarterly net operating cash flow
                    (OCF) is a stronger signal than accrual information of subsequent
                    quarters’ returns. We found that this result is also true for rolling
                    four-quarter OCF and accrual data. When these data were used to construct
                    portfolios that were held for a whole year (as in most of the accruals
                    literature), OCF dominated accruals in the first three fiscal quarters but not
                    in the fourth quarter. Thus, this study shows the importance of using quarterly
                    data to analyze signals based on accruals and OCF.Our analysis of the signals in specific industries showed that rolling
                    four-quarter accruals were significantly and negatively associated with returns
                    over the subsequent year in 5 of the 17 industries analyzed but that OCF was
                    significantly and positively related to future returns in all but 1 industry.
                    When the industry analysis was carried out with both signals used, OCF remained
                    incrementally significant in 13 of 17 industries whereas accruals were
                    incrementally significant in only 5 industries (and even in those cases, the
                    sign was positive instead of the negative sign shown for the full population).
                    Thus, OCF dominated accruals in the industry analysis.The results of this study can be used by investment professionals and financial
                    analysts. The results show the superiority of net operating cash flows as a
                    signal for forming portfolios and for assessing the future prospects of
                    companies, even after accruals have been controlled for. And these results are
                    applicable in most industries. The results also indicate, however, that accruals
                    may provide additional relevant information beyond OCF about companies’
                    future prospects. So, a combination of the two signals may be the most valuable
                    for investors. The study also has benefits for academic research into the role of accruals
                    versus the role of OCF. Previous academic studies on this issue are
                    inconclusive, but they have one common denominator: They all used annual data
                    and investigated the effects of the signals on portfolios held for one year. Our
                    study sheds light on the OCF and accruals signals from quarterly data, and our
                    findings indicate that prior results are sensitive to the use of annual data.
                    Moreover, practitioners are more likely to be interested in using quarterly
                    data, when those data are available, than annual data.
Journal: Financial Analysts Journal
Pages: 67-79
Issue: 3
Volume: 64
Year: 2008
Month: 5
X-DOI: 10.2469/faj.v64.n3.7
File-URL: http://hdl.handle.net/10.2469/faj.v64.n3.7
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Author-Name: Moshe A. Milevsky
Author-X-Name-First: Moshe A.
Author-X-Name-Last: Milevsky
Author-Name: Vladyslav Kyrychenko
Author-X-Name-First: Vladyslav
Author-X-Name-Last: Kyrychenko
Title: Portfolio Choice with Puts: Evidence from Variable Annuities
Abstract: 
 This study investigated the asset allocation behavior of individuals who select
                    an out-of-the-money long-dated longevity-put option on their investment funds.
                    The asset allocations of these people within their variable annuity subaccounts
                    are 5–30 percent more risky than the allocations of those who do not
                    choose this protection. Investors who do not choose the longevity-put option
                    follow the classic life-cycle, age-phased reduction in equity. A rudimentary
                    model of utility-maximizing behavior is suggested that justifies the increased
                    allocation to risk as long as the investor understands the payoff structure of
                    the longevity put and is willing and able to exercise the annuity option if and
                    when it matures in the money.In the study reported here, we investigated the actual asset allocation behavior
                    of individuals who purchase portfolio insurance in the form of an
                    out-of-the-money long-dated longevity-put option on their investment funds. We
                    compare their asset allocations in these special accounts with those of
                    investors who do not elect to pay for any additional insurance protection. The empirical evidence comes from variable annuity (VA) policies made available
                    by insurance companies in the United States. Using a unique database of nearly 1
                    million (anonymous) policyholders contributed by seven insurance companies, we
                    found that, all else being equal, investors assume 5–30 percent more
                    risky-asset (equity) exposure when they have selected a longevity-put option.
                    Furthermore, when they are “protected,” their exposure to risky
                    assets is relatively constant across ages of policyholders in our dataset. But
                    when this longevity put is not purchased—so that the economics of the
                    investment portfolio resembles a conventional (tax-sheltered) mutual
                    fund—we confirmed the age-phased reduction in risky-asset exposure. We
                    also found a strong “intermediary effect” whereby the allocation
                    percentages depend on the individual or institution that intermediated the
                    transaction between the insurer and the investor. In addition, we offer a rudimentary model of utility-maximizing behavior in the
                    presence of this longevity-put option that justifies the observed increased
                    allocation to risky assets, provided that the investor truly understands the
                    payoff structure of the longevity put and is willing and able to exercise the
                    annuity option if and when it matures in the money. The assumption that these
                    options will be exercised if they expire in the money is debatable, of course,
                    in light of the long-standing body of evidence that individuals dislike
                    annuitization.We believe that our study is the first to examine actual asset allocations within
                    VA policies. We expect a continued interest in this topic, partly because the VA
                    market is a $1.5 trillion dollar market in the United States and is expected to
                    grow as aging Baby Boomers take control of their retirement assets and try to
                    generate their own pensions.
Journal: Financial Analysts Journal
Pages: 80-95
Issue: 3
Volume: 64
Year: 2008
Month: 5
X-DOI: 10.2469/faj.v64.n3.8
File-URL: http://hdl.handle.net/10.2469/faj.v64.n3.8
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: The New Organizational Paradigm: A Single Portfolio Manager and a Band of Scouts
Abstract: 
 Because of competition and globalization, the traditional organization of the professional staff of a large institutional portfolio along asset-class lines must change and is changing. The new organizational paradigm calls for a portfolio management unit that controls beta exposures and active risk at the total fund level and a scout unit that seeks exceptional active management opportunities wherever they are.
Journal: Financial Analysts Journal
Pages: 8-10
Issue: 4
Volume: 64
Year: 2008
Month: 7
X-DOI: 10.2469/faj.v64.n4.1
File-URL: http://hdl.handle.net/10.2469/faj.v64.n4.1
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Author-Name: Vineer Bhansali
Author-X-Name-First: Vineer
Author-X-Name-Last: Bhansali
Author-Name: Robert Gingrich
Author-X-Name-First: Robert
Author-X-Name-Last: Gingrich
Author-Name: Francis A. Longstaff
Author-X-Name-First: Francis A.
Author-X-Name-Last: Longstaff
Title: Systemic Credit Risk: What Is the Market Telling Us?
Abstract: 
 The ongoing subprime crisis raises many concerns about the possibility of even
                    more widespread credit shocks. We describe a simple linear version of a
                    sophisticated model that can be used to extract information about macroeconomic
                    credit risk from the prices of tranches of liquid credit indices. The market
                    appears to price three types of credit risk: idiosyncratic risk at the level of
                    individual companies, sectorwide risk at the level of companies within an
                    industry, and economywide or systemic risk. We applied the model to the recent
                    behavior of tranches in the U.S. and European credit derivatives markets and
                    show that the current crisis has more than twice the systemic risk of the
                    automotive-downgrade credit crisis of May 2005.The dramatic meltdown in the subprime market in the summer of 2007 raised many
                    red flags among market participants about their potential exposure to broad,
                    systemic (economywide) credit shocks. The concerns resulted in dramatic declines
                    in market liquidity, restricted access to credit, flights to quality, sharply
                    increased market volatility, and larger risk premiums in many financial markets.
                    Thus, the prices of the most credit sensitive securities in the market may
                    actually play the role of “the canary in the coal mine” in
                    providing information about how market participants collectively assess the risk
                    of systemic or macroeconomic credit shocks. For the study reported in this article, we used the prices of indexed credit
                    derivatives to extract market expectations about the nature and magnitude of the
                    credit risks facing financial markets. Since the inception of indexed credit
                    derivatives in 2002, this market has exploded in size and participation. Broad
                    indices are now traded for the U.S. (Markit CDX) and European (Markit iTraxx)
                    credit markets, which usually have high liquidity, and indices are traded to a
                    lesser degree for the Japanese and U.K. credit markets. As of the end of 2007,
                    the investment-grade CDX index was in its ninth generation and iTraxx, its
                    European counterpart, was in its eighth generation. Even more striking than the
                    success of the indices, however, is the launch and success of
                        tranches on the indices. Tranches can be best thought of as
                    call spreads on the credit losses of a portfolio. Investors can use tranches to
                    control their exposure to particular loss thresholds. To extract the information from these credit derivatives, we first developed a
                    simple linearized version of a sophisticated collateralized debt obligation
                    pricing model. This three-jump model is calibrated directly to the traded
                    spreads of tranches and indices. The model allows for the possibility that
                    credit spreads might be a composite of several different types of credit risk.
                    For the study described here, we fit the linearized version of the model to the
                    market prices of the credit indices and tranches. Using current data for both investment-grade and high-yield indices, we found
                    that the market anticipates three types of credit risk: idiosyncratic credit
                    events, sectorwide credit events, and economywide credit events. What is
                    particularly striking is that the nature of systemic credit risk appears to have
                    changed dramatically. Systemic credit risk was only a small percentage of total
                    credit risk during the automotive-downgrade credit crisis of May 2005. In the
                    2007 subprime crisis, however, systemic credit risk ballooned, and it now
                    approximates the size of the idiosyncratic component of credit spreads. The findings argue that the current credit crisis differs in a fundamental way
                    from previous credit events. An important implication of this finding is that
                    credit risk premiums in financial markets may remain at high levels in the
                    future, which would lead to significantly higher costs of debt for many
                    companies and sectors. Another key implication is that some credit-modeling
                    tools that are widely used in practice may severely underestimate the actual
                    risk exposure of credit portfolios. A downside implication of the shifting trend in the nature of credit risk is that
                    traditional risk management strategies, such as portfolio diversification, may
                    be less effective in the future in controlling credit risk exposure. On the
                    upside, from a strategic perspective, combinations of tranches allow a manager
                    to directly implement a view on one of the three macro spreads. 
Journal: Financial Analysts Journal
Pages: 16-24
Issue: 4
Volume: 64
Year: 2008
Month: 7
X-DOI: 10.2469/faj.v64.n4.2
File-URL: http://hdl.handle.net/10.2469/faj.v64.n4.2
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Author-Name: Boris Groysberg
Author-X-Name-First: Boris
Author-X-Name-Last: Groysberg
Author-Name: Paul Healy
Author-X-Name-First: Paul
Author-X-Name-Last: Healy
Author-Name: Craig Chapman
Author-X-Name-First: Craig
Author-X-Name-Last: Chapman
Title: Buy-Side vs. Sell-Side Analysts’ Earnings Forecasts
Abstract: 
 The study reported here is a comparison of the earnings-forecasting performance
                    of analysts at a large buy-side firm with the performance of sell-side analysts
                    in the 1997–2004 period. The tests show that the buy-side analysts made
                    more optimistic and less accurate forecasts than their counterparts on the sell
                    side. The performance differences appear to be partially explained by the
                    buy-side firm’s greater retention of poorly performing analysts and by
                    differences in the performance benchmarks used to evaluate buy-side and
                    sell-side analysts.The 2003 Global Settlement of Conflicts of Interest between Research and
                    Investment Banking raised fundamental questions about the integrity and quality
                    of sell-side research. Regulators had alleged that investment banking fees used
                    to support research induced sell-side analysts to be overly optimistic about the
                    stocks they covered. By limiting the investment banking benefits from sell-side
                    research, an (unintended) consequence of the Global Settlement has been to
                    reduce sell-side research budgets at leading investment banks and to encourage
                    the growth of buy-side research. Buy-side research, which is privately produced
                    and funded, is used only by fund managers at the producing investment firm. As a
                    result, buy-side analysts do not face the potential conflicts of working for
                    investment banking firms and the need to generate commissions encountered by the
                    sell side. Yet, to our knowledge, because of a lack of data on buy-side
                    research, no public investigation of the performance of buy-side analysts has
                    been carried out.We examined analyst earnings forecast optimism and accuracy for buy-side analysts
                    at a large, reputable money management firm relative to the optimism and
                    accuracy of sell-side analysts in the 1997–2004 period. The sample
                    buy-side firm is a top 10–rated money management firm for which
                    fundamental research is an essential part of the stock selection process. From
                    analyst reports provided by the firm for the period July 1997 through December
                    2004, we collected annual earnings forecasts for each company covered. For
                    sell-side analysts, earnings forecasts came from Thomson Financial’s
                    I/B/E/S database.Our findings indicate that analysts at the buy-side firm made more optimistic and
                    less accurate forecasts than their counterparts on the sell side. As a
                    percentage of actual earnings, the mean (median) buy-side forecasts in the study
                    period are 8–16 percent (3–12 percent) higher than those for the
                    sell side; the mean (median) absolute forecast errors for buy-side analysts are
                    11–15 percent (4–11 percent) higher than for the sell side. The
                    significant differences in forecast optimism and absolute errors held for all
                    forecast horizons and after controlling for differences in analyst experience,
                    industry specialization, coverage, and firm size.Several factors appear to at least partially explain these findings. First,
                    sell-side firms are less likely than the buy-side firm to retain analysts with
                    weak prior-year earnings forecast accuracy. This factor explains roughly
                    one-third of the buy-side analysts’ relative forecast optimism and
                    one-fifth of their absolute errors. Second, until recently, the buy-side firm
                    did not measure its analysts against the sell side. In contrast, sell-side
                    analysts are regularly measured against each other. Finally, we found a sharp
                    decline in buy-side relative forecast optimism and a decrease
                    in relative forecast accuracy after the enactment of Regulation Fair Disclosure,
                    which is consistent with sell-side analysts’ access to company
                    information being curtailed by the new regulation. We are cautious in
                    interpreting these findings, however, because many other factors affected
                    analysts’ performance during this period.Follow-up tests ruled out several other plausible explanations for the findings.
                    The results were unchanged when we compared the buy-side analysts’
                    performance with that of analysts at sell-side firms having a comparable number
                    of analysts and breadth of industry coverage, which suggests that the findings
                    are not driven by differences in the buy- and sell-side analysts’ scope
                    of coverage. Moreover, the buy-side analyst forecasts were relatively
                    optimistic, even for newly covered stocks, which indicates that the findings do
                    not simply reflect that coverage of poorly performing companies was stopped by
                    buy-side analysts. Tests of the quality of analysts hired by the buy-side firm
                    from the sell side indicate that the buy-side firm did not hire low-quality
                    sell-side analysts but that the performance of the new analysts deteriorated
                    after they joined the firm. Finally, we found no evidence that the sample
                    investment firm was a poor performer, which could have explained the performance
                    of its analysts.Our findings raise several questions for researchers and practitioners. First,
                    although we have no reason to believe that the sample firm is anything but a
                    strong performer within the industry, a replication of the tests on a broader
                    sample would be interesting. Second, our findings raise questions about the
                    quality of other buy-side research metrics, such as stock recommendations.
                    Finally, it will be interesting to assess whether (and how) services that
                    benchmark buy-side analysts’ research performance to that of analysts at
                    other buy-side firms and to the sell-side affect the quality of buy-side
                    research.
Journal: Financial Analysts Journal
Pages: 25-39
Issue: 4
Volume: 64
Year: 2008
Month: 7
X-DOI: 10.2469/faj.v64.n4.3
File-URL: http://hdl.handle.net/10.2469/faj.v64.n4.3
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Author-Name: Edward A. Dyl
Author-X-Name-First: Edward A.
Author-X-Name-Last: Dyl
Author-Name: George J. Jiang
Author-X-Name-First: George J.
Author-X-Name-Last: Jiang
Title: Valuing Illiquid Common Stock
Abstract: 
 Illiquid common stock is worth less than stock that can be readily sold because
                    the investor incurs an opportunity cost by being locked into the investment.
                    Quantifying the amount of this illiquidity discount is an important issue in
                    valuing certain common stock, especially for estate valuations. We examine
                    whether a previously developed analytical model for valuing the lost
                    “option to sell” when a stock is illiquid is a useful, practical
                    tool for valuing illiquid common stock.The value of an illiquid asset is generally lower than that of a similar asset
                    that is readily marketable. Investors value liquidity because its absence limits
                    the owner’s option to convert the asset to cash; thus, illiquidity
                    increases potential opportunity costs. Investors locked into a holding of
                    nonmarketable stock are subject to losses resulting from changing stock
                    prices.Valuations of illiquid stock are required for estate valuations for tax purposes,
                    merger and acquisition transactions, divorce settlements and other forms of
                    partnership dissolutions, and situations in which the valuation has important
                    financial consequences for the parties involved. Therefore, valuing illiquid
                    stock can be a contentious issue, and it frequently involves large amounts of
                    money. We examine the usefulness of an options-based framework developed in 1995 to
                    estimate the value of the marketability (i.e., liquidity) of a particular common
                    stock for a particular investor at a particular time. This model explicitly
                    takes into account the put option inherent in a liquid asset. It requires two
                    inputs—namely, the volatility of the shares’ returns and the length
                    of time for which the shares are illiquid. We first report cross-sectional variations in volatility for NYSE and NASDAQ
                    stocks. We then apply the model in an actual case study to assess the extent to
                    which the illiquidity discount for a specific stock holding depends on the
                    volatility of the company’s stock and on other characteristics of the
                    case. We conclude that the model provides a more analytical approach to
                    determining discounts than do current practices but that there is still a role
                    for judgment in determining the appropriate discount in a specific case.
Journal: Financial Analysts Journal
Pages: 40-47
Issue: 4
Volume: 64
Year: 2008
Month: 7
X-DOI: 10.2469/faj.v64.n4.4
File-URL: http://hdl.handle.net/10.2469/faj.v64.n4.4
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# input file: UFAJ_A_12047847_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jia Ye
Author-X-Name-First: Jia
Author-X-Name-Last: Ye
Title: How Variation in Signal Quality Affects Performance
Abstract: 
 The information coefficient (IC), the correlation between forecasted and realized
                    return, is a popular measure of signal quality. As shown in this article,
                    variation in IC is an important source of active risk, and IC variation has an
                    effect on optimal portfolio structure. Contrary to popular belief, the ability
                    to take short positions in equity portfolios does not necessarily lead to
                    superior performance. Managers who can maintain a stable IC over time will
                    benefit from short extensions, but managers who have an unstable IC may see
                    their performance deteriorate from increased short positions.The information coefficient (IC), which is the correlation between forecasted and
                    realized return, is a popular measure of signal quality. The signal quality for
                    active managers tends to vary over time because market inefficiencies are always
                    evolving. I show that variation in signal quality affects performance and that
                    it exerts its impact through risk. The original fundamental law of active management states that the information
                    ratio (IR) is equal to the IC multiplied by the square root of breadth (which is
                    defined as the number of active decisions taken per year). According to the
                    fundamental law, signal quality determines the expected return of an active
                    strategy, so when signal quality varies from one period to the next, the
                    expected return also fluctuates. Active risk arises not only from portfolio
                    holdings’ return variations but also from variation in signal quality.
                    The analysis presented here leads to a generalized fundamental law of active
                    management stating that the performance of active strategies is determined not
                    only by breadth and signal quality but also by variation in signal quality and
                    by constraints.The analysis in this article sheds light on how managers can select optimal
                    portfolio structures that are suitable to their forecasting skills. Intuitively,
                    the right skew in stock returns causes a difference in distribution between the
                    overweighted and the underweighted segments of active portfolios. If these two
                    segments have the same amount of active risk, the overweighted segment will have
                    a higher IR than the underweighted segment. Therefore, to achieve an optimal
                    allocation of risk, a manager should allocate more risk to the overweighted
                    segment than to the underweighted segment—and even more so when signal
                    quality is unstable. The analysis suggests that the long-only constraint, which
                    causes a disproportionately large amount of risk to be allocated to the
                    overweighted segment of a portfolio, may be desirable for managers whose signal
                    quality is unstable.The analysis has an important implication for the application of short-extension
                    strategies. The ideal amount of short extension depends on how stable the signal
                    quality is. Simulation results show that managers who can maintain a stable IC
                    over time will benefit from the efficiency gains of short extensions but
                    managers with unstable ICs may see their performance deteriorate as they take
                    more short positions.
Journal: Financial Analysts Journal
Pages: 48-61
Issue: 4
Volume: 64
Year: 2008
Month: 7
X-DOI: 10.2469/faj.v64.n4.5
File-URL: http://hdl.handle.net/10.2469/faj.v64.n4.5
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# input file: UFAJ_A_12047848_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jacob Oded
Author-X-Name-First: Jacob
Author-X-Name-Last: Oded
Author-Name: Allen Michel
Author-X-Name-First: Allen
Author-X-Name-Last: Michel
Title: Stock Repurchases and the EPS Enhancement Fallacy
Abstract: 
 A common belief among practitioners and academics is that the increased EPS
                    associated with a stock repurchase creates value for a firm’s
                    shareholders. This belief is flawed. With the use of a numerical example and an
                    analysis of ExxonMobil’s recent stock repurchases, this article
                    demonstrates the magnitude of the distortion that arises from using EPS to make
                    such repurchase decisions. The effect of share repurchase is also compared with
                    the effects of alternatives—payment of dividends and cash accumulation.
                    Relative to cash accumulation, neither the negative effect of dividends nor the
                    positive effect of repurchases on EPS is associated with changes in the wealth
                    of shareholders at time zero. Record numbers of firms have carried out share repurchases in the past several
                    years. Recently, firms as diverse as 3M, Capital One Financial, Caterpillar, CBS
                    Corporation, and Accenture announced repurchases of more than $1 billion each. A
                    commonly cited reason in firm press releases and executive surveys for the
                    increased use of share repurchases is to increase EPS. This article addresses the effect of stock buybacks on both a firm’s
                    earnings per share and the value of an investor’s holdings. We
                    demonstrate an important but generally ignored effect of increasing a
                    firm’s EPS growth through share repurchase: Although buying back shares
                    increases EPS, it leaves the value of an investor’s holdings unchanged.
                    Furthermore, we demonstrate that the EPS increase associated with a buyback is
                    merely a risk–return trade-off. The reason is that in a repurchase, the
                    firm retires safe cash and, as a result, its assets become riskier than before
                    the repurchase. With the increased risk, the expected return increases, and this
                    effect is what is reflected in the higher expected EPS.Firms generally choose among several alternatives for using their excess cash.
                    Options typically include dividend payment, share repurchase, and cash
                    accumulation (no payout). We consider each of these alternatives. We show that
                    the value of an investor’s holdings is invariant with respect to the
                    choice of payout policy but that each alternative provides a unique
                    risk–return trade-off that is reflected in the EPS path over time. These
                    results conflict with the commonly accepted intuition that increasing EPS
                    through repurchase creates economic value for the investor.Miller and Modigliani (MM) demonstrated that in a perfect world, payout policy
                    does not matter. The literature that followed their seminal work focused on
                    explaining how market imperfections, however, make payout policy relevant. A
                    broad range of reasons have been given for a firm’s repurchases. They
                    include signaling of undervalued equity in conditions of information asymmetry,
                    reducing the agency costs of having free cash, substituting repurchases for
                    dividends to lower taxes, and capital structure adjustments. We abstract from
                    these motivations and focus on EPS growth. Although MM is well known, managers continue to use EPS as a significant input
                    into their repurchase decision. We show, however, that even in a perfect world,
                    payout policy affects the EPS path but that this result should not be confused
                    with the creation or destruction of value for shareholders. Our analysis thus
                    demonstrates the magnitude of the distortion from using EPS to make share
                    repurchase decisions. At the same time, it guides financial analysts in how to
                    interpret EPS changes—namely, to distinguish between EPS changes that are
                    associated with changes in expected shareholder wealth from EPS changes that are
                    not.As an application, we consider the effect that alternative payout policies would
                    have had on ExxonMobil’s EPS in the 2002–06 period. In this period,
                    ExxonMobil made sizable share repurchases and large dividend payments. We
                    compare the results of our hypothetical policies with ExxonMobil’s actual
                    payout policy. We show that more than 16 percent of the firm’s EPS growth
                    over the past four years is an artificial result of its repurchase program and
                    cannot be associated with improvement in operating performance.Our results have important implications beyond the effect of share repurchase on
                    EPS. For example, many managers suggest that their firm repurchase shares to
                    reverse the share dilution of employee stock and option compensation. Our
                    results suggest that, although repurchasing shares prevents dilution of EPS, it
                    does not prevent dilution of value to shareholders. The reason is that the
                    granting of stock and option compensation does dilute value,
                    but repurchases do not enhance value. Similarly, the newly
                    popular practice of “accelerated repurchase” does not enhance
                    value. In an accelerated repurchase, the firm borrows a large quantity of shares
                    from its shareholders through an investment banker and retires those shares upon
                    receipt. Then, over time, the investment banker buys shares in the open market
                    on behalf of the firm and returns them to the lending shareholders. The practice
                    enables a firm to quickly increase EPS while repurchasing shares slowly over
                    time. The results in this article imply that boosting EPS in this manner does
                    not create value for shareholders.
Journal: Financial Analysts Journal
Pages: 62-75
Issue: 4
Volume: 64
Year: 2008
Month: 7
X-DOI: 10.2469/faj.v64.n4.6
File-URL: http://hdl.handle.net/10.2469/faj.v64.n4.6
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Author-Name: Jie Cai
Author-X-Name-First: Jie
Author-X-Name-Last: Cai
Author-Name: Todd Houge, CFA
Author-X-Name-First: Todd
Author-X-Name-Last: Houge, CFA
Title: Long-Term Impact of Russell 2000 Index Rebalancing
Abstract: 
 The study reported here examined the long-term impact of Russell 2000 Index
                    rebalancing on portfolio evaluation. A buy-and-hold index portfolio outperformed
                    the annually rebalanced index in the 1979–2004 period by an average of
                    2.22 percent over one year and 17.29 percent over five years. Although
                    short-term momentum and the poor long-term returns of new issues partially
                    explain these returns, index deletions were found to provide significantly
                    higher factor-adjusted returns than index additions. Some small-capitalization
                    fund managers appear to capture a portion of these benefits. The strongest
                    performing funds enhanced their factor-adjusted returns by an average of 1.45
                    percent per year by holding index deletions and/or avoiding index additions.
                    Among the weakest performing funds, higher returns from holding index deletions
                    were offset by the poor returns of new issues added to the index. Thus, index
                    methodology may provide a structural incentive for portfolio managers to drift
                    from their benchmarks.Indices provide a performance benchmark for a specific segment of the market.
                    Although many leading indices were not originally developed as investment
                    strategies, today, index funds are increasingly popular investment vehicles.
                    Index providers compete to offer low-cost, representative portfolios that are
                    easy to implement. Yet, an index is not necessarily a passive benchmark. These
                    portfolios are rebalanced periodically as the characteristics of individual
                    holdings evolve. These changes impose short-term costs on portfolios that mimic
                    the index, but the question of how index reconstitution affects long-term
                    portfolio returns and performance measurement remains largely unanswered.This study illustrates the effect of rebalancing on long-term index performance
                    and portfolio evaluation. Examining additions and deletions to the small-cap
                    Russell 2000 Index for 1979–2004, we found that a buy-and-hold portfolio
                    significantly outperformed the annually rebalanced index by an average of 2.22
                    percent over one year and by 17.29 percent over five years. Part of these excess returns can be explained by strong short-term momentum
                    effects. Stocks with good performance grow too big for a small-cap index and
                    continue to have superior performance after being deleted from the index; stocks
                    with poor performance become small enough to enter the index but continue to
                    generate low returns. We found that in the first year after index rebalancing,
                    the deleted stocks outperformed the added stocks by 67 bps per month. Poor long-term returns of new issues also contributed to the lower returns of the
                    added stocks. These stocks lagged the deletions portfolio by an average of
                    42–56 bps per month through the fifth year. Furthermore, the excess returns cannot be explained by the popular risk factors.
                    Using the four-factor model, we estimated that the stocks deleted from the
                    Russell 2000 outperformed the stocks added to the index by 55 bps per month
                    after controlling for the beta, size, book-to-market, and momentum risks. We also document that some small-cap mutual fund managers capture a portion of
                    the performance benefits that arise when the index adds and deletes stocks.
                    Holding index deletions and/or avoiding index additions enhanced the risk
                    factor–adjusted returns of the strongest performing funds by an average of
                    145 bps per year. Among weaker performing funds, the benefits of holding index
                    deletions were offset by the poor returns of new issues added to the index,
                    which the stronger performing funds initially avoid. Our results suggest that index methodology may provide a structural incentive for
                    portfolio managers to drift from their benchmarks.
Journal: Financial Analysts Journal
Pages: 76-91
Issue: 4
Volume: 64
Year: 2008
Month: 7
X-DOI: 10.2469/faj.v64.n4.7
File-URL: http://hdl.handle.net/10.2469/faj.v64.n4.7
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Capital Ideas Evolving (a review)
Abstract: 
 This singular book describes developments since 1992 when Capital
                        Ideas appeared; aside from the rise of behavioral finance,
                    little in the way of new theory is newsworthy, but the book contains in-depth
                    descriptions of the many people who have successfully put the academic theory
                    into practice.
Journal: Financial Analysts Journal
Pages: 93-94
Issue: 4
Volume: 64
Year: 2008
Month: 7
X-DOI: 10.2469/faj.v64.n4.8
File-URL: http://hdl.handle.net/10.2469/faj.v64.n4.8
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Author-Name: Rodney N. Sullivan, CFA
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan, CFA
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 96-96
Issue: 4
Volume: 64
Year: 2008
Month: 7
X-DOI: 10.2469/faj.v64.n4.9
File-URL: http://hdl.handle.net/10.2469/faj.v64.n4.9
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: Prediction Markets
Journal: Financial Analysts Journal
Pages: 8-10
Issue: 5
Volume: 64
Year: 2008
Month: 9
X-DOI: 10.2469/faj.v64.n5.1
File-URL: http://hdl.handle.net/10.2469/faj.v64.n5.1
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# input file: UFAJ_A_12047853_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 5
Volume: 64
Year: 2008
Month: 9
X-DOI: 10.2469/faj.v64.n5.10
File-URL: http://hdl.handle.net/10.2469/faj.v64.n5.10
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich (a review) (corrected)
Abstract: 
 This lively book introduces a promising line of inquiry into why market players act as they do. Neuroeconomics is a mixture of neuroscience, economics, and psychology that interprets seemingly irrational investment decisions as biological phenomena. 
Journal: Financial Analysts Journal
Pages: 102-103
Issue: 5
Volume: 64
Year: 2008
Month: 9
X-DOI: 10.2469/faj.v64.n5.11
File-URL: http://hdl.handle.net/10.2469/faj.v64.n5.11
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Author-Name: Colin J. Kerwin
Author-X-Name-First: Colin J.
Author-X-Name-Last: Kerwin
Title: “The Plan Sponsor’s Goal”: A Comment
Abstract: 
 This material comments on “The Plan Sponsor's Goal” (July/August 1995).
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 5
Volume: 64
Year: 2008
Month: 9
X-DOI: 10.2469/faj.v64.n5.2
File-URL: http://hdl.handle.net/10.2469/faj.v64.n5.2
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Author-Name: Momtchil Pojarliev
Author-X-Name-First: Momtchil
Author-X-Name-Last: Pojarliev
Author-Name: Richard M. Levich
Author-X-Name-First: Richard M.
Author-X-Name-Last: Levich
Title: Do Professional Currency Managers Beat the Benchmark?
Abstract: 
 Investigation of an index of returns on professionally managed currency funds and
                    a subset of returns from 34 individual currency fund managers finds that over
                    the 1990–2006 period, currency fund managers earned excess returns
                    averaging 25 bps per month. The study examines the relationship of these returns
                    to four factors that represent the returns from distinct styles of currency
                    trading—carry, trend, value, and volatility. The four factors explain a
                    substantial portion of the variability in index returns. The study’s
                    approach modifies the definition of alpha returns to only that portion of excess
                    returns not explained by the four factors. The impact of this change on measured
                    alpha is substantial, but some currency fund managers still generate alpha
                    returns. Since the 1990s, the notion of currency as an asset class has gained a wide
                    following. Inspired, perhaps, by numerous studies reporting profitability in
                    various types of currency-trading strategies, investment consultants have
                    promoted currency products as a potential source of alpha (or returns above a
                    certain benchmark). This interest is reflected in the growth of the number of
                    funds in the Barclay Currency Traders Index (BCTI)—from 44 in 1993 to 106
                    in 2006.If currency is indeed an asset class, we should be able to identify a set of
                    factors that correlate with managers’ realized returns from currency
                    investment. In this article, we report our study of the extent to which currency
                    managers’ returns correlate with four factors that are intended to
                    represent feasible benchmark returns from distinct styles of currency
                    trading—carry, trend, value, and volatility.We examined monthly data for the 1990–2006 period and calculated that
                    excess returns earned by currency managers in the BCTI averaged 25 bps per
                    month. Our results also show, however, that a substantial part of currency
                    returns (both for the overall index and for 34 individual currency managers) can
                    be explained by systematic exposure to the four basic trading strategies (i.e.,
                    style betas). Once we accounted for these four factors, our estimate of alpha
                    actually became negative (–9 bps per month) and not statistically
                    different from zero.We examined the stability of these relationships over time and found that both
                    carry and trend strategies played a significant role in the 1990s. After 2000,
                    however, the impact of the carry factor increased somewhat whereas the impact of
                    the trend factor declined. Nevertheless, the trend factor has remained the most
                    dominant factor in terms of R2. It has explained
                    more than 65 percent of the variability of the excess currency returns since
                    1990. In the 1990s, currency manager returns were, at the margin, significantly
                    negatively related to the value factor, meaning that currency managers as a
                    group tended to bet against purchasing power parity and were worse off for it.
                    After 2000, currency manager returns became positively and significantly related
                    to the volatility factor. In summary, after 2000, nearly 77 percent of the
                    variability in monthly returns on the BCTI can be explained by our four
                    factors.The results for individual managers are, naturally, more diverse than the results
                    for the overall index. In the six-year period ending in 2006, 8 of 34 currency
                    fund managers produced statistically significant excess returns (returns over
                    and above the returns associated with the four factors) that averaged about 104
                    bps per month. Although overall managed currency returns have declined sharply
                    in the recent period, some individual managers were still capable of generating
                    alpha in relation to our four-factor model.Our approach significantly alters the definition and measurement of alpha returns
                    in the context of currency speculation. For various reasons (e.g., currency
                    returns alleged to be unpredictable or uncorrelated with equity benchmarks),
                    most studies have adopted zero for currency overlay programs and the risk-free
                    return for absolute-return programs as the appropriate return benchmarks for
                    currency speculation. In prior studies, all excess returns were
                    classified as alpha returns (i.e., beta returns were assumed away). In our
                    framework, alpha currency returns are those over and above returns associated
                    with transparent and readily implemented currency-trading strategies. We show
                    that our framework can significantly alter the ranking of individual managers on
                    such performance measures as the information ratio.As exchange-traded funds become available to proxy the returns from basic
                    currency-trading strategies, investors can capture these returns (i.e., beta
                    returns) with minimal cost. In our framework, professional currency managers who
                    simply mimic the strategies embodied in our four factors are unlikely to earn
                    alpha. Our empirical results support this finding; they show a significant
                    inverse relationship between alpha returns and the variation explained by the
                    four factors. This realization may lead to some repricing for
                    “active” currency products. Funds will have difficulty justifying
                    alpha fees for exposure to currency style betas that could be earned more
                    cheaply.
Journal: Financial Analysts Journal
Pages: 18-32
Issue: 5
Volume: 64
Year: 2008
Month: 9
X-DOI: 10.2469/faj.v64.n5.4
File-URL: http://hdl.handle.net/10.2469/faj.v64.n5.4
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Handle: RePEc:taf:ufajxx:v:64:y:2008:i:5:p:18-32




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# input file: UFAJ_A_12047858_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: K.C. John Wei
Author-X-Name-First: K.C. John
Author-X-Name-Last: Wei
Author-Name: Feixue Xie
Author-X-Name-First: Feixue
Author-X-Name-Last: Xie
Title: Accruals, Capital Investments, and Stock Returns
Abstract: 
 The evidence from this study shows that the “accruals anomaly” and
                    the “capital investment anomaly” are distinct, even though capital
                    investments and accruals may be related in a certain way. The results also
                    indicate that, after adjustment for the Fama–French three risk factors,
                    investors earn substantially higher returns by using a strategy that exploits
                    both anomalies at the same time than by exploiting either anomaly alone. Using
                    current accruals as the measure of accruals produced similar results to using
                    total accruals, and the results are robust to various measures of return. The
                    evidence suggests that managers in companies ranked highest in both accruals and
                    capital investments may be overly optimistic about future demand for their
                    products.This study examined whether the “accruals anomaly” and the
                    “capital investment anomaly” capture the same underlying force.
                    Both anomalies may be linked by way of managers’ overly optimistic
                    expectations about future product demand that lead to a buildup of production
                    capacity and inventory. We further examined whether one anomaly provides new
                    information not provided by the other even if both anomalies are driven by the
                    same expectation of future demand. If both signals are incrementally valuable,
                    an investor can obtain additional abnormal returns by basing a strategy on
                    combining the anomalies, so this possibility should be of great interest to
                    practitioners and investors.Using data from the CRSP/Compustat Merged Database for the period
                    1972–2005, we found that the two anomalies are distinct from each other
                    and that investors can earn substantially higher returns by using a strategy
                    that exploits both anomalies at the same time. Specifically, a trading strategy
                    of buying the shares of companies in the lowest quintile formed on the basis of
                    total accruals and the lowest quintile formed on the basis of capital
                    investments and simultaneously shorting the shares of companies in the highest
                    total accruals quintile and the highest capital investment quintile would have
                    generated a risk-adjusted return of 12 percent per year, on average, in the
                    sample period. The return to such a strategy is substantially larger than the
                    returns from exploiting either the investment anomaly–based strategy (7.66
                    percent) or the total accruals–based strategy (6.74 percent) alone. Using
                    current accruals as an alternative measure of accruals produced similar results.
                    Moreover, we showed that our results are robust to the measure of returns.An important implication of this study is that portfolio managers and investors
                    should exploit the capital investment anomaly and the accruals anomaly at the
                    same time to enhance their trading profitability.
Journal: Financial Analysts Journal
Pages: 34-44
Issue: 5
Volume: 64
Year: 2008
Month: 9
X-DOI: 10.2469/faj.v64.n5.5
File-URL: http://hdl.handle.net/10.2469/faj.v64.n5.5
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Handle: RePEc:taf:ufajxx:v:64:y:2008:i:5:p:34-44




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# input file: UFAJ_A_12047859_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Dan Palmon
Author-X-Name-First: Dan
Author-X-Name-Last: Palmon
Author-Name: Ephraim F. Sudit
Author-X-Name-First: Ephraim F.
Author-X-Name-Last: Sudit
Author-Name: Ari Yezegel
Author-X-Name-First: Ari
Author-X-Name-Last: Yezegel
Title: The Accruals Anomaly and Company Size
Abstract: 
 Research has shown that a trading strategy based on publicly available accounting
                    accrual information can earn abnormal returns of approximately 10 percent in the
                    year after it is applied. This article reports a study of whether this
                    “accruals anomaly” is sensitive to company size. The empirical
                    results suggest that the interaction between company size and accruals provides
                    incremental information about future returns and that the accruals anomaly is
                    not independent of company size. The negative abnormal returns when an
                    accruals-anomaly strategy is applied come primarily from the larger companies,
                    and the positive abnormal returns come from the smaller companies.In the study reported, we investigated the relationship between
                    “accruals-anomaly” abnormal returns, which have been found by
                    previous research, and company size. The accruals anomaly is the existence of a
                    negative relationship between current accruals and future abnormal returns. If
                    evidence were to show the anomaly to be limited to small companies, for which
                    stock transaction costs are greater than for large companies, this evidence
                    would provide an explanation as to why the anomaly has not been arbitraged
                    away.Research has shown that a portfolio strategy of buying companies belonging to the
                    bottom accrual decile (that is, companies with the highest accruals) and selling
                    short companies in the top accrual decile (companies with the lowest accruals)
                    generated significantly positive abnormal returns during the 1962–91
                    period. Results based on recent data also indicate that the accruals anomaly
                    exists. The existence of the accruals anomaly for such an extended period is puzzling.
                    One explanation is that transaction costs restrain investors from exploiting the
                    accruals anomaly. To investigate this possibility, we examine how, in an
                    accrual-based trading strategy, abnormal returns to long and short positions
                    vary in relation to company size.The sample in this study includes all companies traded in the NYSE, Amex, and
                    NASDAQ exchanges for which data are available in the CRSP and Compustat files
                    for the fiscal years 1971 through 2003. Closed-end funds, investment trusts,
                    foreign companies, and financial companies were excluded, and we eliminated
                    shares priced below $5 at the beginning of the holding period to ensure that the
                    results would not be driven primarily by very small, illiquid stocks or by the
                    bid–ask bounce.To explore the relationship between the accruals anomaly and company size, we
                    sorted all companies in our sample into accrual deciles and then sorted the
                    companies in each decile into size quartiles. This procedure yielded four
                    portfolios per accrual decile that had approximately the same level of accruals
                    but varying market values. Through the double sorting, we constructed 40
                    portfolios in which we isolated the effect of size on returns and kept accruals
                    stable.To measure abnormal portfolio returns, we used several risk-adjustment methods,
                    including estimating Jensen’s alphas based on three-factor, four-factor,
                    and liquidity-augmented models and computing size-adjusted buy-and-hold abnormal
                    returns by using size benchmark returns.Our key results indicate that the positive abnormal returns previously documented
                    come primarily from small companies in the bottom accrual decile and the
                    negative abnormal returns come from large companies in the top accrual decile.
                    We found results that were similar for all the methods we used to estimate
                    abnormal returns. In addition, through regression analysis, we analyzed the
                    relationship between company size and size-adjusted returns and obtained
                    consistent results.In contrast to findings in which accruals-anomaly returns were confined to small
                    and illiquid companies, our results for part of the sample indicate that
                    abnormal returns increase as company size (and liquidity) increases. These
                    results are not fully consistent with the view that transaction costs restrain
                    investors from exploiting the accruals anomaly and point to the need to look for
                    other factors that explain why the accruals anomaly might not be arbitraged
                    away.Furthermore, the documented asymmetrical relationship between company size and
                    abnormal returns calls for an accrual-based trading strategy that is slightly
                    different from the standard strategy. The standard accrual-based strategy is to
                    go long all bottom-accrual-decile companies and short all top-accrual-decile
                    companies. In the adjusted strategy, the investor is to purchase companies in
                    the smallest size quartile of the bottom accrual decile and sell short companies
                    in the largest size quartile of the top accrual decile. Such a modified
                    strategy, because of the interaction of the size and accrual terms, generated
                    higher abnormal returns than the standard accrual-based strategy in our tests.
                    In addition, because it is less costly to sell short large-company stocks than
                    to sell short small-company stocks, the modified accrual trading strategy is
                    likely to incur lower transaction costs and, therefore, generate higher abnormal
                    returns net of transaction costs.In summary, our empirical results suggest that accruals-anomaly returns are
                    correlated with company size and that returns to an accrual-based strategy can
                    be increased by assigning long positions to small companies and short positions
                    to large companies.
Journal: Financial Analysts Journal
Pages: 47-60
Issue: 5
Volume: 64
Year: 2008
Month: 9
X-DOI: 10.2469/faj.v64.n5.6
File-URL: http://hdl.handle.net/10.2469/faj.v64.n5.6
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# input file: UFAJ_A_12047860_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Petya Platikanova
Author-X-Name-First: Petya
Author-X-Name-Last: Platikanova
Title: Long-Term Price Effect of S&P 500 Addition and Earnings Quality
Abstract: 
 When a company is added to the S&P 500 Index, it receives a positive price
                    response. Several explanations for this effect have been suggested, but
                    empirical findings do not provide a conclusive cause. The inclusion of a company
                    in the index may strengthen managerial incentives to provide high-quality
                    disclosures of financial data. This study is an examination of the earnings
                    quality of S&P 500 companies before and after their addition to the index.
                    It finds that discretionary accruals significantly decrease after companies are
                    added to the index, which greatly improves earnings quality. This change in
                    earnings quality provides a possible explanation for the price response to the
                    S&P 500 addition.A positive price response has been found to follow a company’s addition to
                    the S&P 500 Index, and the response has been found to generate significant
                    abnormal returns of between 2.7 percent and 5.48 percent. Several explanations
                    for this effect are possible. The increased demand for the stock from index
                    funds and other investors adding the stock to their portfolios may explain how
                    the prices of newly added companies are momentarily affected by index inclusion.
                    This explanation suggests, however, that prices will reverse once the abnormal
                    demand has subsided, but empirical studies have found that the index price
                    effect is at least partly permanent. An explanation that allows for the
                    long-term price effect is that the lack of a substitute limits arbitrage with
                    S&P 500 stocks. Or the permanent price effect could be the result of new
                    information about the expected distribution of a security’s future
                    returns; index inclusion would provide information even though Standard &
                    Poor’s assures investors that the investment merits of a company do not
                    influence its selection.My study examined the quality of earnings data before and after index listing for
                    202 companies added to the S&P 500 in the 1990–2005 period. I find
                    that the addition of a company to the S&P 500 does not necessarily reveal
                    new information but does strengthen managerial incentives to provide
                    high-quality financial disclosures. Discretionary accruals, a measure of
                    earnings quality, are significantly larger in magnitude before index listing
                    than after listing. The change signals a reduction in information risk. The
                    addition of a company to the S&P 500 may increase investors’ and
                    media awareness and, in that way, change managerial incentives to release
                    high-quality earnings data. The change is somewhat permanent: Five years after addition to the S&P 500,
                    discretionary accruals are about one-half their magnitude at the time of
                    inclusion.The price response to S&P 500 addition may come from the change in earnings
                    quality. If investors anticipate an increase in earnings quality, they will
                    reduce the return they demand because of the lower information risk, thus
                    causing the price to rise. Results of my study support the hypothesis that the
                    change in discretionary accruals contributes to the observed S&P 500 effect.
                    The results of this study support the role of information risk and accruals in
                    pricing, which is also consistent with recent findings that companies with poor
                    accruals quality have higher costs of capital.
Journal: Financial Analysts Journal
Pages: 62-76
Issue: 5
Volume: 64
Year: 2008
Month: 9
X-DOI: 10.2469/faj.v64.n5.7
File-URL: http://hdl.handle.net/10.2469/faj.v64.n5.7
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# input file: UFAJ_A_12047861_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bingsheng Yi
Author-X-Name-First: Bingsheng
Author-X-Name-Last: Yi
Author-Name: Mohamed H. El-Badawi
Author-X-Name-First: Mohamed H.
Author-X-Name-Last: El-Badawi
Author-Name: Barry Lin
Author-X-Name-First: Barry
Author-X-Name-Last: Lin
Title: Pre-Issue Investor Optimism and Post-Issue Underperformance
Abstract: 
 Prior studies have documented long-run stock market underperformance after
                    security offerings. Some studies conjectured that the post-issue
                    underperformance might be the result of pre-issue investor optimism. The study
                    reported here investigated (1) whether investor optimism is associated with
                    post-issue underperformance, (2) how investor optimism changes in the one-year
                    period surrounding the security-offering month, (3) whether investor optimism
                    differs between equity issuers and debt issuers, and (4) whether such
                    differences affect companies’ financing choices. We confirmed
                    underperformance of debt and equity issuers and found that the post-issue
                    buy-and-hold abnormal returns are negatively associated with pre-issue investor
                    optimism. We found little evidence, however, that investor optimism affects
                    companies’ financing choices.Poor post-issue performance has been well documented for both equity issuers and
                    debt issuers. Moreover, in prior studies, the equity issuers had worse
                    performance than the debt issuers. These effects have been attributed to
                    investor overoptimism—perhaps, combined with corporate managers’
                    opportunism in taking advantage of investor overoptimism by issuing overpriced
                    securities. No prior studies have directly tested the relationship, however,
                    between pre-issue investor optimism and post-issue stock market performance
                    after seasoned equity offerings and straight-debt offerings. To fill this gap, we report an examination of (1) whether investor optimism is
                    associated with post-issue underperformance, (2) how investor optimism changes
                    in the one-year period surrounding the security-offering month, (3) whether
                    investor optimism differs between equity issuers and debt issuers, and (4)
                    whether such differences affect companies’ financing choices.Assuming that financial analysts’ opinions represent those of investors,
                    to measure investor optimism, we used analyst forecast errors (defined as the
                    mean annual Thomson I/B/E/S consensus EPS forecast minus the actual annual EPS
                    divided by the absolute value of the mean annual consensus EPS), the I/B/E/S
                    consensus analyst forecasts for long-term earnings growth rates, a
                    recommendation revision ratio (that is, the ratio of the number of analysts
                    making upward revisions to their EPS forecasts to the number making downward
                    revisions to their forecasts), and an “investor optimism index.”
                    This index is the equally weighted average of the rank of analyst forecast
                    error, the forecast of long-term EPS growth rates, and the recommendation
                    revision ratio; it has values ranging from 0 to 1. A larger value of the
                    investor optimism index indicates that investors were more optimistic. We applied these measures to seasoned issuers of equity and issuers of straight
                    debt in the 1984–2002 period and found the following: (1) Before the
                    securities were issued, investors appear to have been more optimistic about
                    equity issuers than about debt issuers; we found a score on the pre-issue mean
                    investor optimism index of 0.535 for equity issuers and 0.456 for debt issuers.
                    (2) Somewhat surprisingly, after issue, although the investor optimism index
                    dropped for debt issues (from 0.456 to 0.451), it increased for equity issuers
                    (from 0.535 to 0.573), indicating a continuation of investor optimism about
                    equity issuers; we found both of these changes to be statistically significant
                    at the 1 percent level. (3) For both equity and straight-debt issuers, the
                    post-issue buy-and-hold abnormal returns were negatively associated with
                    pre-issue investor optimism. And this relationship was more negative and
                    statistically more significant for equity issuers than for debt issuers. For
                    example, the results in multiple regressions showed that, after we held other
                    variables constant, for equity offerings, a 1 percent increase in investor
                    optimism was significantly related to a 1.30 percent decrease in the three-year
                    buy-and-hold abnormal return. For straight-debt offerings, however, a 1 percent
                    increase in investor optimism resulted in only a 0.18 percent decrease in the
                    three-year buy-and-hold abnormal return; this impact was statistically
                    insignificant. (4) We found little evidence that investor optimism affects
                    companies’ financing choices. (5) Finally, although multiple issuers have
                    better performance than single issuers, the sequence of the issuance was found
                    to be negatively related to post-issue performance. These findings provide fresh insights into the new-issue process as related to
                    investor sentiments. The results have important implications for both the
                    investment public and the analyst community. For example, the conventional
                    wisdom is that managers’ attempts to sell overpriced equity may be used
                    as a signal for short selling. Our results do not support such a trading
                    strategy. To the contrary, our finding that the post-issue underperformance is
                    positively associated with pre-issue investor optimism may be used as a signal
                    in a strategy of selecting stocks with high pre-issue investor optimism for
                    short selling. 
Journal: Financial Analysts Journal
Pages: 77-87
Issue: 5
Volume: 64
Year: 2008
Month: 9
X-DOI: 10.2469/faj.v64.n5.8
File-URL: http://hdl.handle.net/10.2469/faj.v64.n5.8
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# input file: UFAJ_A_12047862_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Neil Brisley
Author-X-Name-First: Neil
Author-X-Name-Last: Brisley
Author-Name: Chris K. Anderson
Author-X-Name-First: Chris K.
Author-X-Name-Last: Anderson
Title: Employee Stock Option Valuation with an Early Exercise Boundary
Abstract: 
 Many companies are recognizing that the Black–Scholes formula is
                    inappropriate for employee stock options (ESOs) and are moving toward lattice
                    models for accounting or decision-making purposes. In the most influential of
                    these models, the assumption is that employees exercise voluntarily when the
                    stock price reaches a fixed multiple of the strike price, effectively
                    introducing a “horizontal” exercise boundary into the lattice. In
                    practice, however, employees make a trade-off between intrinsic value captured
                    and the opportunity cost of time value forgone. The model proposed here
                    explicitly recognizes and accounts for this reality and is intuitively
                    appealing, easily implemented, and compliant with U.S. accounting standards.Employee stock options (ESOs) must be valued for accounting and economic
                    purposes, but increasing numbers of companies are recognizing that variants of
                    the Black–Scholes formula are inappropriate for this purpose. They are
                    moving toward the use of lattice models—for example, the binomial
                    option-pricing model. The most influential lattice model for option pricing assumes that employees
                    exercise voluntarily when the stock price reaches a fixed multiple,
                        M, of the strike price. Conceptually, this approach
                    introduces a “horizontal” voluntary exercise boundary into the
                    lattice. Empirical evidence suggests, however, that employees make a trade-off
                    between intrinsic value captured and the opportunity cost of
                        time value forgone. So, the stock must be at a relatively
                    high multiple of the strike price to induce voluntary exercise early in the ESO
                    life, whereas later on, employees are willing to exercise at relatively low
                    multiples of the strike price. We propose a model that explicitly recognizes and accounts for this reality. We
                    assume that employees exercise voluntarily when the “moneyness” of
                    the option reaches a fixed proportion, which we term μ, of
                    its remaining Black–Scholes value. This approach results in an intuitively
                    appealing downward-sloping voluntary exercise boundary. Our μ model is
                    compliant with Statement of Financial Accounting Standards No. 123 (revised),
                        Share-Based Payment, is easily implemented, and readily
                    encompasses such ESO characteristics as vesting restrictions, forfeiture, and
                    forced early exercise as a result of employment termination.We show why our model may be less prone to bias than both the M
                    model and the modified Black–Scholes model when parameter inputs are
                    calculated from historical observations of voluntary exercise behavior. Given
                    the known early exercise trade-off made by employees, a company that has enjoyed
                    rapid stock price growth will probably have experienced ESO exercises at
                    somewhat high multiples of strike price (and early in the ESO lives), so using
                    these historical observations to calibrate an M model leads to
                    high ESO valuations (but using the modified Black–Scholes model leads to
                    low values). Conversely, a company that has experienced sluggish stock price
                    growth will have experienced ESO exercises at comparatively low multiples of
                    strike price (and later in the ESO lives), so an M model will
                    produce low ESO values (and a Black–Scholes model will produce high
                    valuations). To the extent that our exercise boundary better describes the
                    exercise decisions of employees than do other models, our model is less
                    susceptible to the biases caused by atypical stock price histories. We
                    illustrate this comparison analytically by simulating stock price paths with a
                    well-known utility-based model of employee exercise as a benchmark.Our results have implications for compensation committees and consultants who
                    need to understand the potential economic cost of ESO awards to executives and
                    employees. The results are also relevant to practitioners who are selecting ESO
                    valuation models for accounting disclosure purposes. Academic researchers and
                    other users of financial statements will find our results important for
                    understanding the sensitivity of the disclosed data to the choice of valuation
                    model and to the estimation of parameter values—which are themselves
                    dependent on the chosen historical dataset.Editor’s Note: The paper on which this article is
                        based won the Second Annual “Best Conference Research Paper
                        Award” from the Canadian Finance Executives Research Foundation at
                        the 2008 Financial Executives International (FEI) Canada conference. 
Journal: Financial Analysts Journal
Pages: 88-100
Issue: 5
Volume: 64
Year: 2008
Month: 9
X-DOI: 10.2469/faj.v64.n5.9
File-URL: http://hdl.handle.net/10.2469/faj.v64.n5.9
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: Seeking a Better Way Forward
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 6
Volume: 64
Year: 2008
Month: 11
X-DOI: 10.2469/faj.v64.n6.1
File-URL: http://hdl.handle.net/10.2469/faj.v64.n6.1
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# input file: UFAJ_A_12047864_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 88-88
Issue: 6
Volume: 64
Year: 2008
Month: 11
X-DOI: 10.2469/faj.v64.n6.10
File-URL: http://hdl.handle.net/10.2469/faj.v64.n6.10
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “The Market for Dividends and Related Investment Strategies,” by Richard Manley and Christian Mueller-Glissmann, in the May/June 2008 issue of the Financial Analysts Journal.
Journal: Financial Analysts Journal
Pages: 8-8
Issue: 6
Volume: 64
Year: 2008
Month: 11
X-DOI: 10.2469/faj.v64.n6.2
File-URL: http://hdl.handle.net/10.2469/faj.v64.n6.2
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Author-Name: Russell McAlmond
Author-X-Name-First: Russell
Author-X-Name-Last: McAlmond
Title: Too Much Emphasis on Quantitative Methods Instead of Ethics?
Abstract: 
 This material comments on the FAJ's coverage of ethics.
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 6
Volume: 64
Year: 2008
Month: 11
X-DOI: 10.2469/faj.v64.n6.3
File-URL: http://hdl.handle.net/10.2469/faj.v64.n6.3
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# input file: UFAJ_A_12047868_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hans R. Stoll
Author-X-Name-First: Hans R.
Author-X-Name-Last: Stoll
Title: Future of Securities Markets: Competition or Consolidation?
Abstract: 
 Although considerable consolidation has recently occurred among securities
                    exchanges, the forces of competition remain strong because they have an ally in
                    technology. Technology evens the playing field and makes the entry of new
                    trading venues easier. Economies of scale and network externalities still have a
                    centralizing tendency, but that tendency is weakened. Networks now extend beyond
                    a single market, which allows venues to compete, and economies of scale can more
                    readily be overcome by a technologically sophisticated competitor. Empirical
                    evidence indicates that as markets become integrated, trading becomes
                    dispersed.My thesis is that the forces of competition in the financial markets are stronger
                    today than they have ever been because these forces have an ally in technology.
                    Technology levels the playing field (i.e., makes the world flat). Technology
                    allows competition by newcomers—Archipelago Holdings, the International
                    Securities Exchange, BATS Trading, and as-yet-unknown entities. Ideally, the
                    role of regulation is to provide a framework in which such competition can take
                    place and in which exchanges can evolve most efficiently.The article first delineates factors that in the past have limited competition in
                    securities trading: A securities exchange tends to be a natural monopoly; it
                    enjoys economies of scale and network externalities that can make competition
                    from new trading venues difficult. Furthermore, an established exchange often
                    adopts anticompetitive rules to solidify its monopoly position. An established
                    exchange also solidifies its position by maintaining external uncertainty about
                    its prices and forcing traders to join the exchange to be able to observe
                    current prices. I call this strategy the “Uncertainty Principle of
                    Markets” (by analogy to the Heisenberg Uncertainty Principle in atomic
                    physics) because traders do not know both the market price and the status of
                    their orders. Next, the article describes the technological and regulatory forces that have led
                    to increased competition in securities markets. And it provides a simple model
                    to illustrate how technology has weakened the economies of scale and network
                    externalities of established markets.Many investors fear that competition will lead to harmful fragmentation, but
                    because of technologies that can link markets at low cost, fragmentation need
                    not occur. An implication of the model developed in this article is that as markets become
                    more effectively linked, trading becomes dispersed. Data on trading volume and
                    quote quality support this conclusion. For example, the fraction of trading in
                    NYSE-listed stocks done on the NYSE fell from 85 percent to 49 percent between
                    2002 and 2007. The remainder was dispersed among other markets. The fraction of
                    time that the NYSE quote was alone at the inside decreased from 80 percent to 20
                    percent in this same period as competing markets matched, and sometimes
                    improved, NYSE quotes.The next step in the development of markets—to integrate global markets in
                    the trading network—will take some time and will require regulatory
                    changes.
Journal: Financial Analysts Journal
Pages: 15-26
Issue: 6
Volume: 64
Year: 2008
Month: 11
X-DOI: 10.2469/faj.v64.n6.5
File-URL: http://hdl.handle.net/10.2469/faj.v64.n6.5
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:64:y:2008:i:6:p:15-26




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Author-Name: Nicole M. Boyson
Author-X-Name-First: Nicole M.
Author-X-Name-Last: Boyson
Title: Hedge Fund Performance Persistence: A New Approach
Abstract: 
 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. When an investor is selecting a hedge fund for investment, is the fund
                    manager’s prior performance record helpful? If past performance is
                    indicative of future results, this information is valuable. If not, investors
                    may be better off selecting a manager on the basis of the manager’s
                    reputation, investment style, or trading costs. Research on persistence in hedge
                    fund performance has delivered mixed results: Early research found evidence of
                    short-term (one-month to three-month) persistence but no evidence of long-term
                    persistence. Some recent research, however, has found evidence of one-year to
                    three-year performance persistence.A separate strand of the hedge fund literature links fund
                    characteristics—such as size, age, and investment
                    inflows/outflows—to performance, with mixed findings. Recent work has
                    provided a theoretical model that links performance persistence and fund
                    characteristics. The results of this model indicate that, although skilled
                    active managers probably exist, active managers typically do not beat their
                    passive benchmarks and also that performance persistence among managers is
                    unlikely. With this model, investors learn about hedge funds through past fund
                    performance and then rationally supply capital to the best past performers. In
                    general, the model implies that, all else being equal, young and/or small funds
                    should have superior performance.Using data provided by Credit Suisse/Tremont Advisory Shareholder Services for
                    the 1994–2004 period, I investigated performance persistence among hedge
                    funds—both single-strategy funds and funds of hedge funds—by
                    composing quintile portfolios of funds on the basis of past performance. The
                    primary measure of past performance was the 36-month
                    t-statistic of alpha (also known as the “information
                    ratio”). I then investigated whether simple sorts on prior-period fund
                    size and fund age have power to detect performance persistence. Next, I examined whether the predictions of the model hold by performing
                    independent sorts of funds on past IR quintiles and fund characteristic (size
                    and age) terciles.The tests in the study found evidence that strongly supports the model:
                    Portfolios of young, small funds that were past good performers outperformed
                    portfolios of older, larger funds with past poor performance by a statistically
                    significant 9.6 percentage points per year. In contrast, persistence tests in
                    which funds were selected for portfolios on the basis of past performance alone
                    found a difference in performance between past good performers and past poor
                    performers of about 3.9 percentage points annually. Hence, investors can
                    significantly improve their ability to select future good performers by choosing
                    the smaller, younger funds that have shown past good performance.
Journal: Financial Analysts Journal
Pages: 27-44
Issue: 6
Volume: 64
Year: 2008
Month: 11
X-DOI: 10.2469/faj.v64.n6.6
File-URL: http://hdl.handle.net/10.2469/faj.v64.n6.6
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Handle: RePEc:taf:ufajxx:v:64:y:2008:i:6:p:27-44




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Author-Name: Alon Brav
Author-X-Name-First: Alon
Author-X-Name-Last: Brav
Author-Name: Wei Jiang
Author-X-Name-First: Wei
Author-X-Name-Last: Jiang
Author-Name: Frank Partnoy
Author-X-Name-First: Frank
Author-X-Name-Last: Partnoy
Author-Name: Randall S. Thomas
Author-X-Name-First: Randall S.
Author-X-Name-Last: Thomas
Title: The Returns to Hedge Fund Activism
Abstract: 
 Hedge fund activism is a new form of investment strategy. Using a large
                    hand-collected dataset from 2001 to 2006, we find that activist hedge funds in
                    the United States propose strategic, operational, and financial remedies and
                    attain success or partial success in two-thirds of the cases. The abnormal stock
                    return upon announcement of activism is approximately 7 percent, with no
                    reversal during the subsequent year. Target firms experience increases in payout
                    and operating performance and higher CEO turnover after activism. We find large
                    positive abnormal return to hedge fund activists, which is higher than the
                    return to other equity-oriented hedge funds.We analyze the currently most extensive and thoroughly documented dataset of
                    hedge fund activism, which extends from the beginning of 2001 through the end of
                    2006. We find that hedge funds increasingly engage in a new form of shareholder
                    activism and monitoring that differs fundamentally from previous activist
                    efforts by other institutional investors.We also find that hedge fund activism as a form of investment strategy generates
                    large positive abnormal returns both for shareholders in the target companies
                    and those in the activist hedge funds. When we compare the returns to
                    self-reported activist hedge funds with the CRSP Value-Weighted Market Index and
                    the Russell 2000 Value Index, we find that our activism index closely tracks the
                    two market indices through mid-1998 but then departs significantly and moves
                    upward. Moreover, since 2003, activist funds have outperformed not only both
                    market indices but also equity-oriented hedge funds. We show that this strong
                    performance is robust to a range of asset-pricing models—including
                    controls for size, book value to market value, and the momentum effect as well
                    as selection bias, incubation bias, and survivorship bias. The median
                    self-reported activist fund in our sample has a monthly four-factor alpha of 63
                    bps, compared with an alpha of 39 bps for all self-reported equity-oriented
                    hedge funds.We find that a significant portion of the targets’ abnormal returns comes
                    from the market’s favorable reaction to the announcement of activism.
                    This finding is consistent with the view that activism creates value. The filing
                    of a Schedule 13D revealing an activist fund’s investment in a target
                    company results in large positive average abnormal returns, in the 7–8
                    percent range, during the (Day –20, Day 20) announcement window. We also
                    find that the positive return at announcement is not reversed over time.
                    Activism that targets the sale of the company or changes in business strategy,
                    such as refocusing and spinning off noncore assets, is associated with the
                    largest positive abnormal return.We examine hedge fund strategies in detail to define the factors that contribute
                    to the large abnormal returns. Hedge fund activists tend to target companies
                    that resemble value companies, with low market value relative to book value,
                    although the companies are profitable and have sound operating cash flows and
                    return on assets. Payout at these companies before intervention is lower than
                    that of matched companies. Target companies also have more takeover defenses and
                    pay their CEOs considerably more than comparable companies. Relatively few
                    target companies are large-capitalization companies. Targets exhibit
                    significantly higher institutional ownership and trading liquidity. These
                    characteristics facilitate the quick acquisition by activists of a significant
                    stake.Hedge fund activists are not short term in focus, as some critics have claimed.
                    The median holding period for completed deals is about one year. Analysis of
                    portfolio turnover rates of the funds in our sample suggests holding periods of
                    close to 22 months. Once activist funds invest in a targeted company, they engage in a wide variety
                    of tactics to achieve their objectives. To illustrate some of these findings, we
                    include two examples of hedge fund activists’ investments in portfolio
                    companies.
Journal: Financial Analysts Journal
Pages: 45-61
Issue: 6
Volume: 64
Year: 2008
Month: 11
X-DOI: 10.2469/faj.v64.n6.7
File-URL: http://hdl.handle.net/10.2469/faj.v64.n6.7
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Handle: RePEc:taf:ufajxx:v:64:y:2008:i:6:p:45-61




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Author-Name: Thomas K. Philips
Author-X-Name-First: Thomas K.
Author-X-Name-Last: Philips
Author-Name: Arun Muralidhar
Author-X-Name-First: Arun
Author-X-Name-Last: Muralidhar
Title: Saving Social Security: A Better Approach
Abstract: 
 The disappearance of the defined-benefit (DB) pension plan is one of the greatest
                    financial tragedies to befall the U.S. citizen. As demographics have changed and
                    as defined-contribution (DC) plans have become the primary vehicles for
                    retirement savings, retirement planning has become fraught with uncertainty.
                    This article argues that DB plans, such as the U.S. Social Security system, are
                    fundamentally superior to DC plans and that the Social Security crisis is
                    largely a crisis of demographics and funding. Social Security’s assets
                    should be invested in a single portfolio that holds both stocks and bonds, and
                    its risky return should be swapped for a fixed return to enable the provision of
                    a DB. This proposal inexpensively affords insurance against a market decline and
                    allows pensions of any kind to be made portable.In recent years, a number of proposals have been made to transform U.S. Social
                    Security from a defined-benefit (DB) pension into a thinly veiled
                    defined-contribution (DC) plan. We contend that a fully or partially funded DB
                    plan is fundamentally superior to a DC plan for Social Security, and in this
                    article, we describe how the DB feature can be preserved in the face of
                    declining population growth, increased life expectancy, potentially lower
                    economic growth, and diminished investment returns.To keep Social Security in some semblance of balance, any proposed restructuring
                    must address four questions. First, should the Social Security system be
                    structured as a pay-as-you-go or PAYGO system (in which the payments of the
                    young are used to pay benefits to the elderly) or as a funded system in which
                    each generation saves, in whole or in part, for its own retirement? Second, how
                    should its assets be invested? Third, what rate of contribution is needed to
                    ensure that citizens receive at least the same level of benefits as they would
                    under the present system? And finally, what additional contribution is required
                    to make the transition from a PAYGO system to a partially funded system?In this article, we argue that Social Security ought to maintain its
                    defined-benefit structure, that it ought to invest in such risky assets as
                    stocks and corporate bonds, and that a small (1.2 percentage points) additional
                    contribution is all that is needed to keep it in balance. We address the many
                    issues that arise when reforming Social Security and examine some examples of
                    privatizations and the reasons for their failure. Social Security contributions have risen over time to 12.4 percent of the first
                    US$102,000 of wage income in 2008 and will increase inexorably to 18 percent of
                    all wage income by 2050 as a result of an increase in life expectancies and a
                    steady decline in the number of workers per retired person. Demographic change
                    is the root of Social Security’s problem; the required level of
                    contribution for all PAYGO systems is inherently unstable. But a viable solution
                    to the problem exists, and the Parable of the Talents from the Bible provides a
                    useful analogy and points to the right solution: Before setting out on a
                    journey, a wealthy landowner gave each of three servants
                        talents (units of money) in proportion to their abilities.
                    The first servant invested his 5 talents wisely and returned 10 talents to his
                    master upon his return. The second, who had two talents, also invested his
                    talents wisely and returned four talents to his master upon his return. The
                    master, delighted by the industriousness of both servants, rewarded them richly.
                    The third servant, however, for fear of losing his one talent, buried it under a
                    tree and returned it unused to his master, who excoriated him for his sloth and
                    had him cast out of his house. The key to our proposal, and to every other
                    sensible proposal to save Social Security, is to follow the example of the first
                    two servants and wisely invest the assets of the Social Security Trust Fund.We propose converting Social Security from a largely PAYGO system into a
                    partially funded system and increasing the contribution rate by 1.2 percentage
                    points. We envision investing Trust Fund assets in stocks and bonds, and we
                    recommend smoothing fluctuations in return by using an innovative swap. These
                    enhancements would eliminate the high costs associated with individual accounts
                    while allowing for both a guaranteed level of benefits and the portability of
                    pensions. The proposed changes would also make transparent the cost of political
                    interference in the management of Social Security’s assets. 
Journal: Financial Analysts Journal
Pages: 62-73
Issue: 6
Volume: 64
Year: 2008
Month: 11
X-DOI: 10.2469/faj.v64.n6.8
File-URL: http://hdl.handle.net/10.2469/faj.v64.n6.8
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Author-Name: Lawrence D. Brown
Author-X-Name-First: Lawrence D.
Author-X-Name-Last: Brown
Author-Name: Gerald D. Gay
Author-X-Name-First: Gerald D.
Author-X-Name-Last: Gay
Author-Name: Marian Turac
Author-X-Name-First: Marian
Author-X-Name-Last: Turac
Title: Creating a “Smart” Conditional Consensus Forecast
Abstract: 
 The study examined analyst forecasts of 26 macroeconomic statistics for August
                    1998 through March 2007. The four research questions were, (1) Does forecast
                    accuracy persist? (2) What are the determinants of such persistence? (3) Do
                    analysts who exhibit these characteristics make more accurate forecasts than the
                    simple consensus? (4) Is a “smart” consensus that is based on
                    individuals exhibiting these characteristics more accurate than the simple
                    consensus? It was shown that analyst forecast accuracy persists and is
                    determined by long-term past accuracy and the analyst’s overall ability
                    in forecasting all statistics.Forecasts of key macroeconomic statistics are an important input in the
                    decision-making process of security analysts, portfolio managers, and investment
                    advisers. A large body of research has shown that the consensus of macroeconomic
                    forecasts is more accurate than most individual forecasts underlying it, from
                    which comes the strong reliance of the investment community on the consensus.
                    This evidence does not preclude the possibility that some analysts can
                    outperform the consensus. Little evidence, however, indicates that a smart
                    consensus based on forecasts of a highly skilled subset of analysts can
                    consistently beat the simple consensus.We examined analyst forecasts of 26 macroeconomic statistics based on surveys
                    conducted by Bloomberg between August 1998 and March 2007. We posed four
                    research questions: (1) Does individual analyst ability to predict macroeconomic
                    data persist? (2) Do systematic aspects of differential ability exist? In
                    particular, do short-term and long-term track records of forecast performance
                    matter, and if so, which one matters more? Moreover, does an individual’s
                    track record in forecasting the macroeconomic statistic in question
                    (“specific ability”) and other macroeconomic statistics
                    (“general ability”) matter, and if so, which matters more? For our
                    last two research questions, we used the forecast by the simple consensus as our
                    benchmark: (3) Do individuals with certain attributes (e.g., long-term track
                    record for all other macroeconomic statistics) outperform the simple consensus?
                    (4) Does a smart consensus conditional on a simple average of forecasts of
                    individuals possessing certain attributes outperform the simple consensus?To examine these questions, we evaluated and classified each analyst’s
                    forecasting performance according to a four-dimensional metric for each
                    macroeconomic statistic and survey period. We repeated and updated evaluations
                    and classifications after each survey period, so for each statistic and analyst,
                    we obtained a time series of performance. On each performance dimension, we
                    classified analysts as “winners” or not based on their performance
                    relative to all other analysts. The first two dimensions were an
                    analyst’s short-term and long-term performance in forecasting a specific
                    statistic, which we refer to as short-term and long-term
                        specific ability or track record. The other two dimensions
                    were the analyst’s short-term and long-term performance with respect to
                    all the other statistics he or she forecasted, which we refer to as short-term
                    and long-term general ability or track record.We provided the following evidence regarding our four research questions. First,
                    analysts do exhibit persistence in predicting macroeconomic data. Second,
                    although all four dimensions of track record helped explain individual accuracy
                    in holdout periods, long-term track record was more important than short-term
                    track record; track records of the other statistics the individual predicted
                    were more important than track records for the statistic in
                    question; and long-term track records regarding the other statistics that the
                    individual forecasted were the most important of the four dimensions. Third,
                    individuals generally did not outperform a simple unconditional
                    consensus, regardless of which performance dimension one used. Fourth, a
                    “smart” conditional consensus (the simple average of all individual
                    forecasters with superior long-term track records for the other statistics
                    predicted) outperformed both the mean and median consensus forecasts.
Journal: Financial Analysts Journal
Pages: 74-86
Issue: 6
Volume: 64
Year: 2008
Month: 11
X-DOI: 10.2469/faj.v64.n6.9
File-URL: http://hdl.handle.net/10.2469/faj.v64.n6.9
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: End of an Era
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 1
Volume: 65
Year: 2009
Month: 1
X-DOI: 10.2469/faj.v65.n1.1
File-URL: http://hdl.handle.net/10.2469/faj.v65.n1.1
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 72-72
Issue: 1
Volume: 65
Year: 2009
Month: 1
X-DOI: 10.2469/faj.v65.n1.10
File-URL: http://hdl.handle.net/10.2469/faj.v65.n1.10
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: 2008 Report to Readers
Journal: Financial Analysts Journal
Pages: 10-12
Issue: 1
Volume: 65
Year: 2009
Month: 1
X-DOI: 10.2469/faj.v65.n1.2
File-URL: http://hdl.handle.net/10.2469/faj.v65.n1.2
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Author-Name: John C. Bogle
Author-X-Name-First: John C.
Author-X-Name-Last: Bogle
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: Markets in Crisis
Abstract: 
 In October 2008, Rodney N. Sullivan, CFA, interviewed John C. Bogle regarding the
                    global financial crisis and his outlook for the future.In John C. Bogle’s recent Financial Analysts Journal
                    article “Black Monday and Black Swans,” the esteemed
                    financial expert wrote about the plethora of risks that arose during the recent
                    financial turmoil. With this context in mind, in October 2008, the
                        FAJ’s associate editor, Rodney Sullivan, CFA,
                    interviewed Mr. Bogle about the global market crisis and his outlook for the
                    future of the global economy.Editor’s Note: For a podcast based on John
                        C. Bogle’s article “Black Monday and Black
                        Swans,” go to http://www.cfainstitute.org/learning/products/multimedia/Pages/12820.aspx.
Journal: Financial Analysts Journal
Pages: 17-24
Issue: 1
Volume: 65
Year: 2009
Month: 1
X-DOI: 10.2469/faj.v65.n1.3
File-URL: http://hdl.handle.net/10.2469/faj.v65.n1.3
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Author-Name: Harry M. Markowitz
Author-X-Name-First: Harry M.
Author-X-Name-Last: Markowitz
Title: Proposals Concerning the Current Financial Crisis
Abstract: 
 A basic cause of the current financial crisis was the mandate from the U.S.
                    Congress to the Federal National Mortgage Association (Fannie Mae) to increase
                    its support of low-income housing. This mandate led to a lowering of lending
                    standards, which encouraged home buyers to spend beyond their means. The problem
                    was aggravated by novel, obscure, highly leveraged financial instruments that
                    were not well understood by either lenders or borrowers. At least two steps are
                    required for the solution to this crisis: (1) Congress should instruct Fannie
                    Mae that the safety of the financial system must take priority over the
                    objective of providing low-income housing, and (2) this article’s
                    “modest” proposal for bringing transparency to the tangle of
                    financial instruments should be implemented. A basic cause of the current financial crisis was the mandate from the U.S.
                    Congress to the Federal National Mortgage Association (Fannie Mae) to increase
                    its support of low-income housing. This mandate led to a lowering of lending
                    standards, which encouraged home buyers to spend beyond their means. The problem
                    was aggravated by novel, obscure, highly leveraged financial instruments that
                    were not well understood by the companies that used them. Part of the cure for the current crisis—which would also remove one
                    potential cause of future crises—is for Congress to stop pressuring Fannie
                    Mae to acquire mortgages with insufficient borrowing standards. On the contrary,
                    any mortgages that Fannie Mae purchases should meet solid, traditional
                    down-payment and documentation requirements. Inducing families to buy houses
                    they could not afford did not benefit them, the U.S. and international financial
                    systems, or the world economy. Reducing the pressure on Fannie Mae to promote low-income housing, however,
                    would not address the financial transparency crisis involving such instruments
                    as collateralized mortgage obligations (CMOs), which pool mortgages and slice
                    them into “tranches” that are sold to clients that, in some cases,
                    use these tranches as inputs to other exotic instruments, such as collateralized
                    debt obligations (CDOs). The result is that the parties do not know the risks to
                    which they and their possible counterparties are exposed. Credit default swaps
                    (CDSs), which are insurance against the default of various obligations, have
                    proved especially dangerous because they are, in effect, insurance against
                    correlated risks.  The following proposal can help solve the current financial crisis and minimize
                    future crises: First and foremost, Congress should instruct Fannie Mae that the
                    safety of the banking system must take priority over the objective of providing
                    housing for low-income families. Second, the government should sponsor a survey
                    of direct exposures and an analysis of indirect exposures of obscure financial
                    instruments. This action is necessary to help restore clarity and trust to the
                    financial system. Third, regulators should recognize that credit default swaps
                    are insurance against correlated risks and are thus subject to much greater
                        portfolio risk than is a portfolio of uncorrelated
                    risks. In general, businesses should understand that financially engineered products
                    are based on assumptions regarding not only parameter estimates but also model
                    specification (model risk). With a highly leveraged portfolio of
                    marked-to-market products, such a misspecification can have disastrous
                    consequences.
Journal: Financial Analysts Journal
Pages: 25-27
Issue: 1
Volume: 65
Year: 2009
Month: 1
X-DOI: 10.2469/faj.v65.n1.4
File-URL: http://hdl.handle.net/10.2469/faj.v65.n1.4
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Author-Name: Emanuel Derman
Author-X-Name-First: Emanuel
Author-X-Name-Last: Derman
Title: Models
Abstract: 
 This article analyzes the methodology of modeling in the physical sciences and in
                    finance. Whereas hobbyists’ models aim for realistic resemblance to the
                    object of the model, physics models aim for accurate divination. Financial
                    models, the article argues, can at best aim to extrapolate or interpolate from
                    the known prices of liquid securities to the unknown values of illiquid ones.
                    Financial models are therefore best regarded as a collection of mathematically
                    consistent, parallel “thought universes,” each of which will always
                    be far too simple to resemble the real financial world, but whose exploration as
                    a whole can nevertheless provide valuable insight. Although models in physics resemble models in finance, the resemblance is
                    superficial. Models in physics aim at divination—foretelling the future and controlling
                    it. Physicists use two different approaches in creating models. The first
                    approach is to build what physicists call a fundamental model, which describes
                    the dynamics behind events in the real world. A fundamental
                    model consists of a system of principles, usually formulated mathematically,
                    that is used to draw causal inferences about future behavior.
                        Dynamics and causality are a fundamental
                    model’s essential characteristics. The second type of model is what physicists call a phenomenological model. Like
                    fundamental models, phenomenological models are used to make predictions, but
                    they do not state absolute principles; instead, they make pragmatic analogies
                    between things that one would like to understand and things that one already
                    understands from fundamental models. The analogies can be descriptive and
                    useful, but analogies are self-limiting and often have a toylike quality. In
                    physics, one does not delude oneself into thinking of analogies as truth.In finance, in contrast, models are used less for divination than for
                    interpolation or extrapolation from the known dollar prices of liquid securities
                    to the unknown dollar values of illiquid securities. Most financial models do
                    not predict the future; instead, they allow us to compare different prices in
                    the present. In contrast to both fundamental and phenomenological physics models, the truth of
                    a financial model is almost indeterminable because fair value is unknown. If
                    fair value were precisely calculable, markets would not exist.The only law of financial modeling is the law of one price, or the principle of
                    no riskless arbitrage, which states that any two securities with identical
                    estimated future payoffs, no matter how the future turns out, should have
                    identical current prices. The law of one price—this valuation by
                    analogy—is the only genuine law in quantitative finance, and it is not a
                    law of nature. It is a general reflection on the practices of human
                    beings—who, when they have enough time and enough information, will grab a
                    bargain when they see one. The law of one price usually holds over the long run
                    in well-oiled markets with enough savvy participants, but short-lived and even
                    long-lived and persistent exceptions can always be found.How do we use the law of one price to determine value? If we want to estimate the
                    unknown value of a target security, we must find some other replicating
                    portfolio—a collection of liquid securities that has the same estimated
                    future payoffs as the target no matter how the future turns out. The
                    target’s value is simply the value of the replicating portfolio.Where do models come in? One needs a model to show that the target and the
                    replicating portfolio have identical estimated future payoffs under all
                    circumstances. To demonstrate payoff identity, we must (1) specify what we mean
                    by “all circumstances” for each security and (2) find a strategy for
                    creating a replicating portfolio that in each future scenario or circumstance
                    will have payoffs identical to those of the target. That is what the
                    Black–Scholes option pricing model does: It tells us exactly how to
                    replicate or manufacture fruit salad (an option) out of fruit (stocks and
                    bonds). The appropriate price should be the cost of manufacture.The tricky part in building these models is specifying what we mean by “all
                    circumstances.” In the Black–Scholes model, all circumstances means
                    a future in which stock returns are normally distributed and stock prices move
                    continuously. Unfortunately, real stock prices do not behave that way.
                    Specifying future scenarios in financial models is always difficult because
                    markets always outwit us eventually. Even if markets are not strictly random,
                    their vagaries are too rich to capture in a few sentences or equations.The “risk” of using models differs from the risk of flipping coins.
                    Although one cannot predict the result of a coin flip, one knows the probability
                    of the coin’s coming up heads or tails. With a model, however, not even
                    the probability of the model’s being right can be known.Financial models are therefore best regarded as a collection of parallel,
                    inanimate “thought universes” available for exploration. Each
                    universe should be internally consistent, but the financial/human world, unlike
                    the world of matter, is vastly more complex and vivacious than any model we
                    could ever make of it. The right way to engage with a model is to be like a
                    reader of fiction—to suspend disbelief and then push ahead with the model
                    as far as possible.
Journal: Financial Analysts Journal
Pages: 28-33
Issue: 1
Volume: 65
Year: 2009
Month: 1
X-DOI: 10.2469/faj.v65.n1.5
File-URL: http://hdl.handle.net/10.2469/faj.v65.n1.5
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:65:y:2009:i:1:p:28-33




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Author-Name: Don Ezra
Author-X-Name-First: Don
Author-X-Name-Last: Ezra
Title: The Second Moment
Abstract: 
 This brief article discusses the statistical “second moment” that
                    measures the variability in a distribution. Over the years, society’s
                    focus has expanded from looking only at first moments to considering second
                    moments. A consideration of second moments of the distributions of an array of
                    economic variables can aid in understanding societal concerns about outcomes and
                    risk tolerance following the recent global financial crisis. Such an
                    understanding provides a basis for interpreting the use of various mechanisms,
                    including prudent asset allocation, options, regulation of the freedom to make
                    contracts, state participation in markets, and taxation. This brief article discusses the statistical “second moment” that
                    measures the variability in a distribution. Over the years, society’s
                    focus has expanded from looking only at first moments to considering second
                    moments. So, we look, for example, not only at the average wage but also at the
                    distribution of wages; we look not only at the expansion of GDP but also at the
                    differences in the way it affects individuals. Considering the second moment is
                    a big advance in the way society evaluates both outcomes and risk tolerance. A consideration of second moments of the distributions of an array of economic
                    variables can aid in understanding societal concerns about outcomes and risk
                    tolerance following the recent global financial crisis. Such an understanding
                    provides a basis for interpreting the use of various mechanisms, including
                    prudent asset allocation, options, regulation of the freedom to make contracts,
                    state participation in markets, and taxation.Note: The author’s views expressed in this article are
                        entirely his own and may not reflect the views held by Russell
                        Investments.
Journal: Financial Analysts Journal
Pages: 34-36
Issue: 1
Volume: 65
Year: 2009
Month: 1
X-DOI: 10.2469/faj.v65.n1.6
File-URL: http://hdl.handle.net/10.2469/faj.v65.n1.6
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:65:y:2009:i:1:p:34-36




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Author-Name: David Blake
Author-X-Name-First: David
Author-X-Name-Last: Blake
Author-Name: Andrew Cairns
Author-X-Name-First: Andrew
Author-X-Name-Last: Cairns
Author-Name: Kevin Dowd
Author-X-Name-First: Kevin
Author-X-Name-Last: Dowd
Title: Designing a Defined-Contribution Plan: What to Learn from Aircraft Designers
Abstract: 
 This article uses the framework of designing a commercial aircraft to illustrate
                    how a personal defined-contribution (DC) pension plan should be designed if it
                    is to achieve its objective of delivering an adequate and secure retirement
                    pension. The article’s suggestions are based on similarities between a DC
                    pension plan and an aircraft journey. For example, the strategic investment
                    strategy is analogous to the aircraft, the plan provider is analogous to the
                    aircraft operator, the contributions are analogous to the fuel, and the
                    accumulation and decumulation stages are analogous to the climb and descent
                    stages of the flight. The significant differences that exist between the two
                    concepts are also highly instructive.Why are pension plans not designed in the same way as commercial aircraft? At
                    first blush, this question might seem a strange one to ask. It is also, however,
                    an instructive one. Given the astounding success of aircraft design over the
                    last century, we suggest that designers of DC pension plans have much to learn
                    from aircraft designers.Many similarities exist between a DC pension plan and an aircraft journey. The
                    strategic investment strategy of a pension plan is analogous to the aircraft.
                    The aircraft’s operator is analogous to the pension plan provider. The
                    contributions into a pension plan are analogous to the aircraft’s fuel.
                    The climb stage of an aircraft’s journey is analogous to the accumulation
                    stage of a pension plan, and the aircraft’s descent stage is analogous to
                    the pension plan’s decumulation stage. The pension fund’s achieving
                    its target outcome is analogous to an aircraft’s safe arrival at its
                    destination. The fund manager’s decisions concerning such issues as market
                    timing and tactical asset allocation are analogous to the actions of the pilot
                    in flying the plane. Sponsoring employers, pension trustees, and regulators are
                    analogous to air traffic controllers.Significant differences between aircraft journeys and pension plans also exist,
                    and these differences are highly instructive:No uncertainty exists about the destination of an aircraft journey, and
                            the passengers can alter neither the destination nor the route once the
                            journey has started. In contrast, with a pension plan, the destination
                            of the journey (the desired amount of the pension), the anticipated
                            length of the journey (the time until the member retires), and the route
                            to be taken (the investment strategy) are generally not clearly
                            formulated when the pension plan journey begins and can be easily
                            changed during the journey.The length of an aircraft journey is also much shorter than the journey
                            of a pension plan, which can be 70 years or more. Aircraft designers
                                must get the design correct before
                            the aircraft ever takes off; otherwise, they would soon lose their good
                            reputations, their jobs, or worse. In contrast, the designers of pension
                            plans will have long since departed the scene by the time members
                            discover whether their plans were well designed; the pensions that the
                            plan members actually receive from their plans will not be the plan
                            designers’ problem.Another important difference is that airline passengers know that they
                            need to get to the airport by a certain time if they want to catch their
                            plane and reach their destination. The much longer journey of a pension
                            plan offers plenty of opportunities to delay the journey’s start
                            and consequently end up with a lower pension by the time the retirement
                            date arrives (or even have to delay retirement).There is little danger that an aircraft will have insufficient fuel to
                            reach its destination, but there is considerable danger that pension
                            plan holders will make insufficient contributions to their pension
                            plans. Of course, no improvement in fuel efficiency can compensate for
                            insufficient fuel to reach the destination; similarly, no increase in
                            investment risk can compensate for inadequate contributions if a
                            particular target pension outcome is desired.Another instructive difference exists in the relationship between the
                            climb and descent stages of an aircraft journey and the accumulation and
                            decumulation stages of a DC pension plan. Whereas the climb and descent
                            stages of an aircraft journey make up a seamless whole, an almost
                            complete lack of integration of the accumulation and decumulation stages
                            exists in the current design of DC pension plans.Finally, a difference in competence exists between the airline passenger
                            and the pension plan member. All the passenger needs to know is the
                            destination and the airline and flight to book. The passenger can,
                            therefore, be treated as an intelligent consumer who knows what to do.
                            Unfortunately, many consumers of financial products are clearly not well
                            informed, especially regarding complex long-term products such as
                            pensions. In that regard, a role might exist for a sort of surrogate
                            “intelligent consumer” to act on behalf of pension plan
                            members as a guide or supervisor. This role might be filled by pension
                            trustees, sponsoring employers, or even regulators.
Journal: Financial Analysts Journal
Pages: 37-42
Issue: 1
Volume: 65
Year: 2009
Month: 1
X-DOI: 10.2469/faj.v65.n1.7
File-URL: http://hdl.handle.net/10.2469/faj.v65.n1.7
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:65:y:2009:i:1:p:37-42




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Author-Name: Stephen Brown
Author-X-Name-First: Stephen
Author-X-Name-Last: Brown
Author-Name: William Goetzmann
Author-X-Name-First: William
Author-X-Name-Last: Goetzmann
Author-Name: Bing Liang
Author-X-Name-First: Bing
Author-X-Name-Last: Liang
Author-Name: Christopher Schwarz
Author-X-Name-First: Christopher
Author-X-Name-Last: Schwarz
Title: Estimating Operational Risk for Hedge Funds: The ω-Score
Abstract: 
 Using a complete set of U.S. SEC filing information on hedge funds (Form ADV) and
                    data from the Lipper TASS Hedge Fund Database, the study reported here developed
                    a quantitative model called the ω-score to measure hedge fund operational
                    risk. The ω-score is related to conflict-of-interest issues, concentrated
                    ownership, and reduced leverage in the Form ADV data. With a statistical
                    methodology, the study further related the ω-score to such readily
                    available information as fund performance, volatility, size, age, and fee
                    structures. Finally, the study demonstrated that although operational risk is
                    more significant than financial risk in explaining fund failure, a significant
                    and positive interaction exists between operational risk and financial risk. The hedge fund industry has experienced tremendous growth in the past decade. An
                    estimated 9,000 hedge funds exist worldwide, with more than $1.8 trillion under
                    management, compared with only $39 billion in 1990. In particular, institutional
                    investors have increased their presence in hedge funds. The hedge fund industry,
                    however, is also known for its high attrition rate. Selecting a successful
                    manager can be very challenging. The increasing demand for hedge funds, together
                    with potential failures as a result of operational risk, calls for due diligence
                    in selecting high-quality managers, which is commonly practiced by many prudent
                    investors before they invest.Because the assessment of operational risk necessarily relies on such intangible
                    variables as historical manager behavior and unethical or illegal acts, due
                    diligence in the hedge fund industry is primarily concerned with qualitative
                    rather than quantitative matters. As the number of funds increases and the fixed
                    cost of evaluating them remains constant, however, numerical scoring models are
                    needed. Although a quantitative model can never fully replace human judgment,
                    the analysis of “soft information” can help prioritize the
                    due-diligence process. Indeed, with the increasing flow of available information
                    about managers, a reliable model that reduces the dimensionality of the
                    due-diligence process is essential to better assess hedge fund exposure to
                    operational risk.In analyzing data from the U.S. SEC Form ADV filings, which some U.S.-based hedge
                    funds were formerly required to submit, we found that operational risk, as
                    measured by the past legal or regulatory problems of investment advisers or fund
                    managers, is strongly related to such Form ADV variables as conflict of
                    interest, ownership, and leverage. Hence, developing an instrument for
                    assessment of operational risk, based on Form ADV data, is feasible. Given that
                    future Form ADV filings will be limited and thus complete information on
                    operational-risk cofactors may not be observable in the future, alternative
                    models based on available information are warranted. In our study, we used
                    variables in the Lipper TASS Hedge Fund Database to develop such an instrument.
                    Through a statistical mapping technology, we were able to link the Form ADV
                    variables with the TASS variables and then use the TASS variables to develop a
                    risk instrument, the ω-score, which is a function of fund performance,
                    volatility, fund age and size, and fee structure.We then turned to the crucial question of whether the ω-score could be used
                    to predict fund failure. The main contribution of our study is a scoring model
                    for detecting operational risk in the hedge fund industry. We also examined the
                    interaction between operational risk and financial risk, especially the marginal
                    impact of operational risk on predicting fund failure after controlling for
                    financial risk. Although we have little doubt that more sophisticated models
                    will be developed, our study demonstrates the feasibility of scoring funds
                    according to their potential for operational-risk events.
Journal: Financial Analysts Journal
Pages: 43-53
Issue: 1
Volume: 65
Year: 2009
Month: 1
X-DOI: 10.2469/faj.v65.n1.8
File-URL: http://hdl.handle.net/10.2469/faj.v65.n1.8
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:65:y:2009:i:1:p:43-53




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Author-Name: Olubunmi Faleye
Author-X-Name-First: Olubunmi
Author-X-Name-Last: Faleye
Title: Classified Boards, Stability, and Strategic Risk Taking
Abstract: 
 Classified boards are the focus of recent shareholder activism aimed at improving
                    U.S. corporate governance. Although critics argue that classified boards reduce
                    directors’ effectiveness, proponents counter that they enhance corporate
                    stability, board independence, and long-term strategic risk taking. Based on
                    hand-collected data, this study found that stability was similar for both
                    classified and nonclassified boards and that continuity rates for independent
                    directors were comparable for both categories. The study found as well that
                    companies with classified boards invested less in R&D and other
                    company-specific capital assets. These findings were also true for companies
                    with relatively complex operations that are often considered most likely to
                    benefit from classified boards.Classified boards are the focus of recent shareholder activism aimed at improving
                    U.S. corporate governance. According to Institutional Shareholder Services, 46
                    shareholder proposals to declassify boards received an average of 60.5 percent
                    favorable votes in 2005; that number increased to 66.8 percent for 42 such
                    proposals voted on by 30 June 2006. On the basis of studies that examined the
                    stock price reaction to adoptions of classified boards and studies that analyzed
                    the impact of classified boards on hostile-takeover activities, critics argue
                    that classified boards harm shareholders by facilitating managerial entrenchment
                    and reducing directors’ effectiveness. Proponents counter that classified
                    boards enhance corporate stability, board independence, and long-term strategic
                    risk taking. To examine these claims empirically, I used hand-collected data for
                    a sample of 2,072 companies in the 1995–2002 period.First, I analyzed the effect of classified boards on long-term board stability,
                    which I defined as the proportion of 1995 directors remaining on the board as of
                    the end of 2002. For companies with classified boards, 58.9 percent of 1995
                    directors remained on the board as of the end of 2002, compared with 60.5
                    percent for companies that elected all directors annually. I obtained similar
                    results for two categories of directors: 59.0 percent of affiliated directors
                    and 59.5 percent of independent directors remained on classified boards,
                    compared with 61.1 percent and 59.5 percent for nonclassified boards. None of
                    these differences is statistically significant, which indicates that electing
                    directors to staggered terms does not enhance board stability any more than
                    electing all directors annually and that independent directors do not last any
                    longer than affiliated directors on classified boards. These conclusions
                    remained unchanged when I controlled for other factors that can affect board
                    stability by using a multiple regression framework.Next, I examined the effect of classified boards on corporate investment in
                    long-term, company-specific capital assets by focusing on expenditures for
                    research and development and net investments in property, plant, and equipment
                    (PP&E). On average, companies with classified boards invested 2.1 percent of
                    their assets in R&D, compared with 4.3 percent for companies with
                    nonclassified boards. Similarly, classified boards increased their net PP&E
                    by 19.8 percent, compared with 20.6 percent for nonclassified boards. Even among
                    companies in complex industries (e.g., pharmaceuticals, electronics, and
                    software development) in which investment in R&D and other company-specific
                    assets is critical for success, those with classified boards spent less on
                    R&D and net PP&E—5.0 percent and 11.5 percent, respectively,
                    compared with 9.3 percent and 15.5 percent for companies with nonclassified
                    boards. Overall, these results are difficult to reconcile with the notion that
                    classified boards enhance directors’ ability to focus on long-term
                    strategy.Finally, I analyzed the effect of classified boards on wealth creation among
                    companies subject to a high degree of operating uncertainty because of the
                    complexity of their business. This group is commonly considered most likely to
                    benefit from having classified boards; nevertheless, I found evidence
                    contradictory to such beliefs. Regardless of how I defined operating complexity,
                    I found that classified boards always had a negative impact on the creation of
                    shareholder value.These results weaken some of the strongest arguments in support of classified
                    boards. That classified boards have powerful antitakeover effects is generally
                    accepted and has been empirically shown. Nevertheless, many proponents support
                    classified boards because they are thought to promote corporate stability. The
                    findings indicate that this claim is without merit and suggest that justifying
                    classified boards on the basis of furthering stability is problematic. Rather,
                    the current wave of shareholder activism aimed at declassifying corporate boards
                    appears to be well justified.
Journal: Financial Analysts Journal
Pages: 54-65
Issue: 1
Volume: 65
Year: 2009
Month: 1
X-DOI: 10.2469/faj.v65.n1.9
File-URL: http://hdl.handle.net/10.2469/faj.v65.n1.9
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:65:y:2009:i:1:p:54-65




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Author-Name: John C. Bogle
Author-X-Name-First: John C.
Author-X-Name-Last: Bogle
Title: The End of “Soft Dollars”?
Abstract: 
 Over the past few decades, mutual fund shareholders have paid to brokerage and
                    investment banking firms billions of dollars in so-called soft-dollar
                    commissions that have far exceeded the costs of executing the transactions. Over
                    the years, the U.S. SEC’s inconsistent interpretations of pertinent
                    sections of the Securities Exchange Act of 1934 have generally allowed the
                    continued use of soft dollars for the payment of not only brokerage commissions
                    but also research products and services. This article discusses the history of
                    the practice and suggests two approaches that may hasten the end of the era of
                    soft dollars: client commission-sharing arrangements and paying for research
                    directly in cash. See comments on this article.Over the past few decades, mutual fund shareholders have paid to brokerage and
                    investment banking firms billions of dollars in commissions that have far
                    exceeded the costs of executing the transactions. This expenditure of
                    shareholder assets has been legally justified by a peculiar provision, Section
                    28(e), added to the Securities Exchange Act of 1934 shortly after fixed
                    commission rates were abolished by the U.S. SEC on 1 May 1975. Section 28(e)
                    provided a “safe harbor” for advisers who “paid up” to
                    acquire research and other services. Although these commissions were paid by the
                    mutual funds themselves, they were controlled and directed by fund managers, who
                    were employees of legally separate management firms. Acquiring this array of
                    services in return for soft dollars reduced the hard-dollar costs of research,
                    administration, and marketing that the advisers would otherwise presumably have
                    had to pay out of their own coffers.The protection afforded by Section 28(e) was apparently insufficient for fund
                    advisers. In 1986, the SEC was persuaded to extend its interpretation of Section
                    28(e) to a wider range of permissible uses of soft dollars (in truth, excess
                    brokerage commissions), including “mixed-use” products and services
                    that covered both research and administrative costs (e.g., computer hardware,
                    communications equipment, and publications) that the advisers would otherwise
                    have had to pay with their own hard dollars. This additional flexibility further
                    blurred the distinction between soft and hard dollars.Over the years, as the use of soft dollars for broker support has inevitably
                    reemerged as a powerful force in fund marketing, the SEC’s inconsistent
                    interpretations of pertinent sections of the Securities Exchange Act of 1934
                    have generally allowed the continued use of soft dollars for the payment of not
                    only brokerage commissions but also research products and services. This
                    practice—so harmful to clients of institutional managers—is
                    virtually indefensible and must be ended.Two new approaches may hasten the end of the era of soft dollars: client
                    commission-sharing arrangements (CCSAs) and paying for research directly in
                    cash. CCSAs allow institutional managers and brokers to set aside a specified
                    share of commissions for research services. CCSAs, which provide precise and
                    measurable data that ought to be fully disclosed, are growing at a rapid rate.
                    Nevertheless, CCSAs, although apparently more respectable than soft dollars
                    because they are more transparent, are still “kissing cousins” of
                    soft dollars. And because CCSAs do not get to the heart of the soft-dollar
                    problem, they will probably prove to be only a bridge to a better approach.One such better approach is Fidelity Investments’ decision, following the
                    SEC’s 2006 guidance, to separate research from trading commissions and to
                        pay for research directly in cash. In time, pressure from
                    regulators, public opinion, and even enlightened self-interest may force other
                    major institutions to adopt Fidelity’s policy. Ultimately, the era of soft
                    dollars, for marketing and research alike, must come to an end, simply because
                    soft dollars ill serve fund investors. Note: The views expressed in this article are the
                        author’s alone and do not necessarily reflect the views of
                        Vanguard’s current management. The managers who supervise the funds
                        under Vanguard’s direct management pay commissions solely for the
                        execution of portfolio transactions and do not pay for distribution,
                        research, or marketing services with soft dollars. 
Journal: Financial Analysts Journal
Pages: 48-53
Issue: 2
Volume: 65
Year: 2009
Month: 3
X-DOI: 10.2469/faj.v65.n2.1
File-URL: http://hdl.handle.net/10.2469/faj.v65.n2.1
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:65:y:2009:i:2:p:48-53




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Author-Name: Eli Beracha
Author-X-Name-First: Eli
Author-X-Name-Last: Beracha
Author-Name: Mark Hirschey
Author-X-Name-First: Mark
Author-X-Name-Last: Hirschey
Title: When Will Housing Recover?
Abstract: 
 An interesting perspective on recent trends in the U.S. housing market is gained
                    by noting how housing prices correspond to per capita income, a traditional
                    measure of affordability. The ratio of housing prices to per capita income is
                    high but close to historical norms in many regional markets. However, notable
                    exceptions do exist. In California, housing prices recently reached levels
                    relative to per capita income far above historical norms. A significant pricing
                    correction has begun in that market. Similarly, housing prices are correcting
                    sharply in Arizona, Florida, and Nevada. Investors need to be mindful of the
                    potential for housing market–related losses and the potential for
                    contagion among asset classes.See comments and response on this article.Falling real prices for housing are unusual in the United States; falling
                        nominal housing prices are unprecedented, at least since
                    the Great Depression of the 1930s. Yet, although complete figures for 2008 are
                    not yet available, we can see that the nation is undergoing an extraordinary
                    decline in both real and nominal housing prices. On a national basis, nominal
                    prices for housing declined by an unprecedented –8.0 percent between
                    Q2:2006 and Q2:2008 (the latest available data). Over this period, regional
                    housing markets were especially weak in California (–27.3 percent), Nevada
                    (–28.6 percent), Arizona (–24.8 percent), Florida (–27.0
                    percent), and Virginia (–19.4 percent). Concern with problems in the
                    California housing market is at the epicenter of the current crisis because
                    California is the largest regional housing market, is presently experiencing a
                    fast rate of price depreciation, and was a pivotal state in the tightly
                    contested 2008 presidential election.We show that the sample of 10 metropolitan statistical areas used in 1987 to
                    constitute the original S&P/Case–Shiller Composite 10 Index—the
                    most widely followed housing price index—is dominated by what turned out
                    to be seven red-hot and then stone-cold regional housing markets, including
                    California, Florida, Nevada, New York, and the District of Columbia. In these
                    markets, prices soared up to a market peak in Q4:2006 and then began a collapse
                    that continues through Q2:2008. At the same time, housing markets remain stable throughout much of the United
                    States. Moreover, despite the severe correction in a handful of high-profile
                    markets, housing prices have continued to rise in 23 states. In another 11
                    states, the recent decline in housing prices is a modest 0–5 percent. The
                    current and unprecedented nationwide decline in housing prices has had little to
                    no effect on homeowners in 34 of 50 states—that is, in roughly two-thirds
                    of the states.For the United States as a whole, housing prices will conform to long-term norms
                    if, in an environment of flat housing prices and continued low interest rates,
                    typical per capita income growth ensues for only 1.20 years. In this case, the
                    nationwide housing “crisis” will be on the road to recovery by the
                    first quarter of 2010.
Journal: Financial Analysts Journal
Pages: 36-47
Issue: 2
Volume: 65
Year: 2009
Month: 3
X-DOI: 10.2469/faj.v65.n2.2
File-URL: http://hdl.handle.net/10.2469/faj.v65.n2.2
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:65:y:2009:i:2:p:36-47




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Author-Name: Ying Duan
Author-X-Name-First: Ying
Author-X-Name-Last: Duan
Author-Name: Gang Hu
Author-X-Name-First: Gang
Author-X-Name-Last: Hu
Author-Name: R. David McLean
Author-X-Name-First: R. David
Author-X-Name-Last: McLean
Title: When Is Stock Picking Likely to Be Successful? Evidence from Mutual Funds
Abstract: 
 Consistent with a costly arbitrage equilibrium in which arbitrage costs insulate
                    mispricing, this study finds that mutual fund managers have stock-picking
                    ability for stocks with high idiosyncratic volatility but not for stocks with
                    low idiosyncratic volatility. These findings suggest that fund managers and
                    other investors may want to pay special attention to
                    high-idiosyncratic-volatility stocks because they provide fertile ground for
                    stock picking. The study also finds that the stock-picking ability of the
                    average mutual fund manager declined after the extreme growth in the number of
                    both mutual funds and hedge funds in the late 1990s.Whether mutual fund managers have stock-picking ability is an important question
                    for both practitioners and mutual fund investors. The empirical evidence is
                    mixed. In this article, we try to answer this question from a fresh angle: If
                    mutual fund managers do possess stock-picking ability, when are they most likely
                    to be successful?We found that mutual fund managers have stock-picking ability in stocks with high
                    idiosyncratic volatility but not in stocks with low idiosyncratic volatility.
                    This finding is consistent with a costly arbitrage equilibrium in which
                    unhedgeable volatility prevents risk-averse arbitrageurs from taking large
                    positions in mispriced securities, and thus, mispricing persists. An alternative
                    explanation for this finding is that high-idiosyncratic-volatility stocks have
                    large streams of company-specific information, thereby providing opportunities
                    for company-specific information production and stock picking. One practical
                    implication of this finding is that fund managers and other investors may want
                    to pay special attention to high-idiosyncratic-volatility stocks because they
                    provide fertile ground for stock picking.We also found little evidence of stock-picking ability among mutual fund managers
                    in the later part of our sample (after the mid-1990s), although fund managers do
                    seem to make better trades in high-idiosyncratic-volatility stocks. One
                    explanation for this finding could be the large increase in the number of both
                    mutual funds and hedge funds that occurred in the late 1990s. Increased
                    competition among managers may have caused a decrease in the number of
                    profitable trading opportunities, and the large increase in the number of
                    managers may have caused the quality of the average mutual fund manager to
                    decline.
Journal: Financial Analysts Journal
Pages: 55-66
Issue: 2
Volume: 65
Year: 2009
Month: 3
X-DOI: 10.2469/faj.v65.n2.3
File-URL: http://hdl.handle.net/10.2469/faj.v65.n2.3
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:65:y:2009:i:2:p:55-66




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Author-Name: Jeffrey H. Brown
Author-X-Name-First: Jeffrey H.
Author-X-Name-Last: Brown
Author-Name: Douglas K. Crocker
Author-X-Name-First: Douglas K.
Author-X-Name-Last: Crocker
Author-Name: Stephen R. Foerster
Author-X-Name-First: Stephen R.
Author-X-Name-Last: Foerster
Title: Trading Volume and Stock Investments
Abstract: 
 Previous studies suggest that trading-volume measures may proxy for a number of
                    factors, including liquidity, momentum, and information. For relatively illiquid
                    (typically smaller) stocks, investors may demand a liquidity premium, which can
                    result in a negative relationship between trading volume (as a
                    proxy for liquidity) and stock returns. For relatively liquid (typically larger)
                    stocks—the focus of this article—momentum and information effects
                    may dominate and result in a positive relationship between
                    trading volume and stock returns. Portfolios of S&P 500 Index and
                    large-capitalization stocks sorted on higher trading volume and turnover tend to
                    have higher subsequent returns (holding periods of 1–12 months) than those
                    with lower trading volume.Previous studies suggest that trading-volume measures may proxy for a number of
                    factors, including liquidity, momentum, and information. For relatively illiquid
                    (typically smaller) stocks, investors may demand a liquidity premium that
                    results in a negative relationship between trading volume (as a
                    proxy for liquidity) and stock returns. But for relatively liquid (typically
                    larger) stocks—the focus of our study—momentum and information
                    effects may dominate and result in a positive relationship
                    between trading volume and stock returns.We back test simulations of historical data of the S&P 500 Index and the
                    largest 1,000 U.S. stocks as measured by market capitalization (Largest 1,000).
                    We derive measures of trading volume (i.e., average daily trading volume over
                    the past three months) and turnover (i.e., annualized trading volume as a
                    percentage of shares outstanding) from January 1991 to December 2007. We show that two trading-volume measures—trailing three-month trading
                    volume (i.e., shares) and turnover—are monotonically related to
                    price-to-book ratio (PB) and market capitalization (MKT). We also discover a
                    U-shaped relationship with momentum strategies (MOM) (i.e., past six-month
                    “winners” and “losers” both tend to experience high
                    trading volume and turnover).We next focus on the potential profitability of long–short portfolios
                    sorted on trading volume and turnover. We form portfolio deciles based on the
                    trading-volume measures and compare returns for the subsequent 1-month, 3-month,
                    6-month, and 12-month periods. Contrary to much of the existing literature, for
                    our sample of larger stocks, we find generally monotonic patterns, with the less
                    (more) traded stocks (i.e., on the basis of trading volume and turnover) having
                    lower (higher) returns. For the trading-volume measure, we find that when we
                    regress excess (of T-bill) returns on market excess returns (i.e., the
                    traditional capital asset pricing model), the alpha is significant for the most
                    heavily traded portfolio. These results are even stronger when we use the
                    three-factor Fama–French model (RmRf, SMB, and HML) and the four-factor
                    Fama–French model (with a momentum factor, UMD, added). The alpha is also
                    positive and significant for the highest-turnover portfolio. Results are
                    sensitive, however, to the nature of the market (i.e., bull or bear).Finally, we create new measures (“trading-volume factors”) in the
                    spirit of the Fama–French factors and investigate their properties. We
                    find that their betas are generally significant when added to the
                    Fama–French four-factor model and regressed against portfolio quintile
                    returns based on PB, MKT, and MOM sorts.Our trading-volume factors may be related to some of the findings in the
                    behavioral finance literature. Regardless of what a trading-volume measure might
                    be a proxy for, it is an important consideration in any quantitatively based
                    investment strategy. Thus, our results suggest that we may look at trading
                    volume not only as a cost of trading (i.e., related to liquidity) but also as a
                    source of information.
Journal: Financial Analysts Journal
Pages: 67-84
Issue: 2
Volume: 65
Year: 2009
Month: 3
X-DOI: 10.2469/faj.v65.n2.4
File-URL: http://hdl.handle.net/10.2469/faj.v65.n2.4
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: Taming Global Markets
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 2
Volume: 65
Year: 2009
Month: 3
X-DOI: 10.2469/faj.v65.n2.5
File-URL: http://hdl.handle.net/10.2469/faj.v65.n2.5
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Author-Name: Bruce I. Jacobs
Author-X-Name-First: Bruce I.
Author-X-Name-Last: Jacobs
Title: Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis
Abstract: 
 The credit crisis reflects the collapse of a tower of structured finance products
                    based on subprime mortgage loans. These instruments—RMBSs, CDOs, SIVs, and
                    CDSs—shifted the risk of mortgage lending, especially the default risk,
                    from one party to another, until many lost sight of the real risks of the
                    underlying loans. But when housing-price appreciation reversed, many subprime
                    borrowers, having made only negligible down payments, owed more on their
                    mortgages than their houses were worth. These borrowers exercised the put
                    options in their mortgages, and defaults rose beyond the expectations priced
                    into mortgage rates, RMBS yields, and CDS premiums. The downside risk of
                    housing-market prices was shifted to lenders, and losses, magnified by vast
                    leverage, spread up the tower of structured instruments to CDO investors and CDS
                    sellers. The real risk of subprime mortgage investing became apparent, blowing
                    up financial firms and, in turn, the economy.The current credit crisis reflects the collapse of a tower of structured finance
                    products based on subprime mortgage loans. Structured finance products such as
                    residential mortgage-backed securities (RMBSs), collateralized debt obligations
                    (CDOs), structured investment vehicles (SIVs), and credit default swaps (CDSs)
                    enabled the expansion of lending to subprime mortgage borrowers while disguising
                    the real risk of such lending. Structured securitization transformed subprime
                    loans into products offering relatively high returns while carrying AAA ratings
                    from the credit-rating agencies. These products seemed to reduce risk by
                    shifting it from the lenders that made the mortgage loans to the banks that
                    bought the loans to pool and package them into RMBSs and CDOs and to the
                    investors that held CDOs, SIV commercial paper, and CDSs. Demand for structured
                    finance products helped fuel mortgage lending, which facilitated more purchases
                    of homes and, in turn, put upward pressure on prices. As lenders exhausted the
                    pool of possible homebuyers, however, housing prices began to decline. Many
                    subprime borrowers who had made little or no down payments found themselves
                    owing more on their mortgages than their houses were worth. These borrowers
                    exercised the put options in their mortgages, and defaults rose beyond the
                    expectations priced into mortgage rates, RMBS yields, and CDS premiums. The
                    downside risk of housing-market prices was shifted to lenders and, magnified by
                    vast amounts of leverage, spread up the tower of structured instruments to
                    investors in CDOs and sellers of CDSs. The solvency of some participating
                    institutions became questionable, lenders were reluctant to extend credit, and
                    liquidity began to dry up, all of which caused further declines in housing
                    prices, more defaults, and more losses. The real risk of subprime mortgage
                    investing became apparent, blowing up financial firms and, in turn, the
                    economy.
Journal: Financial Analysts Journal
Pages: 17-30
Issue: 2
Volume: 65
Year: 2009
Month: 3
X-DOI: 10.2469/faj.v65.n2.6
File-URL: http://hdl.handle.net/10.2469/faj.v65.n2.6
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Author-Name: Marc R. Reinganum
Author-X-Name-First: Marc R.
Author-X-Name-Last: Reinganum
Title: Setting National Priorities: Financial Challenges Facing the Obama Administration
Abstract: 
 During 2008, the U.S. financial system experienced extreme stress and came close
                    to paralysis. The long-term health of the U.S. economy requires more than higher
                    government spending, targeted Treasury bailouts, and unprecedented lending by
                    the Fed. This article recommends four reforms to regain and maintain long-term
                    economic health: (1) The markets for trading credit and its derivative
                    instruments must include a clearinghouse; (2) the markets for credit and its
                    derivative instruments must become public and transparent; (3) the size of
                    companies must be limited, or certain activities that can lead to failure must
                    be prohibited, so that no company can be allowed to become “too big to
                    fail”; and (4) the observed failures in financial agents’ monitoring
                    and in accounting practices must be rectified.During 2008, the U.S. financial system experienced extreme stress and came close
                    to paralysis. The S&P 500 Index declined from a high of 1565.15 on 9 October
                    2007 to 752.44 on 20 November 2008, a retrenchment of −51.9 percent. The
                    S&P 500 financial stocks declined by nearly −73 percent. The
                    ostensible catalyst of the current crisis was falling home prices, which led to
                    a loss of both capital and the ability to lend among financial institutions
                    (i.e., deleveraging and credit contraction). Financial institutions lost
                    confidence and trust in their counterparties’ ability to repay debt
                    obligations. Financial networks began to implode, and the contagion spread to
                    real economic activity.The current economic and political consensus seems to be that the U.S. economy
                    needs massive government spending to stimulate aggregate demand. But the
                    long-term health of the U.S. economy requires more than a higher level of
                    government spending, targeted Treasury bailouts, and unprecedented lending by
                    the Fed. At least four reforms are needed to regain and maintain long-term
                    economic health.First, derivative and credit instruments should no longer be traded like used
                    cars—that is, as completely private transactions between two parties. The
                    market for trading derivative and credit instruments must include a
                    clearinghouse. A clearinghouse, in conjunction with the regulators who oversee
                    it, would determine the necessary rules and capital requirements to ensure a
                    well-functioning market, one that would not need bailouts from taxpayers. More
                    generally, mechanisms and regulations must be fashioned to track financial
                    markets so that yet-to-be-created contracts cannot become widespread without a
                    clearinghouse. After all, the goal is to avoid a future crisis.Second, markets for derivative and credit instruments must become public,
                    transparent markets in which the prices, quantities, and identities of the
                    traded securities are reported and available in real time. Public, transparent
                    credit markets will aid the economy in the process of “price
                    discovery” for credit and risk and ensure that buyers and sellers receive
                    the best price for execution. The evolution of the NASDAQ stock market has shown
                    that multiple-dealer markets work. Standardized, simplified credit securities
                    that are well understood by buyers and sellers need to be developed. Simply put,
                    securities that underlie the financing of much economic activity (including
                    derivative and credit instruments) must be traded in public, transparent markets
                    that can be supervised and observed.Third, no company should be allowed to become “too big to fail.” The
                    proper functioning of competitive markets requires that companies be allowed to
                    fail because failure directs society’s scarce resources away from
                    inefficient activities and toward successful, innovative ones. In most economic
                    writings, “too big” is associated with “too profitable and
                    successful.” Too big to fail is more an idea associated with financial
                    networks as opposed to monopolistic institutions. The failure of any investment
                    firm in the financial network cannot be allowed to affect other firms in the
                    network. New policies should strive to either limit the size of firms or
                    prohibit activities within a firm that can lead to failure—or some
                    combination of the two.Finally, the observed failures in financial agents’ monitoring and in
                    accounting practices must be rectified. In particular, more stringent oversight
                    and enforcement, as well as better risk-sharing arrangements, must be instituted
                    in the loan origination/securitization process. Credit-rating agencies must be
                    given proper incentives to eschew potential conflict-of-interest opinions. The
                    compensation of financial executives must be tied to the time horizons of their
                    investment decisions. On the accounting front, off-balance-sheet obligations
                    need to be minimized; and the regulatory and oversight governing boards should
                    make sure that all markets have honest, fair, and investorcentric accounting
                    rules.Note: This article is based on a speech given by the author
                        in November 2008 at Oberlin College for a symposium titled “Setting
                        National Priorities: Economic Challenges Facing the New
                        Administration.” The views expressed in this article are the
                        author’s alone and do not necessarily reflect those of
                        OppenheimerFunds, Inc. 
Journal: Financial Analysts Journal
Pages: 32-35
Issue: 2
Volume: 65
Year: 2009
Month: 3
X-DOI: 10.2469/faj.v65.n2.7
File-URL: http://hdl.handle.net/10.2469/faj.v65.n2.7
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 88-88
Issue: 2
Volume: 65
Year: 2009
Month: 3
X-DOI: 10.2469/faj.v65.n2.8
File-URL: http://hdl.handle.net/10.2469/faj.v65.n2.8
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Author-Name: Arun Muralidhar
Author-X-Name-First: Arun
Author-X-Name-Last: Muralidhar
Title: “Saving Social Security: A Better Approach”: An Update
Abstract: 
 This material comments on “Saving Social Security: A Better Approach”.
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 2
Volume: 65
Year: 2009
Month: 3
X-DOI: 10.2469/faj.v65.n2.9
File-URL: http://hdl.handle.net/10.2469/faj.v65.n2.9
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Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: Regulating Financial Markets: Protecting Us from Ourselves and Others
Abstract: 
 The current global financial and economic crisis highlights the ongoing
                    tug-of-war between those who pull toward free markets and those who pull toward
                    strict regulation of markets—between those who pull toward libertarianism
                    and those who pull toward paternalism. Rising stock markets and economic
                    prosperity empower those who favor free markets and libertarianism; stock market
                    crashes and economic recessions empower those who favor strict regulation and
                    paternalism. This article discusses the current crisis against the backdrop of
                    earlier crises and focuses on margin regulations, which limit leverage;
                    suitability regulations, which require providers of financial products to act in
                    the interests of their clients; blue-sky laws, which prohibit securities deemed
                    unfair or unduly risky; and mandatory-disclosure regulations, which require
                    providers of financial products to disclose pertinent information even if
                    potential buyers do not ask for it. The current global financial and economic crisis highlights the ongoing
                    tug-of-war between those who pull toward free markets and those who pull toward
                    strict regulation of markets—between those who pull toward libertarianism
                    and those who pull toward paternalism. Motivated by ideology or self-interest,
                    members of each group try to enlist legislators and the general public in their
                    cause. Historical accidents, such as stock market crashes and economic
                    recessions, attract members to one group or the other, boosting its power and
                    tugging the rope left or right. New self-interest groups form once new
                    regulations are enacted, new historical accidents occur, and the tug-of-war
                    continues. This sequence of events played out when the Securities Act of 1933,
                    the Securities Exchange Act of 1934, and the Glass-Steagall Act of 1933 were
                    enacted during the Great Depression; when the Gramm–Leach–Bliley Act
                    was signed into law during the boom of 1999, repealing portions of the
                    Glass–Steagall Act; when the Sarbanes–Oxley Act was enacted after
                    the 2000 crash; and, most recently, when financial institutions were bailed out
                    and their regulation was tightened in the current crisis. We must come to grips
                    with the crisis and reconsider the balance we should strike in this
                    tug-of-war.This article discusses the current crisis against the backdrop of earlier crises
                    and focuses on margin regulations, which limit leverage; suitability
                    regulations, which require providers of financial products to act in the
                    interests of their clients; blue-sky laws, which prohibit securities deemed
                    unfair or unduly risky; and mandatory-disclosure regulations, which require
                    providers of financial products to disclose pertinent information even if
                    potential buyers do not ask for it.In 1999, Senator Phil Gramm spearheaded the Gramm–Leach–Bliley Act,
                    which eased regulation and repealed barriers erected by the Glass–Steagall
                    Act of 1933 to reduce the risk of economic catastrophes by separating commercial
                    banks from investment banks. Senator Gramm was a Republican, but support for the
                    Gramm–Leach–Bliley Act extended beyond his party. The act was signed
                    into law by President Clinton, a Democrat.We should not be surprised to learn that the Gramm–Leach–Bliley Act
                    was enacted in 1999, which was during the top end of a financial and economic
                    boom. Financial and economic booms shift the tug-of-war power from those who
                    pull toward paternalism and heavy regulation to those who pull toward
                    libertarianism and free or lightly regulated markets. Now, in 2009, a year at
                    the bottom end of a financial and economic bust, power is shifting to those who
                    pull toward paternalism and heavy regulation.History tells us that we tend to overreact by urging legislators and government
                    executives to pull too far toward paternalism when we are fearful and too far
                    toward libertarianism when we are exuberant. There is danger in pulling too far
                    toward one end or the other, but there is also danger in not pulling far enough.
                    The pull toward libertarianism and light regulation stoked the stock bubble of
                    the 1990s and the real estate bubble that followed it.Often citing U.S. Supreme Court Justice Louis Brandeis’s 1914 proclamation
                    that the sunlight of disclosure is the best disinfectant, some urge us to stop
                    pulling toward paternalism once we have reached mandatory transparent disclosure
                    to investors and in financial institutions and markets. But today, almost a
                    century after Brandeis’s declaration, we know that our hospitals need more
                    than sunshine as a disinfectant and that diseases can spread rapidly even when
                    relatively few forgo immunization. Mandatory disclosure might keep most of us
                    economically healthy most of the time, but we need the economic equivalent of
                    mandatory immunization to prevent the carelessness of some from infecting us
                    all.
Journal: Financial Analysts Journal
Pages: 22-31
Issue: 3
Volume: 65
Year: 2009
Month: 5
X-DOI: 10.2469/faj.v65.n3.1
File-URL: http://hdl.handle.net/10.2469/faj.v65.n3.1
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Author-Name: Jerry H. Tempelman
Author-X-Name-First: Jerry H.
Author-X-Name-Last: Tempelman
Title: “When Will Housing Recover?”: A Comment
Abstract: 
 This material comments on “When Will Housing Recover?” (March/April 2009).
Journal: Financial Analysts Journal
Pages: 12-14
Issue: 3
Volume: 65
Year: 2009
Month: 5
X-DOI: 10.2469/faj.v65.n3.10
File-URL: http://hdl.handle.net/10.2469/faj.v65.n3.10
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Author-Name: Eli Beracha
Author-X-Name-First: Eli
Author-X-Name-Last: Beracha
Author-Name: Mark Hirschey
Author-X-Name-First: Mark
Author-X-Name-Last: Hirschey
Title: “When Will Housing Recover?”: Authors’ Response
Abstract: 
 This material comments on “‘When Will Housing Recover?’: A Comment” (May/June 2009).
Journal: Financial Analysts Journal
Pages: 14-15
Issue: 3
Volume: 65
Year: 2009
Month: 5
X-DOI: 10.2469/faj.v65.n3.11
File-URL: http://hdl.handle.net/10.2469/faj.v65.n3.11
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 64-64
Issue: 3
Volume: 65
Year: 2009
Month: 5
X-DOI: 10.2469/faj.v65.n3.12
File-URL: http://hdl.handle.net/10.2469/faj.v65.n3.12
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: Parsimonious Asset Allocation
Abstract: 
 What can be done with fewer assumptions is done in vain with more.
—William of Occam, c. 1288–c. 1348
Journal: Financial Analysts Journal
Pages: 6-10
Issue: 3
Volume: 65
Year: 2009
Month: 5
X-DOI: 10.2469/faj.v65.n3.2
File-URL: http://hdl.handle.net/10.2469/faj.v65.n3.2
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Author-Name: Tyler Cowen
Author-X-Name-First: Tyler
Author-X-Name-Last: Cowen
Title: A Simple Theory of the Financial Crisis; or, Why Fischer Black Still Matters
Abstract: 
 The key question about the current financial crisis is how so many investors
                    could have mispriced risk in the same way and at the same time. This article
                    looks at the work of Fischer Black for insight into this problem. In particular,
                    Black considered why the “law of large numbers” does not always
                    apply to expectations in a market setting. Black’s hypothesis that a
                    financial crisis can arise from extreme bad luck is more plausible than is
                    usually realized. In this view, such factors as the real estate market are of
                    secondary importance for understanding the economic crisis, and the financial
                    side of the crisis may have roots in the real economy as a whole.The key question about the current financial crisis is how so many investors
                    could have mispriced risk in the same way and at the same time. This article
                    looks at the work of Fischer Black for insight into this problem. The crisis is
                    plausibly the result of negative shocks that affected many sectors of the
                    economy at the same time. In particular, plans in the real economy were based on
                    systematic overoptimism, which placed many investors in excessively vulnerable,
                    overleveraged positions. Black’s work, which considered why the law of
                    large numbers does not always apply to expectations in a market setting,
                    provides a framework for thinking about how systematic overcommitment is
                    possible. Black’s hypothesis that a financial crisis can arise from
                    extreme bad luck is more plausible than is usually realized. In this view, such
                    factors as the real estate market are of secondary importance for understanding
                    the current economic crisis. Although the crisis showed up in different parts of
                    the real economy at different speeds, those different speeds do not necessarily
                    have causal significance. The current downturn first appeared in the subprime
                    mortgage sector simply because those mortgagors were the first to run out of
                    money and were unable to maintain their unduly optimistic plans.
Journal: Financial Analysts Journal
Pages: 17-20
Issue: 3
Volume: 65
Year: 2009
Month: 5
X-DOI: 10.2469/faj.v65.n3.3
File-URL: http://hdl.handle.net/10.2469/faj.v65.n3.3
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:65:y:2009:i:3:p:17-20




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Author-Name: Raphael Hodgson
Author-X-Name-First: Raphael
Author-X-Name-Last: Hodgson
Title: The Birth of the Swap
Abstract: 
 In the 1970s, the dark ages of regulatory excess, globalization was impeded by
                    tough restrictions imposed by governments on outflows from their capital
                    markets. U.S. and U.K. companies got around some of these restrictions by
                    devising parallel loan agreements whereby U.S. companies funded subsidiaries of
                    U.K. companies in the United States and U.K. companies funded subsidiaries of
                    U.S. companies in the United Kingdom. Thus, cross-border transfers were avoided.
                    But these arrangements were complex and subject to legal haggling. In 1976, the
                    swap emerged as a much simpler solution to the problem, and its popularity has
                    grown ever since as more and more uses have been found for this predominant
                    derivative. In the 1970s, the dark ages of regulatory excess, both the United States and the
                    United Kingdom attempted to guard their foreign-exchange reserves with tough
                    restrictions on outflows from their capital markets. Around the same time,
                    companies in both countries were becoming increasingly globalized and required
                    funding for their international investments. Consequently, a back-scratching
                    arrangement arose whereby a U.S. company with operations in the United Kingdom
                    would provide dollars to a U.K. company’s subsidiary in the United States.
                    At the same time, the U.K. parent company would provide sterling to the U.S.
                    company’s subsidiary in the United Kingdom.This parallel loan arrangement required at least two sets of agreements and was
                    extremely susceptible to legal wrangling. In February 1976, discussions of a
                    parallel loan transaction between two U.K. pension funds, on the one side, and
                    U.S.-based Monsanto Company, on the other, gave rise to a eureka moment: Rather
                    than by lending currencies to and fro, the desired result might be obtained by a
                    direct exchange of equivalent amounts of two currencies and—in 10 years,
                    say—a subsequent re-exchange of equivalent amounts of the same currencies,
                    adjusted by the time value of cash. The first swap was completed a few months
                    later, in August 1976.Although many of the exchange controls that had fostered the emergence of swaps
                    were relaxed or eliminated, currency swaps continued to grow in popularity as
                    the marketplace recognized their many uses beyond facilitating access to
                    foreign-currency markets. For instance, currency swaps often reduced borrowing
                    costs for users by enabling them to take advantage of lower rates for domestic
                    borrowers in foreign countries. They also provided a powerful risk management
                    tool by allowing for the hedging of foreign-exchange risk and the customization
                    of asset and liability flows to suit companies’ financing and other
                    needs.
Journal: Financial Analysts Journal
Pages: 32-35
Issue: 3
Volume: 65
Year: 2009
Month: 5
X-DOI: 10.2469/faj.v65.n3.4
File-URL: http://hdl.handle.net/10.2469/faj.v65.n3.4
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Handle: RePEc:taf:ufajxx:v:65:y:2009:i:3:p:32-35




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Author-Name: Markku Kaustia
Author-X-Name-First: Markku
Author-X-Name-Last: Kaustia
Author-Name: Heidi Laukkanen
Author-X-Name-First: Heidi
Author-X-Name-Last: Laukkanen
Author-Name: Vesa Puttonen
Author-X-Name-First: Vesa
Author-X-Name-Last: Puttonen
Title: Should Good Stocks Have High Prices or High Returns?
Abstract: 
 Using a design involving a between-subjects experimental manipulation, this study
                    surveyed 742 Finnish financial advisers about requiring a risk premium in one
                    mode and about expected returns in the other mode. Company-level risk factors
                    (e.g., leverage) caused an increased return requirement in the first mode but
                    led to lower return expectations in the second mode. Sensitivity to the form of
                    the question revealed an inconsistency in the advisers’ perception of risk
                    and return. Advisers seemed to associate safe stocks with relatively lower
                    discount rates (and thus higher valuations) but also with higher return
                    expectations. This inconsistency may contribute to the overpricing and
                    subsequent inferior performance of glamour stocks. Giving consistent advice is a
                    necessary condition for providing valuable client service. Investors often expect “good” companies to deliver above average
                    returns (where “good” can be variously defined). Asset-pricing
                    theory, however, says that any “good” characteristic that is priced
                    by the market (e.g., low leverage) is associated with lower, not higher, return
                    expectations. Empirically, stocks commonly deemed good do not seem to provide
                    superior returns and, indeed, may provide inferior returns.Do market participants rationally choose to hold beliefs that go against both
                    asset-pricing theory and empirical evidence? Or are they confused by the logic
                    of risk and return? In the latter case, their preferences and expectations might
                    be unstable and could reverse as a result of manipulating the way that the
                    question is posed.To test our hypothesis of labile expectations, we studied financial
                    advisers’ perceptions of company characteristics and expected returns. We
                    sent an online survey to Finnish professional investment advisers and obtained
                    742 responses (representing a 68 percent response rate). We used a
                    between-subjects experimental manipulation. In one experimental mode (the
                    expected returns mode), we asked about the impact of a set of company
                    characteristics on return expectations. In the other mode (the required returns
                    mode), we asked whether the respondents would require higher returns given a
                    particular company characteristic: leverage, growth prospects, stock liquidity,
                    or analyst following.We found that the advisers expected poor stocks to provide low returns and good
                    stocks to provide high returns. At the same time, in the other experimental
                    mode, the majority of advisers associated all the poor stock characteristics
                    with risk and required higher returns for bearing that risk. For example, 86
                    percent of the advisers in the required returns mode required a risk premium for
                    investing in highly leveraged companies but only 13 percent of the advisers in
                    the expected returns mode expected such companies to provide higher returns.
                    Furthermore, an overwhelming 68 percent of the advisers in the expected returns
                    mode expected such companies to provide lower returns. These results show that
                    advisers expect good stocks to have high prices (low discount rates) and high
                    future returns at the same time.These inconsistent expectations may contribute to the overpricing and subsequent
                    inferior performance of glamour stocks: Requiring less of a risk premium for
                    such stocks boosts current prices; but at the same time, expecting higher
                    returns sets the stage for future disappointments. More generally, the value
                    added from advice may be compromised if the advisers are subject to the same
                    biases as the individual investors. Giving consistent advice is a necessary
                    condition for providing valuable client service.
Journal: Financial Analysts Journal
Pages: 55-62
Issue: 3
Volume: 65
Year: 2009
Month: 5
X-DOI: 10.2469/faj.v65.n3.5
File-URL: http://hdl.handle.net/10.2469/faj.v65.n3.5
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:65:y:2009:i:3:p:55-62




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Author-Name: William Fung
Author-X-Name-First: William
Author-X-Name-Last: Fung
Author-Name: David A. Hsieh
Author-X-Name-First: David A.
Author-X-Name-Last: Hsieh
Title: Measurement Biases in Hedge Fund Performance Data: An Update
Abstract: 
 Tending to be static and single-database oriented, existing models for correcting
                    performance measurement biases are unable to detect potential data errors
                    arising from (1) hedge funds that migrate from one database vendor to another
                    and (2) merged databases. In general, return measurement biases can be traced to
                    two key events: when a hedge fund elects to enter one or more databases
                    (backfill bias) and when a hedge fund exits a database (survivorship bias).
                    Artificial rules (e.g., ignoring the first x number of months
                    of performance history to minimize backfill bias) and survivorship statistics
                    based on a single database vendor are susceptible to another form of bias as
                    databases evolve and consolidate. The authors posit that one must be mindful of
                    how much of the hedge fund industry one is observing before passing judgment on
                    the performance statistics of the hedge fund industry as a whole.Are the halcyon days of the hedge fund industry behind us? Can the long-term
                    performance of the hedge fund industry justify the attendant high fees and its
                    correlation with conventional asset classes during downturns? Answering these
                    questions demands accurate performance statistics. Tending to be static and
                    single-database oriented, existing models for correcting performance measurement
                    biases are unable to detect potential data errors arising from (1) hedge funds
                    that migrate from one database vendor to another and (2) merged databases. As
                    the hedge fund industry contracts, this issue is likely to become an important
                    consideration in compiling hedge fund performance statistics. This article
                    summarizes the key return measurement biases in a simplified framework and
                    alerts researchers to the types of dynamic biases that could occur as the
                    industry consolidates.In general, return measurement biases can be traced to two key events: when a
                    hedge fund elects to enter one or more databases and when a hedge fund exits a
                    database. Superficially, these biases appear to be static, requiring only a
                    one-time adjustment. When funds migrate from one database to another, however,
                    survivorship statistics based on a single database vendor may be biased.
                        Missing funds need to be differentiated from
                        liquidated funds. For example, around the end of the first
                    quarter of 2007, fewer than 50 percent of the funds in the Hedge Fund Research
                    graveyard database were classified as liquidated. Put another way, half the
                    funds that were removed from the live database could have been in some other
                    database or could have elected not to report their performance data.The concern over backfill bias revolves around the informational content of a
                    fund’s performance history, from its inception date to its database entry
                    date. All artificial rules (e.g., ignoring the first x number
                    of months of reported performance history as a proxy for excluding a
                    fund’s incubation period) are susceptible to other forms of data error.
                    Setting x equal to the distance from the inception date of a
                    fund to its database entry date may cause the exclusion of valuable performance
                    history when databases merge. In March 1999, TASS sold its database to Tremont
                    Advisors. Some time passed before Tremont was able to identify and consolidate
                    into a single database that portion of its hedge fund data that was incremental
                    to TASS’s data. This activity took place mostly in 2001. This
                    idiosyncratic event caused the number of new funds entering the TASS database to
                    jump from 309 in 2000 to 932 in 2001, of which 544 were added in September.
                    Clearly, not all the data prior to the first 2001 reporting date for those funds
                    added to the TASS database are “backfill-biased.”Overall, the literature tends to focus on the negative aspect of a hedge
                    fund’s ability to choose when and where to report
                    performance—namely, that poor performance is unlikely to be submitted to
                    databases. A counterargument is to observe that close to 40 percent of the
                    Institutional Investor Top 100 hedge fund firms do not report to the four major
                    databases that we analyzed. Assuming that top hedge fund firms are likely to
                    have above-average performance, this fact could represent a sizable bias in the
                    opposite direction—namely, that good performance may also be excluded.
                    This article posits that one must be mindful of how much of the hedge fund
                    industry one is observing before passing judgment on the performance statistics
                    of the hedge fund industry as a whole.
Journal: Financial Analysts Journal
Pages: 36-38
Issue: 3
Volume: 65
Year: 2009
Month: 5
X-DOI: 10.2469/faj.v65.n3.6
File-URL: http://hdl.handle.net/10.2469/faj.v65.n3.6
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:65:y:2009:i:3:p:36-38




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Author-Name: Maria Schutte
Author-X-Name-First: Maria
Author-X-Name-Last: Schutte
Author-Name: Emre Unlu
Author-X-Name-First: Emre
Author-X-Name-Last: Unlu
Title: Do Security Analysts Reduce Noise?
Abstract: 
 This study investigates the role of security analysts in reducing noise in stock
                    price fluctuations. Using a sample of analyst coverage initiations between 1984
                    and 2006, the study finds that (1) noise is significantly reduced in the year
                    following the initiation and (2) the extent of the noise reduction is a function
                    of the intensity of analyst coverage during the initiation year. The results
                    suggest that analyst coverage makes stock prices less noisy. Analysts’
                    noise-reducing ability can have positive consequences for the performance of
                    corporate and portfolio managers who rely on forecasting to make long-term
                    financial decisions.Much of the stock price fluctuations we observe on a daily basis are, to a large
                    degree, unrelated to company fundamentals. This excess volatility comes at a
                    great cost to market participants because it introduces additional uncertainty
                    about future cash flows.In this article, we try to explain why stock prices fluctuate more often and more
                    widely than company fundamentals would suggest. In particular, we examine
                    whether the presence of security analysts makes prices more informative (i.e.,
                    less noisy). We focus on analysts because of their influence on a large number
                    of investors and their advantage over uninformed investors in terms of
                    experience and training. We hypothesize that analyst coverage helps investors
                    gauge the informational content of company-specific news and reduce the
                    proportion of noise-motivated trades. Our study finds evidence consistent with
                    this hypothesis. We find that residual volatility declines significantly in the
                    year following analyst initiation. We also find that the reduction in noise is
                    directly related to the intensity of analyst coverage. That is, the larger the
                    increase in recommendations or revisions on a stock during initiation, the
                    larger the noise reduction. We also find that analysts’ ability to reduce
                    noise in price fluctuations was diminished during the 1998–2000 TMT
                    (technology, media, and telecommunications) bubble and that this reduction was
                    more pronounced for tech stocks. This reduction might have occurred for two
                    reasons. First, the increase in cash flow volatility and the proportion of
                    intangibles in total assets might have temporarily undermined the effectiveness
                    of fundamental analysis. Second, investor optimism and overconfidence during
                    this period was high; in such an environment, investors are more likely to rely
                    on sentiment than on the advice of informed parties, such as analysts.Our results confirm traditional views of the role of analyst research as an
                    instrument for investors to better understand the informational content of
                    company-specific news. On a large scale, the noise-reducing ability of analysts
                    can have important consequences for price and capital allocation efficiency.
                    More efficient prices are more informative and allow for more accurate
                    forecasting, which benefits corporate decision makers and investors. For
                    corporations, seeking analyst coverage for their stocks can improve forecasting
                    ability and reduce business risk. For an individual investor or portfolio
                    manager, incorporating stocks covered by analysts into portfolios can reduce the
                    uncertainty of future portfolio returns and help avoid future economic
                    losses.
Journal: Financial Analysts Journal
Pages: 40-54
Issue: 3
Volume: 65
Year: 2009
Month: 5
X-DOI: 10.2469/faj.v65.n3.7
File-URL: http://hdl.handle.net/10.2469/faj.v65.n3.7
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Author-Name: Perry Mehrling
Author-X-Name-First: Perry
Author-X-Name-Last: Mehrling
Author-Name: Dimitry Mindlin
Author-X-Name-First: Dimitry
Author-X-Name-Last: Mindlin
Title: “The Plan Sponsor’s Goal”: A Comment
Abstract: 
 This material comments on “‘The Plan Sponsor’s Goal’: A Comment” (September/October 2008).
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 3
Volume: 65
Year: 2009
Month: 5
X-DOI: 10.2469/faj.v65.n3.8
File-URL: http://hdl.handle.net/10.2469/faj.v65.n3.8
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: Governance: Travel and Destinations
Journal: Financial Analysts Journal
Pages: 6-10
Issue: 4
Volume: 65
Year: 2009
Month: 7
X-DOI: 10.2469/faj.v65.n4.1
File-URL: http://hdl.handle.net/10.2469/faj.v65.n4.1
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 80-80
Issue: 4
Volume: 65
Year: 2009
Month: 7
X-DOI: 10.2469/faj.v65.n4.10
File-URL: http://hdl.handle.net/10.2469/faj.v65.n4.10
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# input file: UFAJ_A_12047909_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Brendan McFarland
Author-X-Name-First: Brendan
Author-X-Name-Last: McFarland
Author-Name: Gaobo Pang
Author-X-Name-First: Gaobo
Author-X-Name-Last: Pang
Author-Name: Mark Warshawsky
Author-X-Name-First: Mark
Author-X-Name-Last: Warshawsky
Title: Does Freezing a Defined-Benefit Pension Plan Increase Company Value? Empirical Evidence
Abstract: 
 This study empirically tests whether freezing or closing a defined-benefit (DB)
                    pension plan increases the sponsoring company’s market value. The database
                    used for this study consists of 82 publicly traded U.S. companies that announced
                    freezes/closes in 2003–2007. On the basis of this extensive sample and
                    through a set of parametric and nonparametric tests under the event study
                    methodology, the study finds generally negative or insignificant abnormal
                    returns in stock prices that can be associated with the freeze/close events.
                    Little evidence supports the hypothesis that freezing or closing a DB plan
                    increases company value.In recent years, pension coverage in the private sector has been shifting from
                    defined-benefit (DB) plans to defined-contribution (DC) plans. Some employers
                    have closed their DB pension plans to new hires (“close”) or frozen
                    the plan benefit accrual for some or all existing plan participants
                    (“freeze”). The commonly cited motivations for such changes include
                    cost and volatility reduction, consistency with industry-competitive practice,
                    and employee desires and satisfaction. Many have wondered whether and to what
                    extent a DB freeze/close alters the market value of the corporate plan sponsor.
                    Research on this topic, however, is scanty.This empirical analysis tests the hypothesis that freezing or closing DB pension
                    plans increases the sponsoring companies’ market values. The premise for
                    this hypothesis is that DB plan freezes/closes depress the growth of pension
                    liabilities and thus allow more funds to be directed to profit-generating
                    corporate businesses or to other forms of compensation that are less risky or
                    less costly to the company. Our tests, however, found generally insignificant,
                    often negative, abnormal returns in stock prices associated with the
                    freeze/close events and, therefore, yield little evidence to support the
                    hypothesis.Our study contributes to the literature in several ways. First, we constructed a
                    large database comprising 82 publicly traded U.S. companies for the
                    2003–07 time period in various sectors. Identified simply by the
                    availability of specific freeze/close announcement dates, these companies can be
                    considered random draws and are thus fairly representative of the population of
                    corporations that have frozen or closed their DB plans. Second, on the basis of this extensive sample and through a set of parametric and
                    nonparametric tests under the event study methodology, our analysis provides
                    general and robust evidence on the tested hypothesis. In the benchmark test,
                    stocks of 46 companies exhibited negative market-adjusted returns in the wake of
                    the announced DB plan changes. The median value of price change is −0.41
                    percent, which can be attributed to the announcement. The majority of the DB
                    events generate a statistically insignificant impact on stock price. Similar
                    results are obtained by using alternative assumptions that consider
                    sector-specific portfolios, time variations in events, and possible information
                    leaks or delayed market responses.Third, we explored what factors might help explain the market price reactions
                    following the DB freeze/close announcements. The regression results (e.g.,
                    negative coefficients on company size and plan-funding risk) seem to suggest a
                    “signaling” interpretation. That is, companies’ decisions to
                    freeze/close their DB plans might have induced investors to question the
                    financial health of the whole corporate entities beyond the pension plans. This
                    reaction dominated the prospect of potential reductions in pension cost or
                    volatility (if applicable), for which the market might cheer.Our empirical tests generally reject the expectation that freezing a pension plan
                    would deliver an immediate boost to the company’s market value. Several
                    factors may play a role. First, whether the DB plan freeze/close would
                    substantially cut corporate costs is unclear because employers often need to
                    enhance the existing 401(k) plans in the benefits package in order to facilitate
                    the transition and workforce management. Second, any positive financial impact
                    of the plan freeze/close may be outweighed by negative effects on employee
                    morale, productivity, attraction, retention, and optimal retirement patterns.
                    Third, the freeze/close events are often partial and gradual. Many companies
                    sponsor multiple pension plans, have frozen/closed some plans while keeping
                    others open, and have left the retirement benefits intact for many workers
                    covered by the frozen/closed plans (e.g., union members or those fulfilling
                    requirements of age and/or service years). Finally, company management may have
                    viewed DB freezes/closes as useful responses to short-term financial challenges,
                    but the market appears to have been more cautious about the effects and
                    implications of such DB plan events.Note: The views expressed in this article are the
                        authors’ alone and do not necessarily reflect the views of Watson
                        Wyatt Worldwide. 
Journal: Financial Analysts Journal
Pages: 47-59
Issue: 4
Volume: 65
Year: 2009
Month: 7
X-DOI: 10.2469/faj.v65.n4.2
File-URL: http://hdl.handle.net/10.2469/faj.v65.n4.2
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Author-Name: Tarun Chordia
Author-X-Name-First: Tarun
Author-X-Name-Last: Chordia
Author-Name: Amit Goyal
Author-X-Name-First: Amit
Author-X-Name-Last: Goyal
Author-Name: Gil Sadka
Author-X-Name-First: Gil
Author-X-Name-Last: Sadka
Author-Name: Ronnie Sadka
Author-X-Name-First: Ronnie
Author-X-Name-Last: Sadka
Author-Name: Lakshmanan Shivakumar
Author-X-Name-First: Lakshmanan
Author-X-Name-Last: Shivakumar
Title: Liquidity and the Post-Earnings-Announcement Drift
Abstract: 
 The post-earnings-announcement drift is a longstanding anomaly that conflicts
                    with market efficiency. This study documents that the post-earnings-announcement
                    drift occurs mainly in highly illiquid stocks. A trading strategy that goes long
                    high-earnings-surprise stocks and short low-earnings-surprise stocks provides a
                    monthly value-weighted return of 0.04 percent in the most liquid stocks and 2.43
                    percent in the most illiquid stocks. The illiquid stocks have high trading costs
                    and high market impact costs. By using a multitude of estimates, the study finds
                    that transaction costs account for 70–100 percent of the paper profits
                    from a long–short strategy designed to exploit the earnings momentum
                    anomaly. One of the most persistent anomalies that seem to violate the semi-strong-form
                    market efficiency as defined by Fama is the post-earnings-announcement drift
                    (PEAD), or earnings momentum. This anomaly refers to the fact that companies
                    reporting unexpectedly high earnings subsequently outperform companies reporting
                    unexpectedly low earnings. More specifically, a company’s standardized
                    unexpected earnings (SUE) is defined as the difference between the last
                    available quarterly earnings and the earnings during that same quarter in the
                    previous year, scaled by the standard deviation of this difference over the
                    previous eight quarters. A trading strategy that each month goes long the stocks
                    in the top decile of SUE and short the stocks in the bottom decile of SUE earns,
                    on average, 90 bps per month (10 percent annually) over the 1972–2005
                    period.The goal of this article is to demonstrate that stock liquidity is an important
                    consideration for understanding the persistence of the PEAD anomaly over the
                    years. Previous studies have not taken trading costs into account in the
                    calculation of abnormal returns. We studied the impact of illiquidity on the
                    profitability of the PEAD trading strategy and show that this strategy is likely
                    to be unprofitable after adjusting for transaction costs.First, we studied the relationship between the PEAD and illiquidity by using
                    double-sorted portfolios. Our findings suggest that the PEAD is prevalent mainly
                    in illiquid stocks. We examined the profitability of the long–short SUE
                    strategy after sorting stocks into decile portfolios on the basis of their
                    illiquidity. For this analysis, we used the Amihud measure of stock illiquidity,
                    which is the average of the daily price impacts of the order flow (i.e., the
                    daily absolute price change per dollar of daily trading volume). Returns to the
                    long–short SUE strategy increased monotonically from 0.04 percent per
                    month for the most liquid stocks to 2.43 percent for the most illiquid
                    stocks.Because we found that the PEAD is more prevalent in illiquid stocks, following a
                    PEAD trading strategy will generate high transaction costs and a substantial
                    price impact. We used several transaction-cost estimates to calculate the net
                    returns to PEAD trading strategies. Our results show that transaction costs
                    consume 70–100 percent of the potential profits. This lack of
                    profitability can thus explain the persistence of the PEAD anomaly and is
                    consistent with Jensen’s definition of market efficiency and
                    Rubinstein’s definition of minimally rational markets.
Journal: Financial Analysts Journal
Pages: 18-32
Issue: 4
Volume: 65
Year: 2009
Month: 7
X-DOI: 10.2469/faj.v65.n4.3
File-URL: http://hdl.handle.net/10.2469/faj.v65.n4.3
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:65:y:2009:i:4:p:18-32




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Author-Name: James Adams
Author-X-Name-First: James
Author-X-Name-Last: Adams
Author-Name: Donald J. Smith
Author-X-Name-First: Donald J.
Author-X-Name-Last: Smith
Title: Mind the Gap: Using Derivatives Overlays to Hedge Pension Duration
Abstract: 
 Recent legislation and accounting rule changes motivate defined-benefit pension
                    plans to manage the interest rate risk arising from volatility in their
                    liabilities, as measured by either the accumulated benefit obligation (ABO) or
                    the projected benefit obligation (PBO). For either measure, asset portfolios
                    comprising equity and fixed-income bonds usually have much lower average
                    durations than do liabilities. This article discusses how interest rate
                    derivatives overlay strategies can be used to reduce or eliminate the negative
                    duration gap. A theoretical model is developed to show how to calculate the ABO
                    and PBO measures and their duration statistics.Recent legislation and accounting rule changes—in particular, the U.S.
                    Pension Protection Act of 2006 and Financial Accounting Standard (FAS) No.
                    158—motivate sponsors of defined-benefit (DB) pension plans to manage the
                    interest rate risk arising from volatility in their plans’ liabilities, as
                    measured by either the accumulated benefit obligation (ABO) or
                    the projected benefit obligation (PBO). ABO, a
                    measure of the sponsor’s current legal liability, is the present value of
                    retirement benefits based on current wages. PBO is a larger
                    amount because it is based on the estimated future wage level at the time of
                    retirement. In the past, the plan sponsor recognized a funding deficit on its
                    balance sheet only if the fair value of plan assets was less than the
                        ABO liability. Now, under FAS No. 158, PBO
                    is used to determine the funding status of the DB pension plan.In practice, the interest rate risk of an asset or liability is measured by its
                    duration statistic, which is a measure of the change in value given a change in
                    interest rates. The essence of the risk management problem facing the typical DB
                    pension plan is that the average duration of its asset portfolio—which is
                    usually invested about two-thirds in equity and one-third in fixed
                    income—is much less than the estimated duration of either its
                        ABO or PBO liability. Thus, a significant
                    negative duration gap exists: Lower interest rates increase asset values much
                    less than they increase liabilities. In this article, we develop a theoretical
                    model (based on a representative employee) to demonstrate how the
                        ABO and PBO liability durations are
                    estimated.A promising method to decrease the interest rate risk facing a DB pension plan is
                    a derivatives overlay strategy that reduces or eliminates the negative duration
                    gap without changing the asset portfolio. Derivatives—in particular,
                    interest rate swaps or options on swaps
                    (“swaptions”)—transform the risk profile of the overall plan
                    while leaving the existing asset allocation (i.e., investments in equity and
                    fixed income) intact. For example, we show that a receive-fixed interest rate
                    swap has a positive duration. The plan manager can choose the requisite notional
                    principal on the swap to close the negative duration gap fully or partially. We
                    present numerical examples to illustrate this calculation.Another derivatives overlay strategy is for the DB pension plan to buy a
                    “receiver swaption.” The plan pays the premium and has the right to
                    enter into an interest rate swap as the receiver of the fixed rate. If interest
                    rates fall, the value of the swaption goes up, thus offsetting the increase in
                    the plan’s liability. A related strategy is for the plan to enter into a
                    “swaption collar” whereby a “payer swaption” is sold to
                    provide the premium to offset the cost of the purchased receiver swaption.
Journal: Financial Analysts Journal
Pages: 60-67
Issue: 4
Volume: 65
Year: 2009
Month: 7
X-DOI: 10.2469/faj.v65.n4.4
File-URL: http://hdl.handle.net/10.2469/faj.v65.n4.4
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# input file: UFAJ_A_12047912_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Author-Name: Denys Glushkov
Author-X-Name-First: Denys
Author-X-Name-Last: Glushkov
Title: The Wages of Social Responsibility
Abstract: 
 Typical socially responsible investors tilt their portfolios toward stocks of
                    companies with high scores on social responsibility characteristics and shun
                    stocks of companies associated with tobacco, alcohol, gambling, firearms, and
                    military or nuclear operations. Analyzing 1992–2007 returns of stocks
                    rated on social responsibility, this study found that this tilt gave such
                    investors an advantage over conventional investors. The study also found that
                    shunning resulted in a disadvantage for such investors relative to conventional
                    investors. The advantage from tilting toward stocks of companies with high
                    social responsibility scores is largely offset by the disadvantage from the
                    exclusion of stocks of shunned companies. Socially responsible investors can
                    thus do both well and good by adopting the best-in-class method in constructing
                    their portfolios: tilting toward stocks of companies with high scores on social
                    responsibility characteristics but refraining from shunning stocks of any
                    company. Typical socially responsible portfolios are tilted toward stocks of companies
                    with high scores on such social responsibility characteristics as community,
                    employee relations, and the environment. We analyzed the 1992–2007 returns
                    of stocks rated on social responsibility characteristics and found that this
                    tilt gave socially responsible portfolios an advantage over conventional
                    portfolios. This finding is consistent with the “doing good while doing
                    well” hypothesis, whereby the expected returns of stocks of socially
                    responsible companies are higher than those of conventional companies.Typical socially responsible portfolios, however, also shun stocks of companies
                    associated with tobacco, alcohol, gambling, firearms, and military or nuclear
                    operations. We found that such shunning results in a disadvantage for socially
                    responsible portfolios relative to conventional portfolios. This finding is
                    consistent with the “doing good but not well” hypothesis, whereby
                    the expected returns of socially responsible stocks are lower than those of
                    conventional stocks.For socially responsible portfolios, the advantage from the tilt toward stocks of
                    companies with high social responsibility scores is largely offset by the
                    disadvantage from excluding stocks of shunned companies. The net effect is
                    consistent with the “no effect” hypothesis, whereby the expected
                    returns of socially responsible stocks are approximately equal to the expected
                    returns of conventional stocks. This finding is consistent with a world in which
                    the social responsibility feature of stocks has no effect on returns. But it is
                    also consistent with the world we found, in which the advantages of some social
                    responsibility criteria are offset by the disadvantages of other social
                    criteria.Socially responsible investors can do both well and good by adopting the
                    best-in-class method for the construction of their portfolios. That method calls
                    for tilts toward stocks of companies with high social responsibility scores on
                    such characteristics as community, employee relations, and the environment, but
                    it also calls for refraining from shunning the stocks of any company.Editor’s Note: This article is based on the
                        authors’ working paper that won the 2008 Moskowitz Prize for Socially
                        Responsible Investing.
Journal: Financial Analysts Journal
Pages: 33-46
Issue: 4
Volume: 65
Year: 2009
Month: 7
X-DOI: 10.2469/faj.v65.n4.5
File-URL: http://hdl.handle.net/10.2469/faj.v65.n4.5
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Author-Name: Raymond Kan
Author-X-Name-First: Raymond
Author-X-Name-Last: Kan
Author-Name: Guofu Zhou
Author-X-Name-First: Guofu
Author-X-Name-Last: Zhou
Title: What Will the Likely Range of My Wealth Be?
Abstract: 
 The median is often a better measure than the mean in evaluating a
                    portfolio’s long-term value. The standard plug-in estimate of the median,
                    however, is too optimistic. It has a substantial upward bias that can easily
                    exceed a factor of 2. This article provides an unbiased forecast of the median
                    of a portfolio’s long-term value. It also provides an unbiased forecast of
                    an arbitrary percentile of a portfolio’s long-term value distribution,
                    which enables the construction of the likely range of a portfolio’s
                    long-term value for any given confidence level. The article offers an unbiased
                    forecast of the probability of a portfolio’s long-term value falling
                    within a given interval. The article’s unbiased estimators give a more
                    accurate assessment of a portfolio’s long-term value than do traditional
                    estimators and are useful for long-term planning and investment.Forecasting long-term portfolio value is of great interest to investors and fund
                    managers. Earlier researchers showed that in estimating the expected terminal
                    value of a portfolio, both geometric mean returns and arithmetic mean returns
                    are substantially biased, and they offered an approach to correct the bias.
                    Others pointed out that the median terminal wealth is often more useful than the
                    expected terminal wealth in evaluating a portfolio’s long-term value. The
                    usual plug-in median forecast, however, is overoptimistic. It has a substantial
                    upward bias that can easily exceed a factor of 2.In this article, we provide an unbiased forecast of the median of a
                    portfolio’s long-term value. We also provide an unbiased forecast of an
                    arbitrary percentile of a portfolio’s long-term value distribution, which
                    enables the construction of the likely range of a portfolio’s long-term
                    value for any given confidence level. We offer an unbiased forecast of the
                    probability of a portfolio’s long-term value falling within a given
                    interval. Our unbiased estimators give a more accurate assessment of a
                    portfolio’s long-term value than do traditional estimators.Using the U.S. equity market and seven international equity markets as the
                    investment asset, we show that even with 456 months of available data (January
                    1970–December 2007), the usual estimates of the medians, ranges, and
                    probabilities are substantially biased. In contrast, the unbiased forecasts
                    provide more-accurate assessments of the terminal wealth and are much more
                    useful for long-term planning and investment.
Journal: Financial Analysts Journal
Pages: 68-77
Issue: 4
Volume: 65
Year: 2009
Month: 7
X-DOI: 10.2469/faj.v65.n4.6
File-URL: http://hdl.handle.net/10.2469/faj.v65.n4.6
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Author-Name: Barry Marshall
Author-X-Name-First: Barry
Author-X-Name-Last: Marshall
Title: “The End of ‘Soft Dollars’?”: A Comment
Abstract: 
 This material comments on “The End of ‘Soft Dollars’?” (March/April 2009).
Journal: Financial Analysts Journal
Pages: 13-13
Issue: 4
Volume: 65
Year: 2009
Month: 7
X-DOI: 10.2469/faj.v65.n4.7
File-URL: http://hdl.handle.net/10.2469/faj.v65.n4.7
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Author-Name: Robert S. Hudson
Author-X-Name-First: Robert S.
Author-X-Name-Last: Hudson
Author-Name: Christina V. Atanasova
Author-X-Name-First: Christina V.
Author-X-Name-Last: Atanasova
Title: “Equity Returns at the Turn of the Month”: Further Confirmation and Insights
Abstract: 
 This material comments on “‘Equity Returns at the Turn of the Month’” (March/April 2008).See the author response to this comment.
Journal: Financial Analysts Journal
Pages: 14-16
Issue: 4
Volume: 65
Year: 2009
Month: 7
X-DOI: 10.2469/faj.v65.n4.8
File-URL: http://hdl.handle.net/10.2469/faj.v65.n4.8
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Author-Name: John J. McConnell
Author-X-Name-First: John J.
Author-X-Name-Last: McConnell
Author-Name: Wei Xu
Author-X-Name-First: Wei
Author-X-Name-Last: Xu
Title: “Equity Returns at the Turn of the Month”: Extended Analysis with Evidence from the United Kingdom
Abstract: 
 This material responds to “Equity Returns at the Turn of the Month”: Further Confirmation and Insights” (July/August 2009).
Journal: Financial Analysts Journal
Pages: 16-17
Issue: 4
Volume: 65
Year: 2009
Month: 7
X-DOI: 10.2469/faj.v65.n4.9
File-URL: http://hdl.handle.net/10.2469/faj.v65.n4.9
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# input file: UFAJ_A_12047918_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Igor Loncarski
Author-X-Name-First: Igor
Author-X-Name-Last: Loncarski
Author-Name: Jenke ter Horst
Author-X-Name-First: Jenke
Author-X-Name-Last: ter Horst
Author-Name: Chris Veld
Author-X-Name-First: Chris
Author-X-Name-Last: Veld
Title: The Rise and Demise of the Convertible Arbitrage Strategy
Abstract: 
 This article analyzes convertible arbitrage, one of the most successful hedge
                    fund strategies. The aim of the strategy is to exploit underpricing of
                    convertible bonds by taking a long position in a convertible and a short
                    position in the underlying asset. The authors find that convertible bonds are
                    underpriced at the issuance dates; at the same time, short sales of underlying
                    equity increase significantly. Both effects are stronger and more persistent for
                    equity-like convertibles than for debtlike convertibles. Furthermore, short-sale
                    pressures negatively affect stock returns around the announcement and issuance
                    dates of convertibles. All these factors have likely contributed to the shift
                    toward issuing more debtlike convertibles in recent years, which, in turn, has
                    substantially lowered the returns from convertible arbitrage.This article analyzes convertible arbitrage, one of the most successful hedge
                    fund strategies of the last two decades. The aim of the strategy is to exploit
                    the underpricing of convertible bonds by taking a long position in a convertible
                    and a short position in the underlying asset. Convertible arbitrage trades
                    currently represent more than half of the secondary market trades in convertible
                    securities, with hedge funds as the most important player in that market.
                    Moreover, 70–75 percent of primary convertible bond issues are bought by
                    hedge funds. The Convertible Arbitrage Index, which is tracked by Credit
                    Suisse/Tremont, shows that annual returns on convertible arbitrage were, for the
                    most part, above 15 percent in the 1990s and up to 2001. In recent years,
                    however, convertible arbitrage performance has deteriorated. The popular press
                    has proposed various explanations for this decline, including stable equity
                    markets, rising interest rates, withdrawals from funds, increased competition in
                    the hedge fund industry, and lower volatilities in the main capital markets. We
                    demonstrate that the structure of the convertible bond (debt- or equity-like) is
                    an important additional explanation to be considered because the structure
                    affects (1) the degree of underpricing, (2) the “hedging” position
                    in the underlying stock, and (3) the excess returns on the issuer’s
                    equity.We used a sample of convertible bonds in the Canadian market issued between 1998
                    and 2007. We used the delta measure to make a distinction between debtlike and
                    equity-like convertible bond issues. Using a valuation model, we found the
                    equity-like issues (Δ ≥ 0.50) to be about 27 percent underpriced and
                    the debtlike issues (Δ < 0.50) to be about 7 percent underpriced at the
                    issuance date. Although the underpricing declines somewhat immediately after the
                    issuance, it persists over a long period. Using information on aggregated
                    biweekly short positions on the Toronto Stock Exchange, we examined changes in
                    short positions (interest) around the issuance dates of convertible bonds. We
                    observed a significant increase in the short positions (short interest) of the
                    underlying stocks after the announcement. In the 40 trading days following the
                    announcement, the increases in relative short positions for equity-like issuers
                    are about 15 percentage points higher than those for debtlike issuers. These
                    increased aggregated short positions remain stable for a longer period after the
                    issuance of the convertible. Finally, we show that increases in the short positions negatively affect the
                    excess stock returns of the issuers, particularly during the period between the
                    announcement and the issuance of the convertible. The additional downward
                    pressure exerted on excess returns by the increase in short interest has
                    consequences for both shareholders and debtholders of the issuing company.
                    Clearly, it negatively affects shareholders by destroying shareholder value.
                    Moreover, it also affects debtholders because a lower value of a company’s
                    collateral (proxied by the market value) generally leads to an increase in the
                    credit spread and thus a lower value of current (outstanding) debt claims.To cap these losses in shareholder value, issuers apparently switched to issuing
                    fewer underpriced debtlike convertible bonds, packaged the convertible bond
                    issues together with share repurchases (called a “Happy Meal”),
                    and/or moved out of the convertible bond market altogether. We believe that this
                    shift provides an additional explanation for the lower returns on the
                    convertible arbitrage strategy in recent years.
Journal: Financial Analysts Journal
Pages: 35-50
Issue: 5
Volume: 65
Year: 2009
Month: 9
X-DOI: 10.2469/faj.v65.n5.1
File-URL: http://hdl.handle.net/10.2469/faj.v65.n5.1
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Author-Name: Helmut Gründl
Author-X-Name-First: Helmut
Author-X-Name-Last: Gründl
Author-Name: Thomas Post
Author-X-Name-First: Thomas
Author-X-Name-Last: Post
Title: Transparency through Financial Claims with “Fingerprints”: A Mechanism for Preventing Financial Crises
Abstract: 
 Lack of transparency in securitization transactions contributed significantly to
                    the current global financial crisis. This article proposes an
                    incentive-compatible mechanism for future securitization transactions that would
                    increase transparency: financial claims with “fingerprints.” This
                    mechanism would allow market participants at each stage of the securitization
                    process to easily obtain full information about the underlying original risks
                    and the superior claims that need to be satisfied before receiving their own
                    payoffs. The mechanism would considerably enhance transparency in securitization
                    transactions at the expense of some transaction costs.In 2007, the U.S. housing market bubble burst, triggering a financial crisis that
                    resulted in a worldwide recession. Often mentioned as contributors to the crisis
                    are the securitization of mortgages and the repackaging, or tranching, of
                    mortgage-backed securities (MBSs) into collateralized debt obligations (CDOs).
                    MBSs and especially CDOs exhibit a large degree of opaqueness (i.e., market
                    participants often have limited information about the true nature of the risks
                    of the underlying mortgages). Every additional repackaging has the potential for
                    even more information loss. In the run-up to the crisis, this situation caused
                    the market for these securities to dry up. Furthermore, banks that held these
                    opaque securities faced major refinancing problems.The apparent collapse of the market for MBSs has led many policymakers and
                    commentators to demand stricter regulation of transactions and compulsory
                    trading of asset-backed securities at stock exchanges. Some have even called for
                    a complete ban on MBSs.We propose an incentive-compatible mechanism that takes
                    “fingerprints” of the original mortgages and of MBS and CDO
                    transactions. By fingerprints, we mean a complete record of information
                    concerning the original mortgage transactions and all subsequent securitizations
                    of those mortgages. This mechanism would solve many of the markets’
                    problems without stricter regulation and without impeding the potential for
                    innovation in the securitization markets. We believe that our proposed mechanism
                    would offer advantages at all stages of the securitization process, albeit with
                    some possibly minor transaction costs.Our mechanism is related to recent proposals by several researchers, including
                    suggestions to create a global risk map and a global credit register, to
                    increase and standardize information on mortgages, and to set up a clearinghouse
                    to support the regulatory authorities. Some proposals address systemic risks
                    stemming from interbank relationships, counterparty risk, and the opaqueness of
                    financial institutions. Our proposal, however, is targeted at the specific, but
                    important, market segment of mortgage-backed securities that has experienced
                    market failure. Our proposal is extensive, covering transparency for MBS and CDO
                    payment structures. Moreover, our proposal does not entail stricter regulation
                    of MBSs and CDOs; instead, it creates incentives for market participants to
                    enhance transparency and thus keep alive the free market and its innovative
                    forces. Despite our nonregulatory approach, our mechanism could be an integral
                    part of a global risk map.Our proposal is based on an idea put forward by Harry Markowitz, who suggested
                    setting up, as part of efforts to address the immediate problems of the
                    financial crisis, a regulatory body that would conduct an in-depth census of
                    institutions that own securitized assets. The information collected would
                    encompass detailed data on security claim structures and underlying mortgage
                    risks. Markowitz also suggested that the information be used to solve some of
                    the more severe problems of the current crisis—no confidence in financial
                    institutions that hold securitized assets and no trade in “toxic
                    assets.” Under our proposal, a systematic collection of securitization
                    transaction data could become the cornerstone of an incentive-compatible
                    mechanism in securitization transactions and thus foster a revival of
                    securitization markets without new regulations.
Journal: Financial Analysts Journal
Pages: 17-23
Issue: 5
Volume: 65
Year: 2009
Month: 9
X-DOI: 10.2469/faj.v65.n5.2
File-URL: http://hdl.handle.net/10.2469/faj.v65.n5.2
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Author-Name: Darshana D. Palkar
Author-X-Name-First: Darshana D.
Author-X-Name-Last: Palkar
Author-Name: Stephen E. Wilcox
Author-X-Name-First: Stephen E.
Author-X-Name-Last: Wilcox
Title: Adjusted Earnings Yields and Real Rates of Return
Abstract: 
 An accurate forecast of real return requires that accounting and debt adjustments
                    be made to reported earnings. This article presents methodologies that investors
                    can use to estimate the accounting and debt adjustments for individual companies
                    and offers evidence, derived from a predictive regression model, that investors
                    should consider these adjustments important. The article also reviews the use of
                    nonfinancial corporate debt and makes the case that investors should view the
                    use of debt by nonfinancial companies more positively than they currently
                    do.In this article, the authors present methodologies that investors can use to
                    estimate the accounting and debt adjustments for individual companies. These
                    adjustments should be considered important because survey data have shown that
                    earnings are preferred over cash flow, dividends, and book value as a valuation
                    input.The accounting adjustments reflect the adjustments that must be made to
                    GAAP-reported earnings to convert them from a historical-cost into a
                    current-cost accounting system. A current-cost accounting system requires that
                    assets be valued at their replacement cost. Thus, these adjustments would reduce
                    reported earnings when prices are increasing.The authors’ first accounting adjustment is to cost of goods sold for those
                    companies that choose the FIFO method of inventory accounting. The adjustment
                    uses the U.S. Producer Price Index for crude materials to inflate beginning
                    inventory. In estimating this adjustment, the authors incorporated a weighting
                    scheme to reflect the importance of the FIFO method in determining inventory
                    value.The second accounting adjustment is to depreciation expense. The authors used a
                    methodology that converts financial statement depreciation charges into an
                    approximation of current-cost depreciation. This methodology requires an
                    estimation of the average age of fixed assets and then grosses up their value to
                    reflect inflation as measured by the GDP implicit price deflator for
                    nonresidential fixed investment. This adjustment reflects how depreciation
                    expense would change if it was based on the replacement cost of fixed assets
                    rather than on their acquisition cost.The debt adjustment reflects inflation’s effect on the real value of
                    creditor claims; GAAP-based earnings reported by leveraged companies will
                    overstate the true cost of debt because they do not reflect the benefit that
                    accrues to shareholders from being able to repay a fixed amount of principal
                    with a currency that has been devalued by inflation. The authors used a
                    company’s net debt position as the theoretically correct measure of debt
                    and multiplied it by the expected rate of inflation to determine the debt
                    adjustment. Data for the expected rate of inflation are the one-year-ahead
                    inflation forecasts for the chain-weighted GDP price index from the Survey of
                    Professional Forecasters (www.phil.frb.org/econ/spf/index.html).The authors used predictive regression models to test the importance of the
                    accounting and debt adjustments as predictors of real returns. Their results
                    show that the coefficient estimates for the adjustments are statistically
                    significant over the period of the study. Thus, the recommended adjustments to
                    GAAP-based reported earnings should be considered important by investors. The
                    results are particularly robust for the debt adjustment because the coefficient
                    estimate for that variable is statistically significant at the 1 percent level
                    in all regressions.Over the period of the study, average real returns were highest for the quintile
                    of companies with the highest debt-to-market-capitalization ratio. For those
                    companies that increased their debt-to-market-capitalization ratio, the authors
                    found that the quintile of companies with the greatest increase had the highest
                    average real returns over the period of the study. The authors believe that
                    their findings support the contention that debt usage should be viewed in a more
                    favorable light by both investors and nonfinancial companies.
Journal: Financial Analysts Journal
Pages: 66-79
Issue: 5
Volume: 65
Year: 2009
Month: 9
X-DOI: 10.2469/faj.v65.n5.3
File-URL: http://hdl.handle.net/10.2469/faj.v65.n5.3
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Author-Name: Jeroen Derwall
Author-X-Name-First: Jeroen
Author-X-Name-Last: Derwall
Author-Name: Joop Huij
Author-X-Name-First: Joop
Author-X-Name-Last: Huij
Author-Name: Dirk Brounen
Author-X-Name-First: Dirk
Author-X-Name-Last: Brounen
Author-Name: Wessel Marquering
Author-X-Name-First: Wessel
Author-X-Name-Last: Marquering
Title: REIT Momentum and the Performance of Real Estate Mutual Funds
Abstract: 
 REITs exhibit a strong and prevalent momentum effect that is not captured by
                    conventional factor models. This REIT momentum anomaly hampers proper judgments
                    about the performance of actively managed REIT portfolios. In contrast, a REIT
                    momentum factor adds incremental explanatory power to performance attribution
                    models for REIT portfolios. Using this factor, this study finds that REIT
                    momentum explains a great deal of the abnormal returns that actively managed
                    REIT mutual funds earn in aggregate. Accounting for exposure to REIT momentum
                    also materially influences cross-sectional comparisons of the performances of
                    REIT mutual funds. This study has important implications for performance
                    evaluation, alpha–beta separation, and manager selection and
                    compensation.Managers of such real estate portfolios as real estate mutual funds are
                    compensated for the returns they produce on their portfolios relative to a
                    benchmark portfolio’s return. This study focuses on the REIT industry to
                    illustrate that momentum effects in U.S. REIT returns can affect portfolio
                    performance attribution.We first confirmed that the presence of a strong and prevalent momentum effect in
                    REIT returns poses a challenge to performance attribution based on common
                    factors. A REIT momentum strategy, which buys REITs with the highest past return
                    and sells short REITs with the lowest past return, produces a return that is
                    economically larger than that of a common-stock momentum strategy. The
                    common-stock momentum factor, which is explicitly designed to capture momentum
                    effects, does not suffice to capture the REIT momentum anomaly. Instead, return
                    differences among portfolios with different REIT momentum characteristics are
                    best captured by a REIT momentum factor.To gauge the practical implications of the REIT momentum anomaly, we demonstrated
                    how the inclusion of our REIT-specific momentum factor in performance
                    attribution models affects estimates of the value added by active REIT portfolio
                    managers. Using a sample of U.S. REIT mutual funds, we found that REIT momentum
                    explains a great deal of the abnormal returns that such mutual funds earn
                    according to studies that did not account for REIT momentum. Consistent with our
                    expectations, REIT mutual fund returns are better explained by a REIT momentum
                    factor than by the conventional common-stock momentum factor. The positive
                    alphas that REIT funds deliver under conventional factor models dissipate under
                    a model that includes the three Fama–French factors and a REIT momentum
                    factor. Finally, we showed that a consideration of REIT momentum affects our
                    understanding of cross-sectional variation in the performance of REIT funds.
                    Specifically, REIT mutual funds with relatively high past returns continue to
                    earn higher returns than the competition because of greater exposure to the REIT
                    momentum factor. Moreover, the common-stock factor model and the factor model
                    proposed in this study substantially disagree about the rankings of REIT mutual
                    funds by their alphas. These results imply that factoring REIT momentum into
                    performance attribution has important implications for REIT performance
                    evaluation and manager selection and compensation.
Journal: Financial Analysts Journal
Pages: 24-34
Issue: 5
Volume: 65
Year: 2009
Month: 9
X-DOI: 10.2469/faj.v65.n5.4
File-URL: http://hdl.handle.net/10.2469/faj.v65.n5.4
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Author-Name: Dalia Marciukaityte
Author-X-Name-First: Dalia
Author-X-Name-Last: Marciukaityte
Author-Name: Samuel H. Szewczyk
Author-X-Name-First: Samuel H.
Author-X-Name-Last: Szewczyk
Author-Name: Raj Varma
Author-X-Name-First: Raj
Author-X-Name-Last: Varma
Title: Voluntary vs. Forced Financial Restatements: The Role of Board Independence
Abstract: 
 Using a sample of companies that restated their earnings over the period
                    1997–2002, this study finds that the probability of voluntary as opposed
                    to forced restatements is positively related to the independence of both the
                    board of directors and the audit committee. Following both voluntary and forced
                    earnings restatements, companies increase the proportion of independent
                    directors on both the board and the audit committee; three years after
                    restatements, both types of restating companies attain similar levels of
                    director independence. Moreover, the study finds comparable postrestatement
                    long-run stock performance for all restating and matched companies, which
                    suggests that postrestatement enhancements to internal control systems help
                    restore companies’ blemished reputations.This article reports the results of our investigation of the role of corporate
                    governance in monitoring earnings manipulation in which we examined the
                    independence of boards of directors and audit committees in companies that
                    restated their earnings. Extant empirical evidence on board independence and the
                    incidence of accounting irregularities is mixed. Our investigation of 187
                    restatements from 1997 to 2002 finds that director independence is not
                    associated with a lower incidence of earnings restatements. Companies that make
                    voluntary restatements, however, have greater board and audit committee
                    independence than do companies forced to restate earnings by the U.S. SEC and
                    other external agencies. Moreover, the probability of voluntary restatements is
                    positively related to board and audit committee independence. Our results also
                    show that restating companies, especially those forced to restate, increase the
                    independence of their boards and audit committees after restatements. And
                    long-run stock performance after both voluntary and forced restatements is
                    similar to that of matched companies.Our findings point to the importance of independent boards of directors and audit
                    committees in improving the accuracy of financial reporting. Although director
                    independence does not ensure a lower incidence of earnings restatements, it
                    increases the probability that a company will initiate a restatement instead of
                    waiting for outsiders to force it to restate. These findings are relevant to the
                    current controversy surrounding the rising number of restatements since 2001 and
                    support the requirements for greater board and audit committee independence
                    mandated by the Sarbanes–Oxley Act and the rules of major exchanges. Our
                    findings suggest that greater director independence is associated with more
                    efficient internal monitoring of financial reporting and results in a greater
                    number of voluntary restatements. Consequently, the recent increase in
                    restatements may indicate that the corporate governance laws enacted in this
                    decade have taken root rather than the contrary, as some observers believe.The restating companies in our sample responded to the significant cost imposed
                    on them by financial markets by making reputation-enhancing changes to their
                    internal monitoring systems, changes that are evidenced by the increase in the
                    independence of their boards and audit committees. The incentive that restating
                    companies have to maintain their reputations with investors in the capital
                    markets ensures that the negative impact of restatements is short-lived. Our
                    results indicate comparable postrestatement long-run stock performance for all
                    restating and matched companies, which suggests that postrestatement
                    enhancements to internal control systems help restore both blemished reputations
                    and investor confidence. Thus, concerns that the current increase in
                    restatements will erode investor confidence may be unwarranted.
Journal: Financial Analysts Journal
Pages: 51-65
Issue: 5
Volume: 65
Year: 2009
Month: 9
X-DOI: 10.2469/faj.v65.n5.5
File-URL: http://hdl.handle.net/10.2469/faj.v65.n5.5
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: Big Bond Bust
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 5
Volume: 65
Year: 2009
Month: 9
X-DOI: 10.2469/faj.v65.n5.6
File-URL: http://hdl.handle.net/10.2469/faj.v65.n5.6
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 80-80
Issue: 5
Volume: 65
Year: 2009
Month: 9
X-DOI: 10.2469/faj.v65.n5.7
File-URL: http://hdl.handle.net/10.2469/faj.v65.n5.7
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Author-Name: Clifton Green
Author-X-Name-First: Clifton
Author-X-Name-Last: Green
Author-Name: Narasimhan Jegadeesh
Author-X-Name-First: Narasimhan
Author-X-Name-Last: Jegadeesh
Author-Name: Yue Tang
Author-X-Name-First: Yue
Author-X-Name-Last: Tang
Title: Gender and Job Performance: Evidence from Wall Street
Abstract: 
 This study concerns the relationship between gender and job performance among
                    brokerage firm equity analysts. Women’s representation in analyst
                    positions dropped from 16 percent in 1995 to 14 percent in 2005. The study found
                    significant gender-based differences in performance on various dimensions. For
                    example, women cover roughly 9 stocks, on average, as compared with 10 for men,
                    and women’s earnings estimates tend to be less accurate than men’s
                    estimates. But the study also found that women are significantly more likely
                    than men to be designated as All-Stars, which indicates that they outperform men
                    in other aspects of job performance.We examined the relationship between gender and performance among sell-side
                    analysts. Sell-side analysts are unique in that key aspects of their job
                    performance can be publicly observed and evaluated. We used the following
                    measures of job performance: number of stocks that analysts follow, longevity on
                    the job, accuracy of analysts’ earnings forecasts, frequency of forecast
                    revisions, and professional reputation (as measured by the coveted All-America
                    Research Team designation in Institutional Investor
                    magazine).Our findings have important implications for investment managers who use
                    analysts’ forecasts as inputs for investment decisions. Understanding the
                    factors that affect the precision of analysts’ forecasts would help
                    managers appropriately weight individual forecasts to arrive at optimal earnings
                    forecasts. We found that forecast accuracy is significantly related to gender.
                    In fact, we found that gender is more important for forecast accuracy than an
                    analyst’s All-Star status on the Institutional Investor
                    survey.Our study also has important implications for understanding gender balance among
                    sell-side analysts. A vast majority of analysts are men, and women are often
                    alleged to face gender discrimination in such high-profile, well-paying jobs.
                    Such concerns have led many investment banks to institute programs to promote
                    diversity. Perhaps surprisingly, as issues of gender discrimination and
                    affirmative action have attracted considerable attention over time, the
                    proportion of female stock analysts has declined. In our study, we set out to
                    determine whether this decline indicates growing discrimination or whether it
                    reflects a shift in women’s career preferences. Gender discrimination means that when faced with a choice between equally
                    qualified women and men, employers prefer to hire men. On the one hand, if
                    gender discrimination affects hiring decisions, one would expect that a higher
                    hurdle is set for women than for men and thus that women who are able to clear
                    that hurdle would, on average, do a better job than their male counterparts. On
                    the other hand, if affirmative action is an important factor in hiring
                    decisions, then employers may set a lower hurdle for women in order to promote
                    gender balance; if affirmative-action-based hiring is prevalent, women would, on
                    average, perform worse than men. We found that women cover roughly one fewer stock than men do and tend to
                    forecast less accurately than their male counterparts; but women are
                    significantly more likely than men to be designated by Institutional
                        Investor magazine as members of the All-America Research Team,
                    which indicates that women outperform men from their clients’
                    perspective. Overall, neither women nor men exhibit dominant performance
                    relative to the other gender. Taken together, our results do not support the
                    view that employers engage in pervasive gender discrimination in hiring
                    decisions by setting higher standards for women.Longevity on the job is an important consideration in recruitment decisions. We
                    found that women are more likely than men to leave their analyst positions
                    within the first two years after being hired. This statistical relationship
                    between gender and attrition may deter brokerages from hiring women. If women
                    who aspire to be analysts intend to stay on the job longer than indicated by the
                    statistical evidence, they would be well advised to credibly convey their
                    intention to potential employers.
Journal: Financial Analysts Journal
Pages: 65-78
Issue: 6
Volume: 65
Year: 2009
Month: 11
X-DOI: 10.2469/faj.v65.n6.1
File-URL: http://hdl.handle.net/10.2469/faj.v65.n6.1
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Author-Name: James Adams
Author-X-Name-First: James
Author-X-Name-Last: Adams
Author-Name: Donald J. Smith
Author-X-Name-First: Donald J.
Author-X-Name-Last: Smith
Title: “Mind the Gap: Using Derivatives Overlays to Hedge Pension Duration”: Author Response
Abstract: 
 This material comments on “Mind the Gap: Using Derivatives Overlays to Hedge Pension Duration”.
Journal: Financial Analysts Journal
Pages: 10-11
Issue: 6
Volume: 65
Year: 2009
Month: 11
X-DOI: 10.2469/faj.v65.n6.10
File-URL: http://hdl.handle.net/10.2469/faj.v65.n6.10
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 6
Volume: 65
Year: 2009
Month: 11
X-DOI: 10.2469/faj.v65.n6.11
File-URL: http://hdl.handle.net/10.2469/faj.v65.n6.11
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Author-Name: Jerry Sun
Author-X-Name-First: Jerry
Author-X-Name-Last: Sun
Title: Governance Role of Analyst Coverage and Investor Protection
Abstract: 
  This study examines whether investor protection affects the governance role of
                    analysts in constraining earnings management. Using a sample of 50,966
                    company-year observations from 24 countries for 1990–2007, the study finds
                    that earnings management is more negatively associated with analyst coverage in
                    weak investor protection countries than in strong investor protection countries.
                    The findings suggest that analyst coverage plays a more important governance
                    role in countries where investor protection is weak (i.e., a substitute
                    relationship exists between analyst coverage and investor protection). In examining the relationship between analyst coverage and earnings management,
                    recent research has found that high analyst coverage is associated with less
                    earnings management in the United States, suggesting that analyst coverage can
                    play a governance role in capital markets. The research on analysts’
                    governance role is limited, however, especially in an international context.
                    This study examines whether investor protection affects the governance role of
                    analysts in constraining earnings management.Using a sample of 50,966 company-year observations from 24 countries for
                    1990–2007, I found that earnings management is more negatively associated
                    with analyst coverage in weak investor protection countries than in strong
                    investor protection countries. The results are robust to several additional
                    analyses. My findings suggest that analyst coverage plays a more important
                    governance role in countries where investor protection is weak (i.e., a
                    substitute relationship exists between analyst coverage and investor
                    protection).This study contributes to the literature in two ways. First, it extends the
                    limited research on the governance role of analysts. It focuses on international
                    data and the impact of investor protection on analysts’ governance role.
                    By examining the relationship between analyst coverage and earnings management
                    in an international context, this study provides further evidence on the
                    substitute relationship between analyst coverage and investor protection and
                    thus expands the research on the international governance role of analysts.
                    Second, it adds to the growing literature on international analysts. Prior
                    research has focused on investigating the effect of country-level institutions
                    on analyst coverage and forecast accuracy. This study extends that research by
                    examining the relationship between investor protection and the effectiveness of
                    analyst coverage in constraining earnings management.
Journal: Financial Analysts Journal
Pages: 52-64
Issue: 6
Volume: 65
Year: 2009
Month: 11
X-DOI: 10.2469/faj.v65.n6.2
File-URL: http://hdl.handle.net/10.2469/faj.v65.n6.2
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Author-Name: Sumon C. Mazumdar
Author-X-Name-First: Sumon C.
Author-X-Name-Last: Mazumdar
Author-Name: Vikram Nanda
Author-X-Name-First: Vikram
Author-X-Name-Last: Nanda
Author-Name: Rahul Surana
Author-X-Name-First: Rahul
Author-X-Name-Last: Surana
Title: Using Auctions to Price Employee Stock Options: The Case of Zions Bancorporation ESOARS
Abstract: 
 The first empirical analysis of Zions Bancorporation’s 2006 and 2007
                    auctions of Employee Stock Option Appreciation Rights Securities (ESOARS), this
                    study examined (1) the impact of auction rules on bidding strategies and
                    allocations, (2) the efficiency of the auction clearing prices, and (3) the
                    “value gap” between ESOARS auction clearing prices and various
                    model-based estimates. It found that the design features of the auctions (e.g.,
                    ending rules) significantly affected bidding strategies but not final
                    allocations, which remained highly concentrated. It also found that the clearing
                    prices (1) displayed high price elasticities of demand, suggesting efficient
                    price discovery, and (2) were low relative to some, but not all, model-based
                    estimates. These findings suggest design improvements that might benefit
                    auctions of other illiquid derivatives (e.g., banks’ “troubled
                    assets”) currently being considered by the U.S. government. Under Financial Accounting Standard (FAS) No. 123R, companies must report their
                    employee stock option (ESO) grants’ costs. Issuers usually estimate their
                    nontradable ESOs’ fair values by using a permissible model. Different
                    modeling assumptions and parameters, however, yield different model-based
                    valuations. Zions Bancorporation has advanced a different, market-based
                    approach, which the U.S. SEC has approved. Under Zions’ approach, a
                    reference ESO’s fair value is determined by the clearing price of its
                    tracking security (Employee Stock Option Appreciation Rights Securities
                    [ESOARS]) in an auction to outside investors. In this article, which is the
                    first empirical analysis of Zions’ 2006 and 2007 ESOARS auctions, we
                    examine (1) the impact of auction rules on bidding strategies and allocations,
                    (2) the efficiency of auction clearing prices, and (3) the “value
                    gap” between ESOARS auction clearing prices and various model-based
                    estimates.The valuation difference between the auction clearing price and commonly used
                    model-based estimates in the first auction decreased significantly in the second
                    auction. This outcome may be attributable, in part, to the changes made in the
                    second auction’s design (i.e., starting the auction on the reference
                    ESOs’ grant date; adjusting the ESOARS payment for prevesting forfeiture,
                    as FAS No. 123R mandates; and extending the auction’s end time) and to
                    the fact that investors had become better informed about ESOARS auctions, given
                    the SEC’s well-publicized comments on the first auction.We believe that Zions’ market-based approach for deriving the fair value
                    of reference ESOs is a novel and potentially helpful complement to current
                    model-based approaches for valuing ESOs for reporting purposes under FAS No.
                    123R. Although the ESOARS auction’s design leaves room for improvement,
                    Zions’ market-based approach provides a useful valuation benchmark,
                    especially for valuing ESOs granted by relatively young companies for which
                    historical exercise data may be scarce.Absent historical data, bidders could use proxy data from other companies to
                    calibrate their bids in an ESOARS auction hosted by a relatively young company.
                    Although each bid might be noisy, given such imperfect data, the
                    auction’s clearing price would reflect an unbiased consensus value
                    estimate, assuming that the offering was large and bidder entry was
                    unrestricted. In contrast, even if the company itself used the same proxy data
                    to estimate its ESO’s value under a permissible model, it would remain
                    subject to the criticism that such a model-based value reflects only the
                    company’s own (potentially downward-biased) value estimate rather than a
                    consensus view.We found that the design features of the auctions, such as ending rules,
                    significantly affected bidding strategy but not final allocations, which
                    remained highly concentrated. We also found that the clearing prices (1)
                    displayed high price elasticities of demand, suggesting efficient price
                    discovery, and (2) were low relative to some, but not all, model-based value
                    estimates. Such a value gap could be the result of modeling assumptions, as well
                    as auction design flaws that other researchers have noted, including misaligned
                    seller incentives, restricted size of auction, limited bidder participation, and
                    secondary market illiquidity. Our findings suggest design improvements that
                    might benefit auctions of other illiquid derivatives (e.g., banks’
                    “troubled assets”) currently being considered by the U.S.
                    government.
Journal: Financial Analysts Journal
Pages: 79-99
Issue: 6
Volume: 65
Year: 2009
Month: 11
X-DOI: 10.2469/faj.v65.n6.3
File-URL: http://hdl.handle.net/10.2469/faj.v65.n6.3
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Author-Name: Scott D. Stewart
Author-X-Name-First: Scott D.
Author-X-Name-Last: Stewart
Author-Name: John J. Neumann
Author-X-Name-First: John J.
Author-X-Name-Last: Neumann
Author-Name: Christopher R. Knittel
Author-X-Name-First: Christopher R.
Author-X-Name-Last: Knittel
Author-Name: Jeffrey Heisler
Author-X-Name-First: Jeffrey
Author-X-Name-Last: Heisler
Title: Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors
Abstract: 
 To determine whether the investment decisions of institutional plan sponsors
                    contribute to their asset values, this study used a dataset of 80,000 yearly
                    observations of institutional investment product assets, accounts, and returns
                    for 1984−2007. Results show that plan sponsors may not be acting in their
                    stakeholders’ best interests when they make rebalancing or reallocation
                    decisions. Investment products that receive contributions subsequently
                    underperform products experiencing withdrawals over one, three, and five years.
                    For investment decisions among equity, fixed-income, and balanced products, most
                    of the underperformance can be attributed to product selection. Tests suggest
                    that these results are not attributable to survivorship or other biases. Much
                    like individual investors who switch mutual funds at the wrong time,
                    institutional investors do not appear to create value from their investment
                    decisions.Pension plans, endowments, and foundations are typically staffed with
                    professionals who possess years of experience and advanced degrees. These
                    institutional plan sponsors, either working on their own or with the aid of
                    consultants, devote considerable time and resources to selecting asset classes
                    and investment products that are expected to perform well for their
                    beneficiaries or stakeholders. The assets in their care measure in the trillions
                    of dollars, and this article presents a comprehensive examination of where and
                    how their investment decisions contribute to, or detract from, asset value.We used the PSN investment manager database, which is compiled by Informa
                    Investment Solutions from information reported by investment product managers.
                    It contains historical data—annual summary information, quarterly and
                    annual performance, assets and number of accounts under management—on
                    thousands of investment products. The information in this database is used by
                    managers for comparisons with their peers and by plan sponsors and pension
                    consultants to identify investment manager candidates. Our analysis of asset and
                    account flows and postflow performance covers 1984−2007 and includes these
                    PSN categories: domestic equities (including growth, value, growth at a
                    reasonable price, and core); international and global equities; domestic,
                    global, and international fixed income; and domestic balanced.We conducted tests regarding added value by using both asset flows and account
                    changes derived from data on annual assets and accounts under management for
                    each product. Our results show that plan sponsors are not acting in their
                    stakeholders’ best interests when they make rebalancing or reallocation
                    decisions concerning plan assets. Portfolios of products to which they allocate
                    money subsequently underperform products experiencing asset withdrawals or
                    account losses over the one-, three-, and five-year periods following such
                    reallocations. When postflow performance is decomposed into allocations between
                    asset or style categories and product selection within the categories, product
                    selection detracts more from performance than does asset allocation. We show
                    that our results are robust to tests for the impact of survivorship bias, the
                    presence of mutual fund assets, and autocorrelation in the data. Tests with
                    account changes confirm the asset flow results. The economic significance of our findings is gauged by measuring the dollar
                    impact of the return differences between portfolios of products that received
                    inflows and portfolios of products that suffered asset withdrawals. This measure
                    quantifies the value that was added or forgone by sponsors’ decisions
                    regarding their plan assets. The value forgone is considerable, totaling $56.2
                    billion over 22 one-year periods following investment decisions. To avoid double
                    counting in estimating the total longer-term results, we used various weighting
                    schemes to implement assumptions about sponsor reallocations of a portion of
                    assets at the end of Years 1 and 3. The resulting five-year weighted average
                    impact, without compounding, totals −$170.2 billion for the full sample
                    period, a significant figure for the institutional investment industry. Although
                    only estimates, these figures most likely underestimate the economic impact
                    because they exclude the transaction costs required to implement the allocation
                    changes. The message from these results is clear: Plan sponsors could have saved
                    hundreds of billions of dollars in assets had they simply stayed the course.
Journal: Financial Analysts Journal
Pages: 34-51
Issue: 6
Volume: 65
Year: 2009
Month: 11
X-DOI: 10.2469/faj.v65.n6.4
File-URL: http://hdl.handle.net/10.2469/faj.v65.n6.4
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Author-Name: Jerry H. Tempelman
Author-X-Name-First: Jerry H.
Author-X-Name-Last: Tempelman
Title: Will the Federal Reserve Monetize U.S. Government Debt?
Abstract: 
 Purchases of U.S. Treasury securities by the U.S. Federal Reserve in 2009 have
                    prompted concerns that the Fed may monetize debt issued by the federal
                    government, an act with potentially inflationary consequences. Whether such
                    concerns are warranted depends in large part on the amount of Treasury
                    securities the Fed purchases. So long as the Fed’s total ownership of
                    Treasury securities does not exceed the amount of currency in circulation, the
                    Federal Reserve will not be monetizing the federal government’s debt.Purchases of U.S. Treasury securities by the U.S. Federal Reserve in 2009 have
                    prompted concerns that the Fed may monetize debt issued by the federal
                    government, an act with potentially inflationary consequences. Debt monetization
                    occurs when a government does not tax its citizens to repay the debt it incurs
                    but instead prints money—or, in the modern equivalent, its central bank
                    creates banking reserves by buying securities issued by its treasury department.
                    The result is a larger amount of money chasing an unchanged amount of goods,
                    which is a textbook explanation of inflation.Whether the concerns are warranted, however, depends in large part on the amount
                    of Treasury securities the Federal Reserve purchases. So long as the
                    Fed’s total ownership of Treasury securities does not exceed the amount
                    of currency in circulation, the Federal Reserve will not be monetizing the
                    federal government debt.The Fed’s ownership of Treasury securities is a form of seigniorage, which
                    is the favorable difference between the cost of issuing currency and the face
                    value of that currency. To function, an economy needs a certain amount of
                    currency in circulation. The federal government can use the currency it issues
                    to pay for government expenditures without having to raise that amount from
                    taxpayers. So long as the government does not issue more currency than the
                    economy needs to operate, inflation will not necessarily set in. The
                    Fed’s purchases of Treasury securities amount to seigniorage because
                    Treasury securities, which have an interest coupon and a maturity date, are
                    effectively retired and replaced by currency, which is a form of
                    non-interest-bearing government debt with no due date—or not really debt
                    at all.Historically, a close correlation has existed between the amount of currency in
                    circulation and the amount of Treasury securities owned by the Federal Reserve.
                    But beginning in August 2007, the Fed substantially reduced its holdings of
                    Treasury securities in order to offset the increase in reserves in the banking
                    system resulting from its programs meant to support various sectors of the
                    credit markets. Because the amount of Treasury securities that the Federal
                    Reserve decided to buy in 2009 will not cause its total ownership of Treasury
                    securities to exceed the amount of currency in circulation, the Fed will not be
                    monetizing debt incurred by the U.S. federal government.
Journal: Financial Analysts Journal
Pages: 24-27
Issue: 6
Volume: 65
Year: 2009
Month: 11
X-DOI: 10.2469/faj.v65.n6.5
File-URL: http://hdl.handle.net/10.2469/faj.v65.n6.5
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Author-Name: Richard M. Ennis
Author-X-Name-First: Richard M.
Author-X-Name-Last: Ennis
Title: The Uncorrelated Return Myth
Journal: Financial Analysts Journal
Pages: 6-7
Issue: 6
Volume: 65
Year: 2009
Month: 11
X-DOI: 10.2469/faj.v65.n6.6
File-URL: http://hdl.handle.net/10.2469/faj.v65.n6.6
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Author-Name: Viju Joseph
Author-X-Name-First: Viju
Author-X-Name-Last: Joseph
Title: Managing Systemic Counterparty Risk through a Redesigned Financial Architecture
Abstract: 
 This article proposes a centralized financial utility that would mitigate
                    systemic counterparty risk by guaranteeing against counterparty defaults and
                    providing asset protection to its customers. The utility would hold collateral
                    posted to it by each customer and issue secured counterparty risk bonds (CRBs).
                    The fees paid to the utility by customers seeking counterparty risk protection
                    would be paid as coupons to the CRB holders, and the principal would be repaid
                    at maturity after subtracting any losses from counterparty defaults. This
                    approach has numerous advantages, including creation of a market mechanism to
                    mitigate systemic counterparty risk, protection of financial institutions from
                    counterparty defaults, and enhancements to the regulatory monitoring
                    process.This article proposes a centralized financial utility that would mitigate
                    systemic counterparty risk by guaranteeing against counterparty defaults and
                    providing asset protection to its customers. To be able to provide this
                    guarantee, the utility would hold collateral posted to it by each customer and
                    issue secured counterparty risk bonds (CRBs). The fees paid to the utility by
                    customers seeking counterparty risk protection would be paid as coupons to the
                    CRB holders, and the principal would be repaid at maturity after subtracting any
                    losses from counterparty defaults. The losses from counterparty defaults would
                    be borne by CRB holders, thus preventing systemic meltdowns from counterparty
                    defaults. If overall counterparty risk should arise in the financial system, the
                    coupons demanded by bondholders would increase, which would lead to higher fees
                    for such transactions and result in fewer of those transactions whose costs
                    outweigh the benefits. This self-balancing market mechanism would ensure that
                    systemic counterparty risks could increase only if the bearers of such risks
                    were sufficiently compensated.This approach has numerous advantages, including the creation of a market
                    mechanism to mitigate systemic counterparty risk, protection of financial
                    institutions from counterparty default, and enhancements to the regulatory
                    monitoring process. All financial market participants would be required to take
                    part in the new infrastructure by regulation. This approach is different from
                    the current proposal of a centralized clearinghouse, which is based on
                    mutualization of OTC derivative counterparty risk among financial institutions
                    that are members of the clearinghouse but does not address the mitigation of
                    systemic counterparty risk in case of failure of a large financial
                    institution.If this architecture had been in place during the financial crisis of 2008, it
                    would have required collateral to be posted to offset the counterparty risk
                    generated by excessive leverage at AIG’s subsidiaries. After the failure
                    of Lehman Brothers, losses would have been limited to CRB investors, thereby
                    preventing the spread of panic and fears of counterparty risk to other
                    institutions. The article also discusses some of the challenges in implementing this framework
                    and how it could be expanded to mitigate other risks in the financial
                    system.Editor's Note (added July 2010): A patent is currently
                        pending for some of the ideas expressed in this article.
Journal: Financial Analysts Journal
Pages: 28-33
Issue: 6
Volume: 65
Year: 2009
Month: 11
X-DOI: 10.2469/faj.v65.n6.7
File-URL: http://hdl.handle.net/10.2469/faj.v65.n6.7
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Author-Name: William Poole
Author-X-Name-First: William
Author-X-Name-Last: Poole
Title: Moral Hazard: The Long-Lasting Legacy of Bailouts
Abstract: 
 The U.S. government appears to be committed to supporting any large bank that
                    gets into trouble. A bailout environment distorts risk assessments. Debt capital
                    flows more readily to large institutions, even inefficient ones, than to small
                    ones. This article proposes reforms to the U.S. financial system. A change in
                    incentives is needed. Phasing out the deductibility of interest on all business
                    tax returns would reduce the incentive for leverage. Another reform would
                    require all banks to issue 10-year subordinated notes, which would provide a
                    large capital cushion. Banks would have to go to market every year to replace
                    maturing subordinated debt, which would greatly enhance market discipline. Listen to a presentation by the author based on this
                    article.The federal government appears to be committed to supporting any large bank that
                    gets into trouble. A bailout environment distorts market risk assessments. Debt
                    capital flows more readily to large institutions, even inefficient ones, than to
                    small ones. Because of the moral hazard created by the high probability of a
                    government bailout of a failing large bank, capital is misallocated and banks
                    are encouraged to take on excessive risk.The current bailout regime is unacceptable politically because risks are
                    socialized and gains are private. Taxpayers are understandably and appropriately
                    angry that although they assume the risk of failed corporate policies, executive
                    compensation is often huge. The public’s anger over this situation is
                    leading to inefficient and ultimately ineffective regulatory policies, such as
                    constraints on executive compensation.Tougher regulations cannot fix “too big to fail.” For one thing,
                    regulators are not omniscient. They missed the subprime mortgage developments
                    that created the 2007−09 financial crisis, just as they missed the Latin
                    American debt accumulation in the 1970s that almost sank several large
                    money-center banks in the 1980s. Regulators are subject to political pressure,
                    as shown by the savings and loan problems that emerged in the 1970s and 1980s.
                    Even in the midst of the current financial crisis, the U.S. Congress pressured
                    the Financial Accounting Standards Board to modify fair-value accounting.What is needed is a change in incentives, not more regulation. Investment and
                    commercial banks entered the financial crisis with too little capital, motivated
                    in part by the deductibility of interest, but not dividends, on corporate tax
                    returns. Phasing out the deductibility of interest on all business tax returns
                    would reduce the incentive for leverage. A revenue-neutral reform would reduce
                    the statutory corporate tax rate from 35 percent to about 15 percent.Another reform would require all banks to issue 10-year subordinated notes equal
                    to 10 percent of total liabilities. Moral hazard cannot be controlled without
                    putting some creditors at risk. But the creditors at risk must own long-term
                    bonds; short-maturity debt can run by not being rolled over when due, which
                    makes the financial system vulnerable to a liquidity crisis. Long-term
                    subordinated notes would provide a larger capital cushion, and banks would have
                    to go to market every year to replace maturing subordinated debt, which would
                    greatly enhance market discipline. A bank that could not replace maturing
                    subordinated debt would have to shrink. For example, with 10-year notes equal to
                    10 percent of liabilities, a bank unable to sell new subordinated debt would
                    have to shrink by 10 percent to live within its remaining subordinated debt.
                    Contracting a bank by 10 percent a year is perfectly feasible. Any bank
                    restructuring should be managed by the bank and not by regulators.Note: This article is based on a speech that the author gave at the
                            CFA Institute Annual Conference in April 2009. He was president and CEO
                            of the Federal Reserve Bank of St. Louis from March 1998 to March
                            2008.
Journal: Financial Analysts Journal
Pages: 17-23
Issue: 6
Volume: 65
Year: 2009
Month: 11
X-DOI: 10.2469/faj.v65.n6.8
File-URL: http://hdl.handle.net/10.2469/faj.v65.n6.8
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Author-Name: Andrew Slater
Author-X-Name-First: Andrew
Author-X-Name-Last: Slater
Title: “Mind the Gap: Using Derivatives Overlays to Hedge Pension Duration”: A Comment
Abstract: 
 This material comments on “Mind the Gap: Using Derivatives Overlays to
                    Hedge Pension Duration”.
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 6
Volume: 65
Year: 2009
Month: 11
X-DOI: 10.2469/faj.v65.n6.9
File-URL: http://hdl.handle.net/10.2469/faj.v65.n6.9
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Author-Name: Guofu Zhou
Author-X-Name-First: Guofu
Author-X-Name-Last: Zhou
Author-Name: Yingzi Zhu
Author-X-Name-First: Yingzi
Author-X-Name-Last: Zhu
Title: Is the Recent Financial Crisis Really a “Once-in-a-Century” Event?
Abstract: 
 On 9 October 2007, the Dow Jones Industrial Average reached a high of 14,164.53;
                    by 9 March 2009, it had dropped about 54 percent, to a low of 6,547.05. Former
                    Fed chairman Alan Greenspan called this a “once-in-a-century”
                    crisis. The authors show that the probability of a stock market drop of 50
                    percent from a high is about 90 percent over a 100-year period, based on the
                    popular random walk model of stock prices. With a broad market index and a more
                    sophisticated asset pricing model that captures more risks in the economy, the
                    probability rises to above 99 percent. A market drop of 50 percent or more is
                    very likely in long-term stock market investments, and investors should be
                    prepared for it.During the recent financial crisis, the Dow Jones Industrial Average (DJIA)
                    dropped about 54 percent, from a high of 14,164.53 on 9 October 2007 to a low of
                    6,547.05 on 9 March 2009. Former Fed chairman Alan Greenspan called this a
                    “once-in-a century” crisis. In this article, we examine this
                    claim.We used the drawdown probability to measure the likelihood of the occurrence of a
                    crisis with a given magnitude. Based on the assumptions of the random walk model
                    for the DJIA, we calibrated the long-term mean and volatility to the data and
                    found that the drawdown probability for the Dow to drop more than 50 percent
                    from a high is about 90 percent over a 100-year period. The result, however, is
                    sensitive to our estimates of the long-term mean and volatility. With a broad
                    market index and a more sophisticated asset pricing model that captures more
                    risks in the economy, the probability rises to above 99 percent. The probability of a crisis can accumulate over a time horizon, which has a
                    significant impact on long-run investments. Although the expected value of
                    long-run investments grows over time, so does the probability of seeing a large
                    swing of a fixed size. Over a 100-year period, the probability of a crisis can
                    be very large.In terms of investing in the stock market, long-term investors should have
                    prepared for a market drop of more than 50 percent. Based on both simple and
                    complex asset pricing models, such a rare event indeed has a high probability of
                    occurring in a 100-year period (although just a small probability in a given
                    year). In 100 years’ time, such an event is almost certain to occur, and
                    investors should be prepared for it.
Journal: Financial Analysts Journal
Pages: 24-27
Issue: 1
Volume: 66
Year: 2010
Month: 1
X-DOI: 10.2469/faj.v66.n1.1
File-URL: http://hdl.handle.net/10.2469/faj.v66.n1.1
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 88-88
Issue: 1
Volume: 66
Year: 2010
Month: 1
X-DOI: 10.2469/faj.v66.n1.10
File-URL: http://hdl.handle.net/10.2469/faj.v66.n1.10
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Author-Name: Shantaram Hegde
Author-X-Name-First: Shantaram
Author-X-Name-Last: Hegde
Author-Name: Hao Lin
Author-X-Name-First: Hao
Author-X-Name-Last: Lin
Author-Name: Sanjay Varshney
Author-X-Name-First: Sanjay
Author-X-Name-Last: Varshney
Title: Competitive Stock Markets: Evidence from Companies’ Dual Listings on the NYSE and NASDAQ
Abstract: 
 In 2004, NASDAQ launched its dual listing program, which allows NYSE-listed
                    companies to list concurrently on NASDAQ. Investigating this innovation and the
                    impact of competitive interaction between the two markets on both order flow and
                    market liquidity, this study found that dual listing is associated with a
                    significant net growth in aggregate trading volume. Moreover, dual listing
                    narrows the bid–ask spreads on both markets. Overall, dual listing appears
                    to lower transaction costs and improve liquidity for traders on both
                    markets.The tug-of-war between the NYSE and NASDAQ for stock-exchange listings has
                    increased significantly in recent years. In 2004, NASDAQ launched its dual
                    listing program, which allows NYSE-listed companies to list concurrently on
                    NASDAQ.We studied the competitive response of financial markets to the cross-listing of
                    stocks. Listing on NASDAQ by companies that are also listed on the NYSE
                    increases the degree of competition among buyers and sellers of their shares, as
                    well as among market makers and dealers in those markets. Conventional economic
                    theories predict that increased competition will lead to lower trading costs for
                    both stocks and market-making services. When a stock is traded on multiple
                    markets, however, theories on market fragmentation warn that transaction costs
                    could increase. Dual listing provides a unique opportunity to examine the impact
                    of competition versus fragmentation on price discovery and trading liquidity
                    because the same shares are traded on both domestic market centers. A related question is how different market structures influence the competitive
                    response because the NYSE and NASDAQ use disparate trading structures and
                    mechanisms. Current evidence suggests that the NYSE tends to offer lower trading
                    costs, on average, but NASDAQ guarantees greater anonymity of executions. Dual
                    listing enhances opportunities for traders to self-sort into “face
                    time” versus automated trading systems that are based on their unique
                    needs and strategies. It represents a distinctive event that allows us to
                    examine the competitive response from two different market structures.We studied the stocks of eight NYSE companies that participated in the dual
                    listing program by also listing on NASDAQ over our sample period of
                    2004−2007. Because dual listing allows companies to trade their stocks
                    away from the NYSE, it intensifies the degree of competition for order flow
                    between the two markets but accentuates the fragmentation of order flow. We
                    found that the average daily trading volume and the number of trades increase
                    significantly after dual listing for both markets, which indicates net growth in
                    trading activity in the dual-listed stocks. The NYSE attracts more orders, and
                    NASDAQ accounts for a higher proportion of block trades. Further, average
                    bid–ask spreads decrease after dual listing on both markets, with the
                    spreads on the NYSE narrower than those on NASDAQ. NASDAQ, however, offers
                    greater price improvement relative to its quotes through a higher proportion of
                    trades occurring within and also has lower informed trading costs. Overall, our
                    study shows that dual listing provides a net benefit for all traders on both
                    markets through lower trading costs and improved liquidity.
Journal: Financial Analysts Journal
Pages: 77-87
Issue: 1
Volume: 66
Year: 2010
Month: 1
X-DOI: 10.2469/faj.v66.n1.2
File-URL: http://hdl.handle.net/10.2469/faj.v66.n1.2
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Author-Name: William J. Bernstein
Author-X-Name-First: William J.
Author-X-Name-Last: Bernstein
Title: Of Laws, Lending, and Limbic Systems
Abstract: 
 Over the past four centuries, financial crises have occurred at semi-regular
                    intervals of approximately once a decade. Their primary mechanism seems to be
                    the increasingly elastic nature of credit in the modern financial system. Recent
                    advances in neurophysiology and cognitive neuropsychology shed light on this
                    phenomenon and provide hints about how such crises might be mitigated in the
                    future.Financial theorist Hyman Minsky asserted that financial bubbles require two
                    conditions: a trigger, or “displacement”—usually a
                    technological or financial innovation—and abundant credit. In modern
                    times, fractional reserve banking and its equivalents in the non-banking sector
                    have provided the source of liquidity with which to inflate bubbles; and when at
                    some later point credit is withdrawn, panic and crash ensue. Over the past
                    century, lightly regulated “parallel banking systems” have become an
                    increasingly important source of this instability.Minsky also divided capital operations into three classes: “hedging
                    operations” that fund both interest and principal repayments through
                    expected cash flows, “speculative operations” that fund interest but
                    not principal, and “Ponzi operations” that fund neither. Charles
                    Kindleberger listed no fewer than 46 panics and crashes in the world financial
                    system over the past four centuries—approximately one every decade. Thus,
                    the duration of the operations’ liabilities becomes critically important;
                    the shorter the duration, the more vulnerable all operations, even the safest
                    hedging ones, become to the inevitable credit disruptions associated with these
                    events.Recent research in cognitive neuropsychology sheds some light on why both
                    borrowers and lenders involve themselves in speculative and Ponzi operations: In
                    all probability, the prospect of short-term financial reward stimulates the
                    evolutionarily ancient neural circuitry of their rapidly reacting limbic
                    systems. The limbic “greed center” seems to lie in a pair of
                    structures known as the nuclei accumbens. Functional MRI studies show that these
                    nuclei activate with the anticipation of multiple types of
                    reward, including, but not limited to, financial gain and the consumption of
                    addictive substances.During market bubbles, the aggregate stimulation of participants’ limbic
                    systems overwhelms the aggregate of participants’ higher cortical
                    function, the locus of rational, calculating market activity. The cohabitation
                    of the mediation of drug addiction and of short-term financial reward in the
                    limbic system has profound implications; this may help explain why market
                    participants so soon forget the lessons of previous booms and busts.How, if at all, can financial regulation interrupt such neurophysiologically
                    mediated dysfunctional market behavior? Unfortunately, history demonstrates that
                    financial innovation usually races far ahead of the slower-moving regulatory
                    apparatus. Nonetheless, regulation can succeed, as demonstrated by the nearly
                    half-century period of stability and growth following the ensemble of New Deal
                    securities legislation, which at the time was bitterly opposed by the financial
                    industry.Whatever regulatory action is chosen, it should include four mechanisms not
                    commonly considered to be part of the traditional apparatus:A discrete organization dedicated to economic history should be
                            established. Economic history has a great deal to teach us about
                            preventing future blowups; for example, in many aspects, the current
                            crisis was very similar to the panic of 1907.Similarly, cognitive neuropsychological techniques to assess and monitor
                            the degree of speculative behavior should be developed and deployed.An early warning system that tracks the systemic threats from novel
                            financial instruments should be established and given robust enforcement
                            authority.More attention should be given to the dangers of short-term financing in
                            a world prone to periodic credit disruptions.
Journal: Financial Analysts Journal
Pages: 17-22
Issue: 1
Volume: 66
Year: 2010
Month: 1
X-DOI: 10.2469/faj.v66.n1.3
File-URL: http://hdl.handle.net/10.2469/faj.v66.n1.3
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Author-Name: Avraham Kamara
Author-X-Name-First: Avraham
Author-X-Name-Last: Kamara
Author-Name: Xiaoxia Lou
Author-X-Name-First: Xiaoxia
Author-X-Name-Last: Lou
Author-Name: Ronnie Sadka
Author-X-Name-First: Ronnie
Author-X-Name-Last: Sadka
Title: Has the U.S. Stock Market Become More Vulnerable over Time?
Abstract: 
 This study demonstrates that the cross-sectional variation of systematic risk and
                    systematic liquidity has increased from 1963 to 2008. Both have increased
                    significantly for large-capitalization companies but have declined significantly
                    for small-cap companies. These findings have several implications for investment
                    managers, including the declining ability to diversify return volatilities and
                    liquidity shocks by holding liquid, large-cap stocks. The findings suggest that
                    the vulnerability of the U.S. equity market to unanticipated events has
                    increased over the past few decades.This article concerns the evolution of systematic risk and systematic liquidity
                    in a cross-section of U.S. stocks from 1963 to 2008 and the implications for the
                    vulnerability of the U.S. stock market to marketwide liquidity and return
                    shocks. For our sample period of 1963−2008, we found that both systematic
                    risk and systematic liquidity (which we defined as the sensitivity of a
                    stock’s return and liquidity to market return and liquidity, respectively)
                    have decreased significantly for small-capitalization companies but have
                    increased significantly for large-cap companies. We showed that these
                    cross-sectional divergence patterns are associated with each other.The increased cross-sectional divergence of systematic risk and systematic
                    liquidity has important implications for the ability to diversify return
                    volatility and liquidity shocks among companies. We found that the ability to
                    diversify return and liquidity shocks by holding relatively liquid large-cap
                    stocks has declined from 1963 to 2008, both in absolute terms and relative to
                    the diversification benefits of small-cap stocks. Thus, the ability to diversify
                    return volatility and liquidity shocks by holding an otherwise well-diversified,
                    value-weighted portfolio has declined over time. In contrast, we found that the
                    ability to diversify risk and liquidity shocks by holding shares of small
                    companies has improved over time. This finding is particularly noteworthy
                    because of the “flight to quality” from small-cap stocks to
                    large-cap stocks in turbulent times. Our findings, therefore, suggest that the
                    vulnerability of the U.S. equity market to unanticipated events has increased
                    from 1963 to 2008.We conjectured that the trends of increased systematic risk and systematic
                    liquidity can be explained by the growth in institutional ownership from 1963 to
                    2008. We had previously found that the sensitivity of the stock’s
                    liquidity to aggregate liquidity shocks increases with institutional ownership,
                    and institutional investing and index trading have been more concentrated in
                    large-cap stocks than in small-cap stocks. Index and basket trading, both
                    increasingly popular with institutional investors, can affect systematic
                    liquidity via correlated trading patterns that affect the liquidity of many
                    stocks. Moreover, because trading activity and order flows affect stock prices,
                    correlated trading among many stocks can also affect the co-movement of daily
                    stock returns.Our findings have several important implications for investment managers. We
                    showed that because of the increased systematic risk of large companies,
                    building a large-cap index fund has become easier—that is, one can achieve
                    low tracking error, relative to a large-cap index, by using fewer stocks.
                    Moreover, the benefits of diversifying among large-cap stocks when constructing
                    a value-spread portfolio (high-book-to-market stocks minus low-book-to-market
                    stocks) have declined over time; the volatility of the value-spread portfolio
                    constructed with small-cap stocks has declined relative to such a portfolio with
                    large-cap stocks.
Journal: Financial Analysts Journal
Pages: 41-52
Issue: 1
Volume: 66
Year: 2010
Month: 1
X-DOI: 10.2469/faj.v66.n1.4
File-URL: http://hdl.handle.net/10.2469/faj.v66.n1.4
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Author-Name: Bradford Cornell
Author-X-Name-First: Bradford
Author-X-Name-Last: Cornell
Title: Economic Growth and Equity Investing
Abstract: 
 The performance of equity investments is inextricably linked to economic growth.
                    Nonetheless, few studies on investing have explicitly taken research on economic
                    growth into account. This study bridges that gap by examining the implications
                    for equity investing of both theoretical models and empirical results from
                    growth theory. The study concludes that over the long run, investors should
                    anticipate real returns on common stock to average no more than about 4
                    percent.The performance of equity investments is inextricably linked to economic growth.
                    Nonetheless, few studies on investing explicitly take research on economic
                    growth into account. This article bridges that gap by examining the implications
                    for equity investing of both theoretical models and empirical results from
                    growth theory.Bridging the gap involves two fundamental steps. The first is examining the
                    sources of long-run economic growth. Growth theory teaches that in the long run,
                    expansion of real GDP is determined almost exclusively by a combination of
                    population growth and productivity growth attributable to technological
                    innovation. Analyzing these two factors enables the placing of reasonable limits
                    on future real GDP growth in the developed countries. Those limits turn out to
                    be about 3 percent.The second step involves analysis of the relationship between real earnings and
                    real GDP. If the ratio of earnings to GDP is stationary—and the data
                    indicate that it is—then in the long run, real earnings can grow at a rate
                    no faster than real GDP. Those real earnings, however, are the real earnings for
                    the economy as a whole. The real earnings growth that existing investors can
                    expect may be less because of dilution that occurs when new shares are issued,
                    primarily by start-ups. In the case of the United States, for instance, updated
                    data show that dilution drives a 2 percent wedge between aggregate real earnings
                    growth and the real earnings growth experienced by existing investors.Putting the pieces together in conjunction with data on dividend yields, my
                    analysis suggests that over the long run, investors should expect real returns
                    on common stocks to average no more than about 4 percent. Moreover, this result
                    holds for the entire developed world, not just the United States.
Journal: Financial Analysts Journal
Pages: 54-64
Issue: 1
Volume: 66
Year: 2010
Month: 1
X-DOI: 10.2469/faj.v66.n1.5
File-URL: http://hdl.handle.net/10.2469/faj.v66.n1.5
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: Competence Trumps Style
Journal: Financial Analysts Journal
Pages: 6-7
Issue: 1
Volume: 66
Year: 2010
Month: 1
X-DOI: 10.2469/faj.v66.n1.6
File-URL: http://hdl.handle.net/10.2469/faj.v66.n1.6
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Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Author-Name: Anthony Bova
Author-X-Name-First: Anthony
Author-X-Name-Last: Bova
Title: Return Targets and Percentile Fans
Abstract: 
 This article presents a highly intuitive approach for visualizing return
                    distributions for a basic form of cash/equity allocations. This
                    “percentile fan” framework can help clarify some of the key
                    risk–return trade-offs in intuitive ways for a wide set of asset owners.
                    In particular, percentile fans can help investors express their portfolio
                    objectives in terms of return targets or shortfall limits over one or more
                    horizons. For some investors, these intuitive goals, especially when depicted in
                    a visual context, can feel like a more natural approach than the standard
                    mean–variance utility framework.The authors use multiple-percentile “fans” for a range of equity
                    mixtures (described by beta values) to provide a simultaneous view of the
                    prospects for reaching return targets and satisfying prescribed risk limits. In
                    particular, percentile fans can help investors express their portfolio
                    objectives in terms of return targets or shortfall limits over one or more time
                    horizons. For some investors, these intuitive goals, especially when depicted in
                    a visual context, can feel like a more natural approach than the standard
                    mean–variance utility framework.The authors’ findings suggest that to achieve reasonable return targets
                    within the framework of a standard market model, allocations may need to be
                    seriously long-term oriented and yet able to accommodate relatively high levels
                    of year-to-year volatility. Returns from diversifying assets, better-yielding
                    low-risk alternatives, and active strategies can also help in achieving
                    reasonable return targets over the long run but with a potentially greater
                    vulnerability to severely adverse markets.A minimum objective for any risk taking is to surpass the return available from
                    the risk-free rate. In the authors’ analysis, one basically horizontal
                    percentile line always radiates from the risk-free rate. This percentile line
                    acts as a risk floor in the sense that it characterizes a common probability of
                    exceeding the risk-free rate for all portfolios with positive betas. In their
                    basic example, the 60th percentile line delineates this risk floor such that all
                    risky portfolios have the same 60 percent probability of exceeding the risk-free
                    rate. The one exception is the zero beta portfolio, which is 100 percent
                    invested in the risk-free rate itself.Over the long term, a significant probability of achieving decent return targets
                    requires accepting a sufficiently high minimum beta risk. Short-term risk
                    constraints, however, typically set a maximum beta limit. A range of feasible
                    beta values is defined by some combination of a maximum for risk constraints and
                    a minimum for return objectives. The beta range found in their examples roughly
                    approximates the 0.55−0.65 beta values widely seen in practice for most
                    individual and institutional portfolios (even those with high levels of
                    diversification).
Journal: Financial Analysts Journal
Pages: 28-40
Issue: 1
Volume: 66
Year: 2010
Month: 1
X-DOI: 10.2469/faj.v66.n1.7
File-URL: http://hdl.handle.net/10.2469/faj.v66.n1.7
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: 2009 Report to Readers
Journal: Financial Analysts Journal
Pages: 10-11
Issue: 1
Volume: 66
Year: 2010
Month: 1
X-DOI: 10.2469/faj.v66.n1.8
File-URL: http://hdl.handle.net/10.2469/faj.v66.n1.8
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Author-Name: James S. Doran
Author-X-Name-First: James S.
Author-X-Name-Last: Doran
Author-Name: Kevin Krieger
Author-X-Name-First: Kevin
Author-X-Name-Last: Krieger
Title: Implications for Asset Returns in the Implied Volatility Skew
Abstract: 
 This study examined the impact on future asset returns of information contained
                    in the implied volatility skew. Future returns are linked to the discrepancy
                    between call and put volatilities of at-the-money options and to the left side
                    of the volatility skew, calculated as the difference between out-of-the-money
                    and at-the-money puts. The findings discourage the use of skew-based measures
                    for forecasting equity returns without fully parsing the skew into its most
                    basic portions.We examine the impact on future asset returns of information contained in the
                    implied volatility skew. Future returns are linked to the discrepancy between
                    call and put volatilities of at-the-money options and to the left side of the
                    volatility skew, calculated as the difference between out-of-the-money and
                    at-the-money puts. The predictability of the volatility skew is found in U.S.
                    and international markets, as well as in equities and ETFs. Our findings
                    discourage the use of skew-based measures for forecasting equity returns without
                    fully parsing the skew into its most basic portions.
Journal: Financial Analysts Journal
Pages: 65-76
Issue: 1
Volume: 66
Year: 2010
Month: 1
X-DOI: 10.2469/faj.v66.n1.9
File-URL: http://hdl.handle.net/10.2469/faj.v66.n1.9
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Author-Name: Rajesh K. Aggarwal
Author-X-Name-First: Rajesh K.
Author-X-Name-Last: Aggarwal
Author-Name: Philippe Jorion
Author-X-Name-First: Philippe
Author-X-Name-Last: Jorion
Title: Hidden Survivorship in Hedge Fund Returns
Abstract: 
 This study identifies a previously unreported bias in the TASS database. Owing to
                    a merger with the Tremont database, 60 percent of the funds added to the TASS
                    database between April 1999 and November 2001 are likely to be survivors (i.e.,
                    funds that were selected only from funds that were live as of 31 March 1999).
                    The resulting survivorship bias is substantial, averaging more than 5 percent a
                    year. What would normally be termed the backfill period actually represents
                    hidden survivorship. A sorting algorithm to exclude these fund histories is
                    proposed.In this article, the authors identify a previously unreported bias in the Tremont
                    Advisory Shareholder Services (TASS) database. In March 1999, Tremont Capital
                    Management purchased the original TASS database. Before the purchase, Tremont
                    had compiled its own informal database of hedge funds. That database was not
                    absorbed directly into the TASS database. Instead, Tremont invited its hedge
                    fund managers to join the new TASS database. Not all managers joined the
                    database immediately; this process continued gradually until November 2001, when
                    the last of the Tremont funds were added. As a result, a large number of Tremont
                    funds were added to the TASS database between 1 April 1999 and 30 November
                    2001.Only funds that were still operating as of 31 March 1999 or later—that is,
                    survivors—accepted Tremont’s invitation to report to the TASS
                    database. Some 60 percent of the funds added to the TASS database between April
                    1999 and November 2001 are likely to be survivors. Existing methods of dealing
                    with survivorship bias (e.g., including dead funds in the sample) are
                    insufficient to correct for the Tremont survivor problem in the TASS database
                    because at the time of the TASS/Tremont merger, there were no Tremont dead funds
                    to include. The authors find that the size of the survivorship bias arising from
                    the TASS/Tremont merger—measured as the difference between the performance
                    of the survived funds and the rest of the sample—is more than 5 percent,
                    on average, for 1994–2001.Because of the database construction process, the survived Tremont funds are
                    likely to exhibit long backfill periods. But the long backfill periods are not a
                    result of hedge fund managers’ purposefully backfilling the data; rather,
                    they are a spurious effect owing to the design of the database. Therefore, what
                    would usually be called backfill bias really represents survivorship bias. To
                    eliminate the effect of this survivorship bias in empirical analysis, the
                    authors propose a sorting algorithm to exclude these fund histories. Their
                    results should be useful to researchers who increasingly use the TASS database
                    to evaluate the performance characteristics of hedge funds.
Journal: Financial Analysts Journal
Pages: 69-74
Issue: 2
Volume: 66
Year: 2010
Month: 3
X-DOI: 10.2469/faj.v66.n2.1
File-URL: http://hdl.handle.net/10.2469/faj.v66.n2.1
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Author-Name: David T. Jack
Author-X-Name-First: David T.
Author-X-Name-Last: Jack
Title: “Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors”: A Comment
Abstract: 
 This material comments on “Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors”.
Journal: Financial Analysts Journal
Pages: 15-16
Issue: 2
Volume: 66
Year: 2010
Month: 3
X-DOI: 10.2469/faj.v66.n2.10
File-URL: http://hdl.handle.net/10.2469/faj.v66.n2.10
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Author-Name: William Poole
Author-X-Name-First: William
Author-X-Name-Last: Poole
Title: “Moral Hazard: The Long-Lasting Legacy of Bailouts”: Author Response to James Allen
Abstract: 
 This material comments on “Moral Hazard: The Long-Lasting Legacy of Bailouts”.
Journal: Financial Analysts Journal
Pages: 11-14
Issue: 2
Volume: 66
Year: 2010
Month: 3
X-DOI: 10.2469/faj.v66.n2.11
File-URL: http://hdl.handle.net/10.2469/faj.v66.n2.11
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Author-Name: William Poole
Author-X-Name-First: William
Author-X-Name-Last: Poole
Title: “Moral Hazard: The Long-Lasting Legacy of Bailouts”: Author Response to Eric Boughton
Abstract: 
 This material comments on “Moral Hazard: The Long-Lasting Legacy of Bailouts”.
Journal: Financial Analysts Journal
Pages: 15-15
Issue: 2
Volume: 66
Year: 2010
Month: 3
X-DOI: 10.2469/faj.v66.n2.12
File-URL: http://hdl.handle.net/10.2469/faj.v66.n2.12
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 80-80
Issue: 2
Volume: 66
Year: 2010
Month: 3
X-DOI: 10.2469/faj.v66.n2.13
File-URL: http://hdl.handle.net/10.2469/faj.v66.n2.13
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Author-Name: Wonseok Choi
Author-X-Name-First: Wonseok
Author-X-Name-Last: Choi
Author-Name: Kenton Hoyem
Author-X-Name-First: Kenton
Author-X-Name-Last: Hoyem
Author-Name: Jung-Wook Kim
Author-X-Name-First: Jung-Wook
Author-X-Name-Last: Kim
Title: Capital Gains Overhang and the Earnings Announcement Volume Premium
Abstract: 
 This study examined why stocks that experience high abnormal trading volume
                    around earnings announcements earn high returns. The high returns of high-volume
                    stocks appear to be associated with selling pressure that is independent of
                    fundamentals and that comes from a subset of investors who base their selling
                    decisions on the magnitude of unrealized capital gains or losses. Supplementary
                    evidence based on account-level data from a U.S. brokerage firm suggests extra
                    selling pressure for stocks with large capital losses around earnings
                    announcements. These patterns also suggest that the conventional interpretation
                    of the disposition effect may not hold for stocks with large, unrealized capital
                    losses around earnings announcements.In this article, the authors examined a possible cause of the higher returns
                    realized by stocks that experience high abnormal trading volume around earnings
                    announcements, which they termed the earnings announcement volume premium
                    (EAVP). The higher risk-adjusted returns for high-volume stocks suggest that
                    sellers’ decisions are suboptimal and not based on fundamentals. All else
                    being equal, such uninformed selling creates temporary downward pressure on a
                    stock’s price that leads to higher abnormal returns as the price pressure
                    dissipates. In searching for a determinant of such uninformed pressure, the
                    authors drew on recent literature that suggests that certain investors’
                    sell decisions could be affected by unrealized capital gains or losses (i.e.,
                    capital gains overhang [CGO]) as predicted by the disposition effect.The EAVP conditioned on the magnitude of CGO is both statistically and
                    economically significant (as high as 10 percent a year). The authors also found
                    a strong U-shaped relationship between the returns of high-volume stocks and
                    CGO. This finding suggests that large unrealized losses, as well as large
                    unrealized gains, prompt selling. The authors further refined the EAVP by
                    conditioning it on both CGO and the content of earnings news. Finally, using
                    account-level data from a U.S. brokerage firm, they found supplementary evidence
                    of extra selling pressure for stocks with large capital losses around earnings
                    announcements. The patterns they documented suggest that the conventional
                    interpretation of the disposition effect may not hold for stocks with large
                    unrealized capital losses around earnings announcements.
Journal: Financial Analysts Journal
Pages: 40-53
Issue: 2
Volume: 66
Year: 2010
Month: 3
X-DOI: 10.2469/faj.v66.n2.2
File-URL: http://hdl.handle.net/10.2469/faj.v66.n2.2
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Author-Name: Gaurav Jetley
Author-X-Name-First: Gaurav
Author-X-Name-Last: Jetley
Author-Name: Xinyu Ji
Author-X-Name-First: Xinyu
Author-X-Name-Last: Ji
Title: The Shrinking Merger Arbitrage Spread: Reasons and Implications
Abstract: 
 The merger arbitrage spread has declined by more than 400 bps since 2002. This
                    decline, which is both economically and statistically significant, corresponds
                    to the decline in aggregate returns of merger arbitrage hedge funds, as well as
                    increased inflows into merger arbitrage hedge funds. Part of the decline in the
                    arbitrage spread may be explained by increased trading in the targets’
                    stocks following the merger announcement, reduced transaction costs, and changes
                    in risk related to merger arbitrage. These findings suggest that some of the
                    decline is likely to be permanent; therefore, investors seeking to invest in
                    merger arbitrage hedge funds should focus on returns since 2002.This article examines the evolution of the merger arbitrage spread between 1990
                    and 2007. The authors first analyzed arbitrage spreads and returns of merger
                    arbitrage hedge funds and found that both have experienced statistically and
                    economically significant declines in recent years.In particular, the median first-day arbitrage spread ranged from 4.10 percent to
                    7.94 percent for deals announced before 2001, whereas for the period after 2001,
                    the median first-day arbitrage spread ranged from 1.74 percent to 2.63 percent.
                    The conclusion that arbitrage spreads have declined significantly did not change
                    when similar comparisons were made for periods extending to 90 trading days
                    following the merger announcement.Similarly, an analysis of monthly returns of merger arbitrage hedge funds
                    indicated that although the distributions of returns were similar for
                    1990–1995 and 1996–2001, the returns declined in the latter period.
                    A regression analysis shows that for 2002–2007, relative to the earlier
                    periods, the aggregate alpha of the merger arbitrage hedge funds declined by
                    about 41 bps, equivalent to an annual decline of 4.81 percentage points.Three possible reasons for the decline were explored: a reduction in transaction
                    costs related to risk arbitrage, capacity constraints over time (i.e., more
                    money chasing a limited number of deals), and a reduction in risks associated
                    with merger arbitrage.To test whether the transaction costs related to mergers experienced a similar
                    decline, the authors compared the completion-date arbitrage spreads of
                    successful deals and found evidence of a transaction cost decline.To determine whether increased investment in merger arbitrage contributed to the
                    decline in the spread, the authors analyzed the relative trading volume
                    (RV)—the trading volume the day after the merger announcement divided by
                    the average trading volume from 50 to 25 days before the announcement—in
                    the target stock. The results show that first-day RV has experienced a
                    significant increase since 2001.To ascertain whether completion risk associated with merger arbitrage has
                    changed, the authors first compared the success rates of mergers since 1990 and
                    found that the overall success rate has remained relatively stable. Thus, that
                    observed declines in the arbitrage spread are attributable to reduced completion
                    risk is unlikely. Further, to measure any change in the loss an arbitrageur
                    suffers upon deal failure, the authors computed the loss associated with failed
                    mergers announced between 1990 and 2007 and found that the loss resulting from
                    deal failure has declined.The authors then used a regression model to analyze the factors that could
                    explain, at least in part, the observed decline in the arbitrage spread. The
                    regression results confirmed that part of the decline in the arbitrage spread
                    and, thus, in the aggregate alpha of merger arbitrage hedge funds is the result
                    of increased trading in the target’s stock following the merger
                    announcement. This finding shows that one of the consequences of the increase in
                    capital devoted to merger arbitrage is reduced aggregate profitability of merger
                    arbitrage hedge funds. As a result, the increase in volume seems to be
                    permanent. Therefore, to the extent that reviewing historical returns associated
                    with an investment strategy is useful, investors seeking to invest in merger
                    arbitrage hedge funds should focus on returns since 2002 rather than returns
                    over a longer period.Note: The views expressed in this article do not necessarily
                            represent those of the Analysis Group.
Journal: Financial Analysts Journal
Pages: 54-68
Issue: 2
Volume: 66
Year: 2010
Month: 3
X-DOI: 10.2469/faj.v66.n2.3
File-URL: http://hdl.handle.net/10.2469/faj.v66.n2.3
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Author-Name: Roger G. Ibbotson
Author-X-Name-First: Roger G.
Author-X-Name-Last: Ibbotson
Title: The Importance of Asset Allocation
Abstract: 
 This article discusses the impact on performance of the long-term asset
                    allocation policy relative to the impact of active management. Most of the
                    variation in time-series returns for a typical fund comes from general market
                    movement. The remaining variation comes about equally from asset allocation
                    policy and active management.How important is asset allocation policy in determining performance? In
                    particular, what is the impact of the long-term asset allocation policy mix
                    relative to the impact of the active performance from timing, security
                    selection, and fees?Most of the variation in a typical fund’s return comes from market
                    movement. Funds differ by asset allocation, but almost all of them participate
                    in the general market instead of just holding cash. The total return of a fund
                    can be split into three parts: (1) the return from the overall market movement,
                    (2) the incremental return from the asset allocation policy of the specific
                    fund, and (3) the active return (the alpha) from timing, selection, and fees. In general (after controlling for interaction effects), about three-quarters of a
                    typical fund’s variation in time-series returns comes from general market
                    movement, with the remaining portion split roughly evenly between specific asset
                    allocation and the active management. In a year like 2008, almost all funds are
                    down, whereas in a year like 2009, almost all funds are up, despite their
                    specific asset allocation or active management activities.The time has come for folklore to be replaced with reality. Asset allocation is
                    very important, but nowhere near 90 percent of the variation in returns is
                    caused by the specific asset allocation mix. Instead, most time-series variation
                    comes from general market movement, and active management has about the same
                    impact on performance as a fund’s specific asset allocation policy.
Journal: Financial Analysts Journal
Pages: 18-20
Issue: 2
Volume: 66
Year: 2010
Month: 3
X-DOI: 10.2469/faj.v66.n2.4
File-URL: http://hdl.handle.net/10.2469/faj.v66.n2.4
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Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: What Investors Really Want
Abstract: 
 Editor’s Note: With this piece, the FAJ introduces the Guest Editorial column, which will appear occasionally.
Journal: Financial Analysts Journal
Pages: 8-10
Issue: 2
Volume: 66
Year: 2010
Month: 3
X-DOI: 10.2469/faj.v66.n2.5
File-URL: http://hdl.handle.net/10.2469/faj.v66.n2.5
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Author-Name: Mark Kritzman
Author-X-Name-First: Mark
Author-X-Name-Last: Kritzman
Author-Name: Sébastien Page
Author-X-Name-First: Sébastien
Author-X-Name-Last: Page
Author-Name: David Turkington
Author-X-Name-First: David
Author-X-Name-Last: Turkington
Title: In Defense of Optimization: The Fallacy of 1/N
Abstract: 
 Previous research has shown that equally weighted portfolios outperform optimized
                    portfolios, which suggests that optimization adds no value in the absence of
                    informed inputs. This article argues the opposite. With naive inputs, optimized
                    portfolios usually outperform equally weighted portfolios. The ostensible
                    superiority of the 1/N approach arises not from limitations in optimization but,
                    rather, from reliance on rolling short-term samples for estimating expected
                    returns. This approach often yields implausible expectations. By relying on
                    longer-term samples for estimating expected returns or even naively contrived
                    yet plausible assumptions, optimized portfolios outperform equally weighted
                    portfolios out of sample.Previous research has shown that equally weighted portfolios outperform optimized
                    portfolios, which suggests that in the absence of informed inputs, optimization
                    adds no value. We argued the opposite. Using naive inputs, we demonstrated that
                    optimized portfolios usually outperform equally weighted portfolios. The
                    ostensible superiority of the 1/N approach arises not from
                    limitations in optimization but, rather, from reliance on rolling short-term
                    samples for estimating expected returns. By relying on longer-term samples for
                    estimating expected returns or even naively contrived yet plausible assumptions,
                    optimized portfolios outperform equally weighted portfolios out of sample.Our study covered 13 datasets comprising 1,028 data series. We constructed more
                    than 50,000 optimized portfolios and evaluated their out-of-sample performance
                    as compared with the market portfolio and the 1/N portfolio. We
                    grouped portfolios into three categories: asset class, beta, and alpha.We used three approaches to estimate expected returns for optimized portfolios:
                    (1) We generated the minimum-variance portfolio; (2) for each asset, we
                    estimated a risk premium over a long data sample before the backtest start date
                    and assumed that it remained constant throughout the backtest; and (3) in the
                    spirit of classical statistics, we used a growing sample that included all
                    available out-of-sample data.Although extremely simple, these expected returns have an important difference
                    from most of the expected returns used in previous studies: They do not rely on
                    rolling samples of realized returns, which often imply implausible expectations.
                    For example, we might forecast that cash will outperform stocks because it did
                    so in the past five years. Why would this particular realization be a good
                    forecast of the next one? We should not use these past data; all we need is a
                    reasonable forecast tied to economic intuition.Our results show that optimized portfolios significantly outperform the
                        1/N portfolio, even across beta universes, which are
                    notorious for the exceptional performance of the 1/N portfolio
                    as compared with the market portfolio. We showed that even without any ability
                    to forecast returns, optimization of the covariance matrix by itself adds value.
                    In our view, 1/N is not a viable alternative to thoughtful
                    optimization but is, rather, a capitulation to cynicism.
Journal: Financial Analysts Journal
Pages: 31-39
Issue: 2
Volume: 66
Year: 2010
Month: 3
X-DOI: 10.2469/faj.v66.n2.6
File-URL: http://hdl.handle.net/10.2469/faj.v66.n2.6
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Author-Name: James X. Xiong
Author-X-Name-First: James X.
Author-X-Name-Last: Xiong
Author-Name: Roger G. Ibbotson
Author-X-Name-First: Roger G.
Author-X-Name-Last: Ibbotson
Author-Name: Thomas M. Idzorek
Author-X-Name-First: Thomas M.
Author-X-Name-Last: Idzorek
Author-Name: Peng Chen
Author-X-Name-First: Peng
Author-X-Name-Last: Chen
Title: The Equal Importance of Asset Allocation and Active Management
Abstract: 
 What is the relative importance of asset allocation policy versus active
                    portfolio management in explaining variability in performance? Considerable
                    confusion surrounds both time-series and cross-sectional regressions and the
                    importance of asset allocation. Cross-sectional regressions naturally remove
                    market movements; therefore, the cross-sectional results in the literature are
                    equivalent to analyses of excess market returns even though the regressions were
                    performed on total returns. In contrast, time-series analyses of total returns
                    do not naturally remove market movements. Time-series analyses of excess market
                    returns and cross-sectional analyses of either total or excess market returns,
                    however, are consistent with each other. With market movements removed, asset
                    allocation and active management are equally important in determining portfolio
                    return differences within a peer group. Finally, an examination of
                    period-by-period cross-sectional results reveals why researchers using the same
                    regression technique can get widely different results.Our study helped identify and alleviate a significant amount of the long-running
                    confusion surrounding the importance of asset allocation. First, by decomposing
                    a portfolio’s total return into its three components—(1) the market
                    return, (2) the asset allocation policy return in excess of the market return,
                    and (3) the return from active portfolio management—we found that market
                    return dominates the other two return components. Taken together, market return
                    and asset allocation policy return in excess of market return dominate active
                    portfolio management. This finding confirms the widely held belief that market
                    return and asset allocation policy return in excess of market return are
                    collectively the dominant determinant of total return variations, but it
                    clarifies the contribution of each.More importantly, after removing the dominant market return component of total
                    return, we answered the question, Why do portfolio returns differ from one
                    another within a peer group? Our results show that within a peer group, asset
                    allocation policy return in excess of market return and active portfolio
                    management are equally important. Critically, this finding is not the result of
                    a mathematical truth. In contrast to the mathematical identity that in
                    aggregate, active management is a zero-sum game (and thus, asset allocation
                    policy explains 100 percent of aggregate pre-fee returns), the relative
                    importance of both asset allocation policy return in excess of market return and
                    active portfolio management is an empirical result that is highly dependent on
                    the fund, the peer group, and the period being analyzed.The key insight that ultimately enabled us to conclude that asset allocation
                    policy return in excess of market return and active portfolio management are
                    equally important is the realization that cross-sectional regression on
                        total returns is equivalent to cross-sectional regression
                    on excess market returns because cross-sectional regression
                    naturally removes market movement from each portfolio. We believe that this
                    critical and subtle fact has not been clearly articulated in the past and has
                    been overlooked by many researchers, especially when interpreting
                    cross-sectional results vis-à-vis the overall importance of asset
                    allocation.The insight that cross-sectional regression naturally removes market movement
                    leads to the notion that removing market movement from traditional total return
                    time-series regression is necessary should one want to put the time-series and
                    cross-sectional approaches on an equal footing. After putting the two approaches
                    on an equal footing, we found that the values of R2
                    for the excess market time-series regressions and the cross-sectional
                    regressions (on either type of return) are consistent.Finally, by examining period-by-period cross-sectional results and highlighting
                    the sample period sensitivity of cross-sectional results, we explained why
                    different researchers using the same regression technique can get widely
                    different results. More specifically, cross-sectional fund dispersion
                    variability is the primary cause of the period-by-period cross-sectional
                        R2 variability.
Journal: Financial Analysts Journal
Pages: 22-30
Issue: 2
Volume: 66
Year: 2010
Month: 3
X-DOI: 10.2469/faj.v66.n2.7
File-URL: http://hdl.handle.net/10.2469/faj.v66.n2.7
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Author-Name: James C. Allen
Author-X-Name-First: James C.
Author-X-Name-Last: Allen
Title: “Moral Hazard: The Long-Lasting Legacy of Bailouts”: A Comment
Abstract: 
 This material comments on “Moral Hazard: The Long-Lasting Legacy of Bailouts”.
Journal: Financial Analysts Journal
Pages: 11-11
Issue: 2
Volume: 66
Year: 2010
Month: 3
X-DOI: 10.2469/faj.v66.n2.8
File-URL: http://hdl.handle.net/10.2469/faj.v66.n2.8
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Author-Name: Eric Boughton
Author-X-Name-First: Eric
Author-X-Name-Last: Boughton
Title: “Moral Hazard: The Long-Lasting Legacy of Bailouts”: A Comment
Abstract: 
 This material comments on “Moral Hazard: The Long-Lasting Legacy of Bailouts”.
Journal: Financial Analysts Journal
Pages: 14-15
Issue: 2
Volume: 66
Year: 2010
Month: 3
X-DOI: 10.2469/faj.v66.n2.9
File-URL: http://hdl.handle.net/10.2469/faj.v66.n2.9
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Author-Name: Vincent Gasparro
Author-X-Name-First: Vincent
Author-X-Name-Last: Gasparro
Author-Name: Michael S. Pagano
Author-X-Name-First: Michael S.
Author-X-Name-Last: Pagano
Title: Sovereign Wealth Funds’ Impact on Debt and Equity Markets during the 2007–09 Financial Crisis
Abstract: 
 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.We examined the largely unexplored effect of sovereign wealth fund (SWF) investments in
          two major developed markets that have strong economic linkages: the United States and
          Canada. The economic relationship between the United States and Canada is one of the most
          successful relationships in global economic history. Between the Automotive Products Trade
          Agreement (also known as the Auto Pact), the United States–Canada Free Trade
          Agreement, the North American Free Trade Agreement, and scores of other bilateral and
          multilateral agreements, the United States and Canada have embraced a fully interconnected
          and market-based economy. Although both countries encourage a free market approach, the
          Canadian financial system has a different organizational structure (five large commercial
          banks are dominant), tighter regulation (including lower leverage ratios than their U.S.
          counterparts), and a generally lower risk appetite. Thus, despite their strong economic
          linkages, the two countries might not have the same reaction to the recent financial
          crisis and the devastating effects that the crisis has had on the global economy.By engaging in this analysis, we can identify how news related to the financial crisis
          and SWFs’ capital injections into large U.S. and European financial institutions has
          not only affected returns on U.S. money market instruments and the common stock of U.S.
          financial institutions but also created negative “spillover” effects on
          Canadian money markets and the equity returns of Canadian financial institutions. These
          spillover effects may be the result of the aforementioned economic linkages between these
          two countries. Therefore, investors might fear the threat of large institutional failures
          in Canada when U.S. and European financial institutions require capital infusions from
          sovereign wealth funds or other large investors. Overall, we found that news of an SWF
          capital injection into a large U.S. or European financial institution caused
          across-the-board declines of 13–61 bps in U.S. short-term rates, such as one- and
          three-month commercial paper rates (a “stabilizing” effect of SWF
          investments). These news announcements also created a negative spillover, or
          “destabilizing,” effect for short-term Canadian corporate rates, such as the
          overnight money market rate and the Canadian Deposit Offered Rate (Canada’s
          equivalent to LIBOR), with heightened global systemic risk causing rates to increase
          15–29 bps.This increase in Canadian rates suggests that SWF investments in the United States can
          have unintended “crowding-out” effects on the demand for capital in other
          parts of the world because other countries might feel the need to increase rates in order
          to attract capital and remain competitive in the global capital markets. In contrast to
          Canadian debt market rates, U.S. money market rates reacted more consistently and
          significantly to news specifically related to the financial crisis (with declines of
          24–72 bps). A “flight-to-quality” effect is also clearly evident for
          both U.S. and Canadian short-term treasury rates (with rate declines of 43–97 bps
          when major news related to the crisis was publicly released). These debt-specific
          reactions to news related to SWF investments and the financial crisis highlight how the
          credit crunch, initiated by problems in the subprime credit sector, quickly rippled
          through both the U.S. and Canadian markets.
Journal: Financial Analysts Journal
Pages: 92-103
Issue: 3
Volume: 66
Year: 2010
Month: 5
X-DOI: 10.2469/faj.v66.n3.1
File-URL: http://hdl.handle.net/10.2469/faj.v66.n3.1
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Author-Name: Raymond Kan
Author-X-Name-First: Raymond
Author-X-Name-Last: Kan
Author-Name: Guofu Zhou
Author-X-Name-First: Guofu
Author-X-Name-Last: Zhou
Title: “What Will the Likely Range of My Wealth Be?”: Author Response
Abstract: 
 This material comments on “‘What Will the Likely Range of My Wealth Be?’: A Comment” (May/June 2010).
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 3
Volume: 66
Year: 2010
Month: 5
X-DOI: 10.2469/faj.v66.n3.10
File-URL: http://hdl.handle.net/10.2469/faj.v66.n3.10
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 3
Volume: 66
Year: 2010
Month: 5
X-DOI: 10.2469/faj.v66.n3.11
File-URL: http://hdl.handle.net/10.2469/faj.v66.n3.11
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Author-Name: Philippe Bertrand
Author-X-Name-First: Philippe
Author-X-Name-Last: Bertrand
Title: Another Look at Portfolio Optimization under Tracking-Error Constraints
Abstract: 
 Research has shown that adding constraints to total portfolio volatility can
          substantially improve the performance of managed portfolios. Although other work has
          considered constant tracking-error volatility frontiers, in this study tracking error was
          allowed to vary but the risk aversion was fixed. The resulting optimal portfolios have
          several desirable properties.Today, the use of benchmark portfolios to evaluate the relative performance of portfolio
          managers is common practice in the financial management industry. This setup allows the
          investor to evaluate the added value in line with the risks taken. The relevant concept of
          risk is the relative risk as defined by the tracking-error volatility (TEV).The problem of minimizing the volatility of tracking error was originally solved in 1992.
          The optimal portfolios obtained had several undesirable properties, however, and
          introducing an additional constraint on the beta of the portfolio was suggested.In 2003, the problem was again tackled, this time in a study that pointed out that
          constant-TEV portfolios are described by an ellipse. Because of the flat shape of this
          ellipse, adding a constraint on total portfolio volatility can substantially improve the
          performance of the managed portfolio.This article looks at the problem from another angle. Instead of considering constant-TEV
          frontiers, the author allowed tracking error to vary but fixed the risk aversion. He found
          that the resulting optimal portfolios have several desirable properties.
Journal: Financial Analysts Journal
Pages: 78-90
Issue: 3
Volume: 66
Year: 2010
Month: 5
X-DOI: 10.2469/faj.v66.n3.2
File-URL: http://hdl.handle.net/10.2469/faj.v66.n3.2
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Author-Name: William F. Sharpe
Author-X-Name-First: William F.
Author-X-Name-Last: Sharpe
Title: Adaptive Asset Allocation Policies
Abstract: 
 This article proposes an asset allocation policy that adapts to market movements
                    by taking into account changes in the outstanding market values of major asset
                    classes. Such a policy considers important information, reduces or avoids
                    contrarian behavior, and can be followed by a majority of investors.Many institutional and individual investors adopt asset allocation policies that
                    call for investing a specified percentage of the total value of a portfolio in
                    each of several asset classes. To conform with such a policy as market values
                    change requires selling assets that performed relatively well and buying those
                    that performed relatively poorly. Such a strategy is clearly contrarian and can
                    be followed by only a minority of investors. In practice, many investors seldom
                    rebalance completely to conform with such a policy. But many multi-asset mutual
                    funds, increasingly used in defined-contribution plans, do so frequently, which
                    results in contrarian behavior.From January 1976 through June 2009, the ratio of the market value of U.S. stocks
                    to the sum of the market values of U.S. stocks and bonds averaged 60.7 percent,
                    close to the traditional 60/40 stock/bond mix. But during this period, the
                    proportion in stocks ranged from slightly more than 43 percent to more than 75
                    percent. A fund that rebalanced its holdings frequently to a 60/40 mix would
                    thus range from being considerably more risky than the U.S. bond and stock
                    markets to being considerably less risky. If its goal was to represent the U.S.
                    market of such instruments, it should instead have adjusted its asset allocation
                    policy to reflect the relative values of the two asset classes.More generally, it seems appropriate for any fund to adapt its asset allocation
                    policy from time to time in light of current relative market values of asset
                    classes. This adaptation can be done by periodically conducting a reverse
                    optimization analysis, in which current asset values are used to adjust asset
                    risk and return forecasts, and then computing a new asset allocation by using
                    these forecasts in an optimization analysis. This article proposes a much
                    simpler approach in which an asset allocation policy adapts to market movements
                    by taking into account changes in the outstanding market values of major asset
                    classes. Such adaptive asset allocation policies consider important information,
                    reduce or avoid contrarian behavior, and can be followed by a majority of
                    investors.
Journal: Financial Analysts Journal
Pages: 45-59
Issue: 3
Volume: 66
Year: 2010
Month: 5
X-DOI: 10.2469/faj.v66.n3.3
File-URL: http://hdl.handle.net/10.2469/faj.v66.n3.3
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: Speculative Leverage: A False Cure for Pension Woes
Abstract: 
 The Editor’s Corner is a regular feature of the Financial Analysts Journal. This piece reflects the views of the author and does not represent the official views of the FAJ or CFA Institute.
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 3
Volume: 66
Year: 2010
Month: 5
X-DOI: 10.2469/faj.v66.n3.4
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Author-Name: James W. Deitrick
Author-X-Name-First: James W.
Author-X-Name-Last: Deitrick
Title: What Analysts Should Know about FAS No. 141R and FAS No. 160
Abstract: 
 FAS No. 141R, “Business Combinations,” and FAS No. 160, “Noncontrolling
          Interests in Consolidated Financial Statements,” became effective for fiscal years
          beginning after 31 December 2008. Many quarterly and annual reports for 2009 incorporated
          the requirements of these standards. In this article, the author discusses changes
          resulting from the standards’ implementation. The dramatic events of the past two years have brought unprecedented levels of
          uncertainty and controversy to the challenging world of financial analysts. They include a
          global financial meltdown, collapsing real estate markets, record unemployment, a
          recession, depressed equity values, and struggling businesses in all industries. Cruising
          under the radar of many analysts, however, are a few new accounting standards that could
          yield even more confusion and chaos. Among them are Statement of Financial Accounting
          Standards (FAS) No. 141R, “Business Combinations,” and FAS No. 160,
          “Noncontrolling Interests in Consolidated Financial Statements.” Both
          standards are effective for fiscal years beginning after 15 December 2008.As a result of these standards, the financial statements of many corporations have been
          modified, especially if they include less than wholly owned subsidiaries. For example, FAS
          No. 160 requires the term “noncontrolling interests” to replace
          “minority interests.” This change is consistent with recent efforts to base
          the consolidation decision on the merits of managerial control rather than majority stock
          ownership. Moreover, the positioning of noncontrolling interests on consolidated balance
          sheets is now standardized, and their position on consolidated income statements has been
          significantly altered to accommodate a new measure of consolidated net income (CNI).
          According to FAS No. 160, the interests of noncontrolling shareholders in the net assets
          of a consolidated subsidiary are now reported as a component of shareholders’
          equity. The option no longer exists to report this amount among the liabilities or in the
          “mezzanine” area between liabilities and shareholders’ equity. This
          requirement will certainly lead to higher levels of reported shareholders’ equity
          for many companies, thereby lowering debt-to-equity and return-on-equity ratios.Just as significant is the fact that the interests of noncontrolling shareholders in
          subsidiary earnings are no longer a component in the calculation of CNI. Thus, CNI is
          higher for parent companies with profitable subsidiaries because the noncontrolling
          interests in subsidiaries’ earnings are no longer deducted when CNI is computed. The
          primary thrust of this change is to provide decision makers with a profit measure for the
          entire consolidated entity. To supplement this change and provide a measure of consistency
          with the past, consolidated income statements must allocate CNI between the amount
          associated with the noncontrolling interests and the amount associated with the parent
          company. This latter amount is similar to CNI of previous periods.FAS No. 141R, which is not applied retroactively, introduces the “acquisition
          method” as a replacement for the “purchase method” for new business
          combinations (i.e., those taking place in fiscal years beginning after 15 December 2008).
          Two major features of the acquisition method are that direct costs associated with a
          business combination are now expensed as incurred (previously, they were capitalized as
          part of a combination’s price) and purchased in-process R&D is now capitalized
          until projects become reclassified operating assets or are abandoned (previously,
          in-process R&D was expensed in the period of the purchase). For an acquisition of a
          less than wholly owned subsidiary, the related goodwill calculation has been changed.
          Rather than basing goodwill on the amount associated with the parent company’s less
          than 100 percent investment, the acquisition method determines goodwill for the entire
          subsidiary. Consequently, goodwill is now measured as the excess of the fair value of the
          consideration issued by the acquirer plus the fair value of the noncontrolling interests
          minus the fair values of the subsidiary’s individual net assets. This change is
          likely to yield higher reported amounts of goodwill from new acquisitions. Similarly, with
          emphasis on the whole consolidated entity, the individual assets and liabilities of an
          acquired subsidiary are first consolidated at their full fair values instead of their
          proportionate values, as in the past. To accommodate this increase in reported values, the
          noncontrolling interests in the subsidiary’s net assets become correspondingly
          higher. With higher consolidated assets, there will likely be higher related expenses in
          future periods, thereby producing lower CNI.Should a new business combination involve a bargain purchase, the resulting negative
          goodwill is immediately reported in CNI (previously, it was allocated as a reduction among
          the acquired company’s long-term assets).As a result of changes brought about by FAS No. 141R and FAS No. 160, analysts need to be
          cautious when analyzing consolidated financial information influenced by these new
          standards, when performing time-series analyses of reported variables and their related
          ratios, and when forecasting future amounts of important variables.
Journal: Financial Analysts Journal
Pages: 38-44
Issue: 3
Volume: 66
Year: 2010
Month: 5
X-DOI: 10.2469/faj.v66.n3.5
File-URL: http://hdl.handle.net/10.2469/faj.v66.n3.5
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Author-Name: Laurie S. Goodman
Author-X-Name-First: Laurie S.
Author-X-Name-Last: Goodman
Title: Dimensioning the Housing Crisis
Abstract: 
 The author argues that more than one borrower in every five could face foreclosure absent
          stronger policy measures. The solution is to (1) reduce the housing supply through a
          modification program that explicitly addresses negative equity and (2) increase housing
          demand by expanding the availability of credit to investors.With the apparent stabilization of home prices and the increase in existing-home sales,
          many investors believe that the housing market has bottomed and is beginning to recover. I
          believe that such optimism is premature. To be sure, there are many positives in the
          housing market: Prices have fallen significantly, housing is more affordable now than at
          any time in the past two decades, and the tax credit for first-time homebuyers has helped
          spur purchasing. Investors, however, are overlooking two critical factors: (1) the size of
          the “housing overhang” (i.e., the number of loans in delinquency or
          foreclosure) and (2) the borrowers with negative equity who are likely to default.I argue that the solution to the current housing crisis is to (1) reduce the housing
          supply through a modification program that explicitly addresses negative equity and (2)
          increase housing demand by expanding the availability of credit to investors.
Journal: Financial Analysts Journal
Pages: 26-37
Issue: 3
Volume: 66
Year: 2010
Month: 5
X-DOI: 10.2469/faj.v66.n3.6
File-URL: http://hdl.handle.net/10.2469/faj.v66.n3.6
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Author-Name: William Poole
Author-X-Name-First: William
Author-X-Name-Last: Poole
Title: Ending Moral Hazard
Abstract: 
 FAJ editor Rodney Sullivan, CFA, recently sat down with former Federal
          Reserve Bank president William Poole for an interview about the fallout from the global
          market crisis and how to end the moral hazard arising from government bailouts. In William Poole’s recent Financial Analysts Journal article
          “Moral Hazard: The Long-Lasting Legacy of Bailouts” (November/December 2009),
          the former Federal Reserve Bank president discussed the critical need to end government
          bailouts. With that context in mind, FAJ editor Rodney Sullivan
          interviewed Poole in January 2010 about the fallout from the current global market crisis
          and what to do about the moral hazard arising from government bailouts.Editor’s Note: For a podcast of this interview, go to http://www.cfainstitute.org/learning/products/multimedia/Pages/25609.aspx.
Journal: Financial Analysts Journal
Pages: 17-24
Issue: 3
Volume: 66
Year: 2010
Month: 5
X-DOI: 10.2469/faj.v66.n3.7
File-URL: http://hdl.handle.net/10.2469/faj.v66.n3.7
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Handle: RePEc:taf:ufajxx:v:66:y:2010:i:3:p:17-24




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Author-Name: Husayn Shahrur
Author-X-Name-First: Husayn
Author-X-Name-Last: Shahrur
Author-Name: Ying L. Becker
Author-X-Name-First: Ying L.
Author-X-Name-Last: Becker
Author-Name: Didier Rosenfeld
Author-X-Name-First: Didier
Author-X-Name-Last: Rosenfeld
Title: Return Predictability along the Supply Chain: The International Evidence
Abstract: 
 In this study of a sample of equities listed on the exchanges of 22 developed countries,
          equity returns of customer industries led the returns of supplier industries. This
          customer–supplier/lead–lag effect exhibits characteristics consistent with the
          view that the effect results from a slow diffusion of value-relevant information.Recent research in finance has suggested that investors’ inattention to information
          can result in the predictability of security returns. Previous researchers have argued
          that if investors have limited ability to gather and process all publicly available
          information, value-relevant information that is incorporated in the stock prices of
          customer companies may not be fully reflected in the stock prices of their suppliers.
          Using company-level data on U.S. customer–supplier relationships, they found support
          for this proposition: Lagged equity returns of customer companies are positively
          correlated with suppliers’ contemporaneous equity returns.This article contributes to this strand of literature by examining whether a
          customer–supplier/lead–lag effect exists in international equity markets. We
          used the U.S. IO accounts to identify customer industries for each supplier industry in a
          sample of companies from 22 developed markets for January 1995–July 2007. Using a
          four-factor model to estimate abnormal returns, we found that the stock returns of
          customer industries lead the returns of supplier industries. Ranking supplier industries
          in ascending order on the basis of the one-month lagged returns of customer industries, we
          found that an equally weighted portfolio that buys supplier industries with the highest
          lagged customer returns (top quintile) and sells short industries with the lowest customer
          returns (bottom quintile) yields an annual abnormal return of up to 15 percent.Next, we examined whether the lead–lag effect depends on the characteristics of
          supplier companies. First, we found that our results are not driven by very small and
          highly illiquid supplier companies. Second, we documented that the customer–supplier
          cross-predictability is stronger for smaller suppliers and is statistically insignificant
          for the largest suppliers. We also conducted cross-sectional analyses to examine whether
          the lead–lag effect is subsumed by other factors known to be correlated with
          contemporaneous returns. We found that lagged customer returns predict supplier returns
          after controlling for other known factors, such as the company’s and the
          industry’s lagged short- and long-term returns and size effect.We conducted additional tests to examine whether the lead–lag effect is
          attributable to the slow diffusion of information among economically linked companies. We
          found that the cross-predictability of equity returns is stronger when security analysts
          have more difficulty in assessing how suppliers will be affected by news about their
          customers. We also found that the customer–supplier/lead–lag effect is more
          pronounced for suppliers with stronger economic links with their customers.Overall, this study contributes to the literature by documenting customer–supplier
          return cross-predictability in international markets. By examining the cross-sectional
          variation in the customer–supplier/lead–lag effect, we found results
          consistent with the view that this effect is attributable to the slow diffusion of
          value-relevant information. On the methodological front, we showed that the U.S.
          input-output accounts can be used to capture industry-level customer–supplier
          relationships in other markets, which should be of particular interest to investment
          practitioners in global equity markets.
Journal: Financial Analysts Journal
Pages: 60-77
Issue: 3
Volume: 66
Year: 2010
Month: 5
X-DOI: 10.2469/faj.v66.n3.8
File-URL: http://hdl.handle.net/10.2469/faj.v66.n3.8
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Handle: RePEc:taf:ufajxx:v:66:y:2010:i:3:p:60-77




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Author-Name: Wade D. Pfau
Author-X-Name-First: Wade D.
Author-X-Name-Last: Pfau
Title: “What Will the Likely Range of My Wealth Be?”: A Comment
Abstract: 
 This material comments on “What Will the Likely Range of My Wealth Be?” (July/August 2009).
Journal: Financial Analysts Journal
Pages: 10-12
Issue: 3
Volume: 66
Year: 2010
Month: 5
X-DOI: 10.2469/faj.v66.n3.9
File-URL: http://hdl.handle.net/10.2469/faj.v66.n3.9
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Handle: RePEc:taf:ufajxx:v:66:y:2010:i:3:p:10-12




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Author-Name: Binh Do
Author-X-Name-First: Binh
Author-X-Name-Last: Do
Author-Name: Robert Faff
Author-X-Name-First: Robert
Author-X-Name-Last: Faff
Title: Does Simple Pairs Trading Still Work?
Abstract: 
 Despite confirming the continuing downward trend in profitability of pairs trading, this
          study found that the strategy performs strongly during periods of prolonged turbulence,
          including the recent global financial crisis. Moreover, alternative algorithms combined
          with other measures enhance trading profits considerably, by 22 bps a month for bank
          stocks. Pairs trading is a relative value arbitrage in equity markets and is particularly
          attractive to hedge funds that seek to profit from temporary price deviations between
          stocks of close economic substitution. The scant research on this topic is mostly confined
          to seminal works that have documented economically and statistically significant, albeit
          declining, profits (on the order of 1 percent a month) from the use of a very simple pairs
          trading rule. This remarkable success has not been subjected to independent scrutiny,
          unlike other well-documented anomalies, such as momentum trading.We re-examined and expanded evidence on pairs trading in the U.S. market by using an
          extended dataset covering July 1962–June 2009. We confirmed a continuation of the
          declining trend in profitability over time, with the mean excess return for the portfolio
          of the top 20 pairs dropping precipitously, from 0.86 percent a month for 1962–1988
          to 0.37 percent for 1989–2002 and to just 0.24 percent for 2003–2009. Although
          the literature suggests that this decline is the consequence of increased competition
          within the growing hedge fund industry, which competes away the same opportunities,
          careful analysis shows that not to be the case in pairs trading. We argued that pairs
          trading is essentially a risky arbitrage; thus, its performance depends on not only the
          state of market efficiency but also the degree of arbitrage risks facing arbitrageurs.
          These risks encompass fundamental risk, noise-trader risk, and synchronization risk, all
          of which work to prevent or delay arbitrage or to inflict losses on arbitrageurs. Using a
          simple attribution analysis, we were able to show that the “market efficiency”
          story, in which the hedge fund factor is just one component, is only partly to blame for
          the decline. Instead, we found that the worsening arbitrage risks facing pairs traders
          contribute up to 70 percent of the drop in profits.We also found that pairs trading performed particularly strongly during recent periods of
          prolonged turbulence, namely, the 2000–02 bear market and the 2007–09 global
          financial crisis. Although this finding seems counterintuitive, the increase in arbitrage
          risks during these periods of panic was outweighed by a corresponding decrease in market
          efficiency. Thus, some arbitrageurs have overcome worsening arbitrage risks to
          successfully exploit mispricings that appear to be abundant in such turbulent periods.We further proposed alternative algorithms that incorporate two additional pair-matching
          criteria: industry homogeneity and historical frequency of reversal in the price spread
          (in addition to the conventional price spread metric). Homogeneity involves matching
          securities within the same and narrowly defined industry groups to ensure close
          substitution by classification and lower divergence risk. To some extent, this metric can
          be viewed as a first step toward incorporating a fundamental aspect in pairs trading,
          which is traditionally a technical concept. Reversal frequency, computed as the number of
          zero crossings by the normalized price spread, measures how frequently two securities
          crossed each other in the past. A high number of zero crossings signifies a “track
          record” of frequent mispricings within a pair that were successfully corrected by
          market participants. When combined with the SSD and homogeneity metrics, this track record
          measure has been found to enhance trading profits considerably, by 22 bps a month for bank
          stocks.
Journal: Financial Analysts Journal
Pages: 83-95
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.1
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.1
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Author-Name: Ralph Goldsticker
Author-X-Name-First: Ralph
Author-X-Name-Last: Goldsticker
Title: “Speculative Leverage: A False Cure for Pension Woes”: A Comment
Abstract: 
 This material comments on “Speculative Leverage: A False Cure for Pension Woes”.
Journal: Financial Analysts Journal
Pages: 12-14
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.10
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.10
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: “Speculative Leverage: A False Cure for Pension Woes”: Author Response
Abstract: 
 This material comments on “‘Speculative Leverage: A False Cure for Pension Woes’: A Comment”.
Journal: Financial Analysts Journal
Pages: 14-16
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.11
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.11
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Author-Name: Edouard Sénéchal
Author-X-Name-First: Edouard
Author-X-Name-Last: Sénéchal
Author-Name: Brian Singer
Author-X-Name-First: Brian
Author-X-Name-Last: Singer
Title: “The Equal Importance of Asset Allocation and Active Management”: A Comment
Abstract: 
 This material comments on “The Equal Importance of Asset Allocation and Active Management ”.
Journal: Financial Analysts Journal
Pages: 16-17
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.12
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.12
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Author-Name: James X. Xiong
Author-X-Name-First: James X.
Author-X-Name-Last: Xiong
Author-Name: Roger G. Ibbotson
Author-X-Name-First: Roger G.
Author-X-Name-Last: Ibbotson
Author-Name: Thomas M. Idzorek
Author-X-Name-First: Thomas M.
Author-X-Name-Last: Idzorek
Author-Name: Peng Chen
Author-X-Name-First: Peng
Author-X-Name-Last: Chen
Title: “The Equal Importance of Asset Allocation and Active Management”: Author Response
Abstract: 
 This material comments on “‘The Equal Importance of Asset Allocation and Active Management’: A Comment”.
Journal: Financial Analysts Journal
Pages: 17-18
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.13
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.13
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Author-Name: Joel Tillinghast
Author-X-Name-First: Joel
Author-X-Name-Last: Tillinghast
Title: “The Shrinking Merger Arbitrage Spread: Reasons and Implications”: A Comment
Abstract: 
 This material comments on “The Shrinking Merger Arbitrage Spread: Reasons and Implications”.
Journal: Financial Analysts Journal
Pages: 18-18
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.14
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.14
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Author-Name: Gaurav Jetley
Author-X-Name-First: Gaurav
Author-X-Name-Last: Jetley
Author-Name: Xinyu Ji
Author-X-Name-First: Xinyu
Author-X-Name-Last: Ji
Title: “The Shrinking Merger Arbitrage Spread: Reasons and Implications”: Author Response
Abstract: 
 This material comments on “‘The Shrinking Merger Arbitrage Spread: Reasons and Implications’: A Comment”.
Journal: Financial Analysts Journal
Pages: 19-19
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.15
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.15
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 112-112
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.16
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.16
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Handle: RePEc:taf:ufajxx:v:66:y:2010:i:4:p:112-112




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Author-Name: Roger M. Edelen
Author-X-Name-First: Roger M.
Author-X-Name-Last: Edelen
Author-Name: Alan J. Marcus
Author-X-Name-First: Alan J.
Author-X-Name-Last: Marcus
Author-Name: Hassan Tehranian
Author-X-Name-First: Hassan
Author-X-Name-Last: Tehranian
Title: Relative Sentiment and Stock Returns
Abstract: 
 The sentiment of retail investors relative to that of institutional investors was
          measured by comparing their respective portfolio allocations to equity versus cash and
          fixed-income securities. The results suggest that fluctuations in retail sentiment are a
          primary driver of equity valuations for reasons unrelated to fundamentals.In the study reported, we measured the sentiment of retail investors versus the sentiment
          of institutional investors by comparing their respective portfolio allocations to equity
          versus cash and fixed-income securities. And we considered whether fluctuation in relative
          sentiment is associated with variation in expected stock market returns. Whereas several other studies used indirect proxies for aggregate investor sentiment, we
          used actual asset allocation decisions of investors as direct evidence of their sentiment.
          We could thus focus on the essential meaning of sentiment: a time-varying propensity to
          invest in risky assets that is unrelated to fundamentals. The cost of our approach,
          however, is that asset allocations can reveal only the sentiment of one group of investors
          relative to the sentiment of another group.We found that relative sentiment is uncorrelated with indicators of absolute investor
          sentiment and appears to have considerable value as a (contrarian) market-timing tool at a
          quarterly frequency. High levels of relative retail sentiment are associated with
          significantly lower future excess equity returns, and the change in relative sentiment is
          strongly positively related to concurrent market returns. This pattern is consistent with
          the hypothesis that retail sentiment is more variable than institutional sentiment and
          retail investors move prices as they update their asset allocations to reflect their
          shifting sentiment rather than for reasons related to fundamentals.The relationships between relative sentiment and stock returns that we documented are
          economically as well as statistically significant. For example, sorting on values of our
          index of relative sentiment yielded an annualized average market return in the following
          quarter equal to 25.6 percent when relative sentiment was low (in the lower quartile of
          the distribution) and only 4.5 percent when relative sentiment was high (in the upper
          quartile). Although we follow convention in labeling shifts in retail demand for equities
          independent of fundamentals as “sentiment driven,” our results are
          fully consistent with a rational interpretation of retail-side behavior. Shifts in retail
          risk tolerance lead to precisely the same pattern as shifts in the optimism of cash flow
          forecasts (relative to fundamentals). Increases in risk tolerance will induce
          contemporaneous increases in both prices and retail equity allocations as the retail
          sector bids up shares from the institutional side and will be followed by lower future
          expected returns. Increases in risk aversion will work similarly. In our framework,
          sentiment should be interpreted broadly—and not necessarily
          pejoratively—as also encompassing variation in risk tolerance.Our results are consistent with a smart money/dumb money view of the world in which all
          investors use the same risk-adjusted discount rate but one group (institutions) is better
          at forecasting future prospects. The key distinction between this view and a rational
          interpretation (that the difference in behavior comes from time-varying risk tolerance)
          lies with investors’ expectations. In the smart money/dumb money interpretation,
          if retail investors knew the conditional expected returns that we have documented, they
          would alter their behavior. In the rational interpretation, they would not. Unfortunately,
          these two interpretations are not readily distinguished by empirical analysis.
Journal: Financial Analysts Journal
Pages: 20-32
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.2
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.2
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Author-Name: Andrew L. Berkin
Author-X-Name-First: Andrew L.
Author-X-Name-Last: Berkin
Author-Name: Christopher G. Luck
Author-X-Name-First: Christopher G.
Author-X-Name-Last: Luck
Title: Having Your Cake and Eating It Too: The Before- and After-Tax Efficiencies of an Extended Equity Mandate
Abstract: 
 This article shows that extended mandates are especially effective for investors subject
          to taxes. Not only is the portfolio more efficiently positioned from a before-tax
          perspective, but it also offers significant after-tax benefits from both increased loss
          harvesting and tax arbitrage between tax rates on long and short positions.Recent studies have shown that adding a short extension to a long-only tax-exempt equity
          portfolio leads to a more efficient portfolio. In this article, we show that these
          extended mandates are even more effective for taxable investors. Not only is the portfolio
          more efficiently positioned from a pretax perspective, but it also offers significant
          after-tax benefits from increased loss-harvesting opportunities and tax arbitrage between
          tax rates on long and short positions.Following a review of extended strategies, the principles of tax-efficient investing, and
          the relevant tax regulations for long and short holdings, we give a conceptual rationale
          of why this strategy works so well for taxable investors. One reason is that a portfolio
          with long and short positions offers loss-harvesting opportunities in both up and down
          markets, in contrast to a long-only portfolio, which suffers from a lock-in effect during
          bull markets. Extended mandates also offer an effective arbitrage on differential tax
          rates because both realized losses and the expensing of dividends on the short side are
          always at short-term rates. A short extension thus allows holdings to be repositioned in a
          more tax-efficient manner, which creates a more optimal portfolio from a pretax
          perspective and reduces taxes from both inside and outside the portfolio.To explore our conceptual expectations and provide empirical support, we ran a series of
          Monte Carlo simulations based on 25 years of actual S&P 500 Index returns. We
          constructed forecasts with a moderate amount of explanatory power by using realized
          returns mixed with a significant amount of noise; we also constructed monthly
          risk-controlled portfolios for both long-only and short-extension strategies that were
          managed in both a tax-exempt and a tax-efficient manner. We examined returns and their
          components on a before- and after-tax basis.Our simulation results confirm our expectations. If run in a tax-insensitive fashion, the
          tax-exempt long-only case has a positive added value that becomes negative after taxes,
          but it retains a significant amount of added value when run with proper tax management.
          The tax-exempt extended mandate improves upon the long-only case. These results confirm
          and enhance prior research. The after-tax results of extended mandates are particularly
          new and interesting. Even when run in a tax-insensitive fashion, the extended strategy
          retains positive after-tax performance because of realized losses from short positions
          sold in a generally rising market. The real power arises when short-extension portfolios
          are run in a tax-sensitive manner, with annualized after-tax alpha more than double that
          in the long-only case. To gain further insight into the dynamics of these strategies, we
          examined their performance and characteristics over time and analyzed the components of
          after-tax value performance. Both tax-advantaged strategies notably reduce gains
          realization, but extended mandates have a superior dividend advantage and dramatically
          increase the capture of short-term losses.We close with some practical considerations. We discuss the impact of different tax
          rates, both individual and corporate. We also discuss the impact of forecasting skill
          because we assumed a respectable amount thereof in our simulations. Although pretax added
          value is one aspect of added value, the after-tax aspect is far larger and far more
          certain. Finally, adding a short extension is particularly useful for legacy assets with a
          low cost basis because the extra extension can reposition the portfolio and the additional
          loss harvesting allows large positions to be reduced in a tax-efficient manner. For
          taxable investors, the case for extended mandates is quite compelling.
Journal: Financial Analysts Journal
Pages: 33-45
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.3
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.3
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Author-Name: Laurence B. Siegel
Author-X-Name-First: Laurence B.
Author-X-Name-Last: Siegel
Title: Black Swan or Black Turkey? The State of Economic Knowledge and the Crash of 2007–2009
Journal: Financial Analysts Journal
Pages: 6-10
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.4
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.4
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Author-Name: Gerardo Palazzo
Author-X-Name-First: Gerardo
Author-X-Name-Last: Palazzo
Author-Name: Stefano Nobili
Author-X-Name-First: Stefano
Author-X-Name-Last: Nobili
Title: Explaining and Forecasting Bond Risk Premiums
Abstract: 
 In examining the risk premiums for U.S. and German 10-year government bond yields, the
          authors found that the decline in bond risk premiums since the 1980s is associated with a
          decrease in global output variability and an increase in the power of 10-year government
          bonds to diversify portfolios. This article examines the dynamics of risk premiums for U.S. and German 10-year
          government bond yields and shows that the estimated patterns are associated with a
          decrease in the systematic component of risk.Using a no-arbitrage, essentially affine three-factor model and in line with the existing
          literature, we found that bond risk premiums have followed a downward trend since the
          1980s: from 4.9 percent in 1981 to 1.2 percent in mid-2009 for the U.S. bond and from 3.3
          percent to 1.1 percent for the German bond. We studied the relationship between the
          estimated government bond risk premiums and the risk associated with such securities in
          the context of fully integrated financial markets. Our basic conjecture is derived from
          modern portfolio theory (MPT): Holders of a financial asset can expect a premium over the
          risk-free asset only if they bear systematic risk, measured by the covariance between the
          asset returns and the returns of a global market portfolio. We estimated an error
          correction model (ECM) to analyze the co-movements between bond premiums (as implied by
          the affine model) and two variables: (1) the standard deviation of the world GDP growth
          rate and (2) the correlation between government bond returns and the returns of a
          portfolio diversified by asset class, geographic region, and currency. The use of
          variables that may be regarded as a single proxy for the MPT systematic risk allows us to
          interpret the ECM-fitted premiums as the fair values that investors require as
          remuneration for the risk of long-term government bonds.We show that the decrease in government bond premiums since the mid-1980s is mainly
          attributable to the reduction in the systematic component of risk and that the low
          premiums that prevailed until the third quarter of 2008 were broadly consistent with the
          perceived level of risk at the time.We also show that data from the most recent period—fourth quarter of 2008 to second
          quarter of 2009—reveal a dramatic gap between the level of premiums embedded in bond
          prices (those premiums remain extremely low) and the level of premiums that investors
          should require given their risk (such premiums have risen to historically high values).
          Although it is too early to say whether this fact constitutes evidence of a structural
          breakdown in the relationship we have estimated, our guess is that it is simply the result
          of investors shunning almost every asset class with an uncertain payoff in the aftermath
          of the Lehman Brothers bankruptcy. If so, as economic agents’ behavior returns to
          normal, most of the gap should narrow and disappear.We believe that these results are important for long-term investors. The lower the risk
          of government bonds, the lower the premium investors require (ex ante) to
          hold such securities, and the higher the price they are willing to pay. Over
          1980–2005, a period seemingly marked by declining required bond premiums,
            (ex post) excess returns on government bonds were highly significant,
          especially when compared with the average values recorded over the 20th century.Of course, in order to answer the question about future bond risk premiums, one must
          explicitly express a view about the most plausible evolution of the current macroeconomic
          environment. To the extent that the great moderation of economic systems and the
          well-anchored inflation expectations we have experienced in the last two decades may be
          traced to structural changes that will persist even after the current crisis, investors
          may be confident that long-run bond risk premiums will remain low. Conversely, if
          financial markets have entered a completely new (and riskier) era and the past reduction
          in macroeconomic uncertainty has been merely the lucky upshot of fewer and smaller shocks
          hitting the economy, the outlook for long-term government bonds is gloomy.The main conclusion of this article is that investors’ expectations about long-term
          excess returns for 10-year government bonds will have to be significantly lower than the
          average values over the last two decades. Taking the current macroeconomic uncertainty
          into account, strategic investors should allow for an increase in (ex
            ante) bond risk premiums that may even depress bond prices. Investors will have
          to reconsider excess returns more in line with the average over a very long-term horizon,
          such as the last century.Note: The views expressed in this article are the authors’ own and do not
              necessarily reflect the views of the Bank of Italy.
Journal: Financial Analysts Journal
Pages: 67-82
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.5
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.5
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Author-Name: Armen Hovakimian
Author-X-Name-First: Armen
Author-X-Name-Last: Hovakimian
Author-Name: Ekkachai Saenyasiri
Author-X-Name-First: Ekkachai
Author-X-Name-Last: Saenyasiri
Title: Conflicts of Interest and Analyst Behavior: Evidence from Recent Changes in Regulation
Abstract: 
 Regulation FD made analysts less dependent on insider information and diminished
          analysts’ motives to inflate their forecasts. The Global Research Analyst Settlement
          had an even bigger impact on analyst behavior: The mean forecast bias declined
          significantly, whereas the median forecast bias essentially disappeared. These results are
          similar for all analysts. In the early part of the first decade of this century, in an effort to restore public
          confidence in U.S. capital markets, U.S. regulators enacted several rules and regulations,
          prosecuted analysts whose research reports were tainted by conflicts of interest, and
          fined banks that failed to prevent research analysts’ conflicts of interest. Two of
          the main regulatory developments during this period were (1) Regulation Fair Disclosure
          (Reg FD), which became effective on 23 October 2000, and (2) the Global Research Analyst
          Settlement (Global Settlement), which was announced on 20 December 2002. We examined
          whether these two actions by U.S. regulators reduced the bias in analysts’ earnings
          forecasts documented in prior studies.We obtained sell-side analysts’ earnings forecasts for fiscal year-end dates
          between 1996 and 2006 from the I/B/E/S Detail file. We documented that analysts’
          conflicts of interest were evident prior to the Global Research Analyst Settlement and
          were not limited to the 12 banks covered by it. Analysts tended to make overoptimistic
          earnings forecasts prior to Reg FD and the Global Settlement.Reg FD made analysts less dependent on insider information and thus diminished
          analysts’ motives to favor company managers by inflating their earnings forecasts.
          The impact of Reg FD is more significant for companies with a less transparent information
          environment in which insider information has the most value.Introduced in 2002, the Global Settlement and related regulations had an even bigger
          impact than Reg FD on analyst behavior. After the Global Settlement, the mean forecast
          bias declined significantly, whereas the median forecast bias essentially disappeared.
          Although disentangling the impact of the Global Settlement from that of related rules and
          regulations aimed at mitigating analysts’ conflicts of interest is impossible,
          forecast bias clearly declined around the time the Global Settlement was announced. These
          results suggest that the recent efforts of regulators have helped neutralize
          analysts’ conflicts of interest.
Journal: Financial Analysts Journal
Pages: 96-107
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.6
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.6
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Author-Name: Heather S. Knewtson
Author-X-Name-First: Heather S.
Author-X-Name-Last: Knewtson
Author-Name: Richard W. Sias
Author-X-Name-First: Richard W.
Author-X-Name-Last: Sias
Author-Name: David A. Whidbee
Author-X-Name-First: David A.
Author-X-Name-Last: Whidbee
Title: Style Timing with Insiders
Abstract: 
 Aggregate demand by insiders predicts time-series variation in the value premium. Insider
          trading forecasts the value premium because insiders sell (buy) when
          markets—especially growth stocks—are overvalued (undervalued). This
          article suggests that investors can use signals from aggregate insider behavior to adjust
          style tilts and exploit sentiment-induced mispricing.Aggregate insider demand forecasts time-series variation in the value premium—a
          high level of insider buying signals that the future value premium will be lower (growth
          beats value), whereas insider selling portends a higher value premium (value beats
          growth). For example, between 1978 and 2004, an increase of one standard deviation in
          aggregate insider demand measured over the previous six months forecasted a 53 bp decline
          (6.54 percentage points [pps] annualized) in the expected value premium in the month
          following publication of the insider trading data. Moreover, aggregate insider demand
          forecasts the value premium more effectively than either the difference in growth and
          value stock valuations (the “value spread”) or lag returns.Consistent with previous research, we found that aggregate insider demand also forecasts
          market returns. The relationship between aggregate insider demand and future market
          returns, however, largely results from aggregate insider demand’s forecasting
          growth stock returns. An increase of one standard deviation in aggregate insider demand
          forecasts a 76.8 bp increase in monthly growth stock returns (9.62 pps annualized) versus
          a 23.9 bp increase in monthly value stock returns (2.91 pps annualized). Further analysis
          indicated that aggregate insider demand in either value stocks or growth stocks predicts
          growth stock returns and the value premium. In contrast, we found no evidence of a
          meaningful relationship between subsequent value stock returns and lag aggregate insider
          demand in all stocks, value stocks, or growth stocks. Although we considered several
          alternatives, additional tests suggested that aggregate insider demand forecasts the value
          premium because insiders trade against sentiment-induced mispricing and growth stocks are
          more sensitive than value stocks to investor sentiment.Contrary to previous research and our own results for the primary sample period (ending
          in mid-2004), out-of-sample tests that incorporated the most recent market turmoil
          (forecasting returns from July 2004 to September 2009) revealed no evidence that aggregate
          insider demand measured over the previous six months forecasts market returns or the value
          premium. We did find some evidence, however, that short-term aggregate insider demand
          (measured over the previous month) forecasts the value premium. The weaker relationship
          between aggregate insider demand and the subsequent value premium in the out-of-sample
          period is fully driven by the final seven months in the out-of-sample period (returns from
          March 2009 to September 2009), when aggregate insider demand dropped sharply but remained
          high relative to historical averages. Thus, aggregate insider demand continued to forecast
          a reduction in the value premium during a time when the value premium recovered.
Journal: Financial Analysts Journal
Pages: 46-66
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.7
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.7
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Author-Name: Peter Eickelberg
Author-X-Name-First: Peter
Author-X-Name-Last: Eickelberg
Title: “Of Laws, Lending, and Limbic Systems”: A Comment
Abstract: 
 This material comments on “Of Laws, Lending, and Limbic Systems”.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 4
Volume: 66
Year: 2010
Month: 7
X-DOI: 10.2469/faj.v66.n4.8
File-URL: http://hdl.handle.net/10.2469/faj.v66.n4.8
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Author-Name: Ivo Ph. Jansen
Author-X-Name-First: Ivo Ph.
Author-X-Name-Last: Jansen
Author-Name: Lee W. Sanning
Author-X-Name-First: Lee W.
Author-X-Name-Last: Sanning
Title: Cashing In on Managerial Malfeasance: A Trading Strategy around Forecasted Executive Stock Option Grants
Abstract: 
 This study examined the profitability of a trading strategy that exploits the
          manipulation of stock prices around the grant date of executive stock options. The
          strategy generates annualized abnormal returns of 1.4–5.2 percent net of transaction
          costs and is relatively unaffected by the Sarbanes–Oxley Act of 2002.Executive stock option compensation creates an incentive for managers to temporarily
          manipulate their companies’ stock price downward before an option grant. This
          incentive stems from the fact that the option strike price is typically set equal to the
          market price of the stock on the date the option is granted and the payoff at exercise
          equals the difference between the stock price and the strike price. Therefore, because
          option value and strike price are negatively related, executive stock options are more
          valuable the lower the stock price (and thus the strike price) on the grant date. Previous
          researchers have argued that managers act on these incentives and manipulate stock prices
          downward by accelerating the release of “bad news” before an option grant and
          delaying the release of “good news” until after an option grant. Consistent
          with this argument, others have documented significant negative abnormal returns in the
          days preceding executive stock option grants and significant positive abnormal returns
          following such grants.In our study, we designed and evaluated a trading strategy that seeks to profit from
          managerial manipulation of stock prices around the date of option grants. We limited our
          strategy to companies that award options on apparently fixed schedules (i.e., we
          eliminated companies that backdate or randomly award stock options) so that we could form
          reasonable expectations about upcoming award dates. This approach was critical because
          option grants are seldom announced before the fact. To maximize the potential
          profitability of our trading strategy, we wanted to take a short position before an
          expected option grant and reverse it immediately afterward. We implemented our trading
          strategy as follows. First, we identified companies as granting on fixed schedules when
          they awarded stock options for at least four consecutive years within one week of the
          preceding year’s option grant date. Second, we defined the most recent calendar date
          of an option grant for these “fixed granters” as the expected option grant
          date for the following year. Next, in the year after which the company established itself
          as a fixed granter, we took a short position during the 20 trading days before the
          expected grant date to take advantage of any downward manipulation of the stock price
          preceding an option grant. Finally, on the expected grant date, we reversed our short and
          took a long position for 60 trading days to take advantage of the reversal of any downward
          manipulation of the stock price.We compared the returns from our trading strategy with those of three different
          benchmarks: the return predicted by the market model, the return on the S&P 500, and
          the return predicted by the Fama–French three-factor model. Depending on the
          benchmark, we found that the 81-day holding period abnormal returns from our trading
          strategy are statistically significantly positive and range from about 1 percent to 2.15
          percent. We estimated that the transaction costs for our strategy—which requires
          four trades—are 0.56 percent, so the strategy is implementable to generate abnormal
          returns of about 0.44 percent to 1.59 percent in excess of transaction costs. On an
          annualized basis, our trading strategy generates abnormal returns of approximately 3
          percent to 6.5 percent (1.4 percent to 5.2 percent net of trading costs).We further assessed the profitability of our trading strategy for two separate periods:
          1996–2002 and 2003–2008. The results are similar for both periods, which
          suggests that traders did not learn from the pattern of abnormal returns in earlier years
          to arbitrage away abnormal returns in later years. The results also suggest that the
          passing of the Sarbanes–Oxley Act of 2002, which includes stricter disclosure
          requirements for stock option grants, did not significantly affect the profitability of
          our trading strategy.
Journal: Financial Analysts Journal
Pages: 85-93
Issue: 5
Volume: 66
Year: 2010
Month: 9
X-DOI: 10.2469/faj.v66.n5.1
File-URL: http://hdl.handle.net/10.2469/faj.v66.n5.1
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 96-96
Issue: 5
Volume: 66
Year: 2010
Month: 9
X-DOI: 10.2469/faj.v66.n5.10
File-URL: http://hdl.handle.net/10.2469/faj.v66.n5.10
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Author-Name: William J. Bernstein
Author-X-Name-First: William J.
Author-X-Name-Last: Bernstein
Title: “Adaptive Asset Allocation Policies”: A Comment
Abstract: 
 This material comments on “Adaptive Asset Allocation Policies ”
          (May/June 2010).
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 5
Volume: 66
Year: 2010
Month: 9
X-DOI: 10.2469/faj.v66.n5.11
File-URL: http://hdl.handle.net/10.2469/faj.v66.n5.11
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Author-Name: Laurence B. Siegel
Author-X-Name-First: Laurence B.
Author-X-Name-Last: Siegel
Title: Risk Parity: Classical Finance Properly Implemented, or Misunderstood?
Abstract: 
 This material comments on “Speculative Leverage: A False Cure for Pension Woes” (May/June 2010).
Journal: Financial Analysts Journal
Pages: 15-16
Issue: 5
Volume: 66
Year: 2010
Month: 9
X-DOI: 10.2469/faj.v66.n5.12
File-URL: http://hdl.handle.net/10.2469/faj.v66.n5.12
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Author-Name: Seth A. Klarman
Author-X-Name-First: Seth A.
Author-X-Name-Last: Klarman
Author-Name: Jason Zweig
Author-X-Name-First: Jason
Author-X-Name-Last: Zweig
Title: Opportunities for Patient Investors
Abstract: 
 At the CFA Institute 2010 Annual Conference in Boston, Jason Zweig sat down with
          legendary investor Seth Klarman to gain insights into Mr. Klarman’s successful
          approach to investing.At the CFA Institute 2010 Annual Conference in Boston, Wall Street Journal
          columnist Jason Zweig sat down with legendary investor Seth Klarman to gain
          insights into Mr. Klarman’s successful approach to investing.
Journal: Financial Analysts Journal
Pages: 18-28
Issue: 5
Volume: 66
Year: 2010
Month: 9
X-DOI: 10.2469/faj.v66.n5.2
File-URL: http://hdl.handle.net/10.2469/faj.v66.n5.2
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Author-Name: Mark Kritzman
Author-X-Name-First: Mark
Author-X-Name-Last: Kritzman
Author-Name: Yuanzhen Li
Author-X-Name-First: Yuanzhen
Author-X-Name-Last: Li
Title: Skulls, Financial Turbulence, and Risk Management
Abstract: 
 Based on a methodology introduced in 1927 to analyze human skulls and later applied to
          turbulence in financial markets, this study shows how to use a statistically derived
          measure of financial turbulence to measure and manage risk and to improve investment
          performance. View a webinar based on this article. We extended the research of those who have been analyzing the creation of optimal
          portfolios during times of financial turbulence. That research produced a mathematical
          measure of financial turbulence that captured the statistical unusualness of a set of
          asset returns given their historical pattern of behavior, including extreme price moves,
          decoupling of correlated assets, and convergence of uncorrelated assets. We showed that this measure of financial turbulence is nearly identical to the
          Mahalanobis distance, which was derived decades ago to analyze human skulls. Then, we
          provided evidence that this mathematical measure coincides with well-known episodes of
          financial turbulence, such as the stagflation of the late 1970s and early 1980s, the 1987
          stock market crash, the Gulf War, Russia’s default on its sovereign debt, the
          technology bubble, 9/11, and the recent global financial crisis. We next discussed two intriguing features of financial turbulence. First, returns to risk
          are substantially lower during turbulent periods than during nonturbulent periods, and
          second, turbulence is persistent. It may arrive unexpectedly, but it does not immediately
          subside. It typically continues for weeks as market participants digest and react to its
          cause. Finally, we explored a variety of useful ways to apply this measure of financial
          turbulence. We showed how to stress-test portfolios by estimating value at risk from the
          covariances that prevailed during the turbulent subsample. We showed how to construct
          portfolios that are relatively resistant to turbulence by conditioning inputs to the
          portfolio construction on the performance of assets during periods of turbulence. In
          addition, we showed how to enhance the performance of certain risky strategies by using
          turbulence as a filter for scaling exposure to risk.
Journal: Financial Analysts Journal
Pages: 30-41
Issue: 5
Volume: 66
Year: 2010
Month: 9
X-DOI: 10.2469/faj.v66.n5.3
File-URL: http://hdl.handle.net/10.2469/faj.v66.n5.3
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Author-Name: Michelle L. Barnes
Author-X-Name-First: Michelle L.
Author-X-Name-Last: Barnes
Author-Name: Zvi Bodie
Author-X-Name-First: Zvi
Author-X-Name-Last: Bodie
Author-Name: Robert K. Triest
Author-X-Name-First: Robert K.
Author-X-Name-Last: Triest
Author-Name: J. Christina Wang
Author-X-Name-First: J. Christina
Author-X-Name-Last: Wang
Title: A TIPS Scorecard: Are They Accomplishing Their Objectives?
Abstract: 
 Treasury Inflation-Protected Securities were developed to provide (1) consumers with
          assets that permit hedging against real interest rate risk, (2) nominal contract holders a
          means of hedging against inflation risk, and (3) everyone with an indicator of the term
          structure of expected inflation. This article evaluates progress toward these
          objectives.In 1997, the U.S. Treasury introduced Treasury Inflation-Protected Securities (TIPS) to
          achieve three major policy objectives: (1) to provide consumers with a class of assets
          that enables them to hedge against real interest rate risk, (2) to
          provide holders of nominal contracts with a way to hedge against inflation
            risk, and (3) to provide everyone with a reliable indicator of the term
          structure of expected inflation. We examined the extent to which these objectives have
          been achieved and sought to identify ways whereby they can be better achieved in the
          future.The viability of the TIPS market hinges on whether TIPS provide an effective hedge for
          most investors against unexpected changes in the real rate of interest that could result
          from unexpected fluctuations in inflation. Inflation-protected indexed bonds are designed
          to deliver, to the extent possible, a certain pretax real return to maturity. In the
          United States, these bonds are indexed to the Consumer Price Index (CPI) for all urban
          consumers (CPI-U). We focused on two important factors that may limit the ability of this
          class of securities to offer investors a complete hedge against unexpected changes in the
          real rate: (1) the possibility that the CPI may not be an appropriate index for all
          investors and (2) the potential for technical revisions to the measurement of the CPI,
          such as those recommended by the Boskin Commission just before the initial auctioning of
          TIPS in January 1997. Either or both of these factors could engender inflation basis risk.
          We did not address another widely known limiting factor: the fact that the CPI is not
          continuously measured and published, with the result that the indexation of TIPS’
          nominal cash flows occurs with some lag.During the summer of 2008, a spate of popular press articles claimed that the existing
          methodology of computing the CPI underestimates true inflation. Some authors even asserted
          that the measure is subject to political influence and has been biased downward over time
          via methodological changes during several presidential regimes. Because these concerns
          speak to uncertainties regarding the ability of TIPS to hedge effectively against
          unexpected changes in the real rate, a few of these articles, not surprisingly, concluded
          that for many investors, TIPS are not, in fact, good hedges against inflation. We
          evaluated these criticisms and, to the extent that they are valid, assessed their
          implications for the efficacy of TIPS as a hedge against unexpected changes in the real
          rate of interest.We explained the design of TIPS, their tax implications for investors, the demographics
          of TIPS holders, and other considerations relating to whether TIPS should yield measures
          of breakeven inflation rates comparable with survey measures of consumers’ inflation
          expectations. We used both theoretical and empirical analysis to evaluate criticisms of
          the CPI as an inflation benchmark for adjusting the return on TIPS. We discussed whether
          the potential mismeasurement of the CPI is relevant to the efficacy of TIPS as a hedging
          instrument to guarantee the real return, whether the CPI is a good measure for everyone,
          and whether there might be more appropriate measures for certain heterogeneous groups, as
          well as the costs and benefits of issuing such securities. We then demonstrated the
          efficacy of TIPS as a hedge against various ex ante and ex
            post inflation measures and their efficacy as a short-term versus a long-term
          hedge.We conclude that the TIPS market provides a good hedge against inflation risk, and from a
          cost/benefit perspective, little is to be gained from indexing to other inflation
          measures, be they broader, such as the GDP deflator, or narrower, such as regional
          inflation measures or the CPI-E (for the elderly). As the proportion of retirees who have
          defined benefit pensions continues to decrease, the need for individuals to manage
          lump-sum accounts to provide a steady stream of real income during their retirement
          becomes more difficult. A “ladder” of TIPS with maturities linked to the dates
          when the money will be needed for expenses is a safe investment well suited to retirees
          and those approaching retirement. TIPS have the potential to be the backbone asset
          underlying inflation-indexed annuities, but the maximum duration of TIPS would need to be
          extended in order to facilitate such annuities.Note: The views expressed in this article are solely those of the
            authors and do not necessarily reflect the views of the Federal Reserve Bank of Boston
            or the Federal Reserve System.
Journal: Financial Analysts Journal
Pages: 68-84
Issue: 5
Volume: 66
Year: 2010
Month: 9
X-DOI: 10.2469/faj.v66.n5.4
File-URL: http://hdl.handle.net/10.2469/faj.v66.n5.4
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Author-Name: James Allen
Author-X-Name-First: James
Author-X-Name-Last: Allen
Title: Big Risks in the Big Bill
Abstract: 
 Guest Editorial is an occasional feature of the Financial Analysts Journal. This piece reflects the views of the author and does not represent the official views of the FAJ or CFA Institute.
Journal: Financial Analysts Journal
Pages: 6-9
Issue: 5
Volume: 66
Year: 2010
Month: 9
X-DOI: 10.2469/faj.v66.n5.5
File-URL: http://hdl.handle.net/10.2469/faj.v66.n5.5
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Author-Name: John Hull
Author-X-Name-First: John
Author-X-Name-Last: Hull
Author-Name: Alan White
Author-X-Name-First: Alan
Author-X-Name-Last: White
Title: The Risk of Tranches Created from Mortgages
Abstract: 
 Using the criteria of the rating agencies, the authors tested how wide the AAA tranches
          created from residential mortgages can be. They found that the AAA ratings assigned to
          ABSs were not totally unreasonable but that the AAA ratings assigned to tranches of Mezz
          ABS CDOs cannot be justified.We examined the AAA ratings that were assigned to the structured products created from
          residential mortgages between 2000 and 2007. We considered both asset-backed securities
          (ABSs), which are created from a pool of mortgages, and ABS collateralized debt
          obligations (ABS CDOs), which are created from a portfolio of BBB rated ABS tranches.
          Standard & Poor’s and Fitch Ratings used probability of loss as the
          basis for rating tranches; Moody’s Investors Service used expected loss. We
          considered both criteria and tested how wide they allowed AAA tranches to be in different
          circumstances. In addition to the widely used Gaussian copula constant recovery rate
          model, we considered models whose recovery rate decreases as the default rate increases
          and models whose defaults are driven by a non-Gaussian copula model that increases the
          probability of extreme outcomes. When considering ABS CDOs, we used a two-factor model
          that distinguishes between within-pool default correlation and between-pool default
          correlation.We found that the AAA ratings assigned to senior ABS tranches were not totally
          unreasonable. For many of the assumptions that rating agencies might reasonably have made,
          expected loss and probability of loss were not markedly different from those of AAA rated
          bonds whose lives equaled the expected lives of the tranches. But the AAA ratings assigned
          to tranches of ABS CDOs cannot be justified. The risk of an ABS CDO tranche depends
          critically on the correlation between mortgage pools and the correlation model. A key
          point is that BBB tranches of ABSs cannot be considered equivalent to BBB bonds for
          purposes of subsequent securitizations.
Journal: Financial Analysts Journal
Pages: 54-67
Issue: 5
Volume: 66
Year: 2010
Month: 9
X-DOI: 10.2469/faj.v66.n5.6
File-URL: http://hdl.handle.net/10.2469/faj.v66.n5.6
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Author-Name: Bruce I. Jacobs
Author-X-Name-First: Bruce I.
Author-X-Name-Last: Jacobs
Author-Name: Kenneth N. Levy
Author-X-Name-First: Kenneth N.
Author-X-Name-Last: Levy
Author-Name: Harry M. Markowitz
Author-X-Name-First: Harry M.
Author-X-Name-Last: Markowitz
Title: Simulating Security Markets in Dynamic and Equilibrium Modes
Abstract: 
 An asynchronous discrete-time model run in “dynamic mode” can model the
     effects on market prices of changes in strategies, leverage, and regulations, or the effects of
     different return estimation procedures and different trading rules. Run in
     “equilibrium mode,” it can be used to arrive at equilibrium expected
     returns.Asynchronous discrete-time simulations, in which the time intervals between events are
     irregular, can be used to examine the mechanisms behind price movements and can thus be used to
     test the effects of changes in investors’ strategies, modifications in overall
     leverage, and switches in regulatory regimes. They can also be used to solve for equilibrium
     expected returns without requiring the kinds of unrealistic assumptions that some analytical
     models require. In this study, we used our asynchronous discrete-time simulation in (1) the
     dynamic analysis (DA) mode to investigate how changing input parameters changes simulated
     market behavior and (2) the capital market equilibrium (CME) mode to demonstrate how one can
     obtain estimates of equilibrium expected returns that are consistent with the aggregate
     holdings of heterogeneous investors subject to realistic constraints.In the DA mode, ideal portfolio weights are determined by simulated portfolio analysts who
     use inputs from simulated statisticians and investors’ risk-aversion parameters and
     portfolio constraints. Prices and volume arise endogenously as simulated traders seek to
     complete the trades required to move investors’ current portfolios toward their ideal
     portfolios. Examining how prices and volumes react to changes in the initial random seeds that
     determine individual investor initial wealth and cash flows, we found that although
     idiosyncratic differences exist in security prices and volumes, markets overall are largely
     insensitive to such changes. We also examined the effects of changes in the proportions of
     entities that use various methods of estimating expected returns and changes in trading
     rules.We found that simulated markets are sensitive to changes in both return estimation procedures
     and trading rules. For example, if all investors use return estimates based on
     securities’ historical returns and variances (which leads to
     “momentum” investing because the investors buy as prices increase and sell
     as prices decline), security prices are destabilized. Even when we varied the number of periods
     (days, months, quarters) used to estimate returns, we still found destabilization in the
     presence of investors who use historical returns. We introduced another type of investor, one
     who estimates returns on the basis of fixed future dollar returns per share (which leads to
     “value” investing: buying as prices decline and selling as prices rise). We
     found that when the ratio of momentum investors to value investors is large, security prices
     still tend to “explode”; but when the ratio is low, prices do not become
     destabilized.Our simulations also showed that traders must be subject to some kind of anchoring rules
     designed to approximate real-world traders’ sense of how much to pay or ask for a
     security on the basis of not only current prices but also recent past prices. Absent such
     rules, security prices tend to either explode or implode.In the CME mode, a simulation can find market-clearing expected returns.
     Securities’ expected returns are determined by an iterative adjustment procedure,
     rather than by the use of simulated statisticians, as is the case in the DA mode. In response
     to expected return changes, investors change their portfolios in such a way that the aggregate
     of all investors’ portfolios converges toward target market portfolio weights. In the
     CME mode, the simulator is able to solve for expected returns in markets with real-world
     constraints, such as restrictions on borrowing and/or short selling.
Journal: Financial Analysts Journal
Pages: 42-53
Issue: 5
Volume: 66
Year: 2010
Month: 9
X-DOI: 10.2469/faj.v66.n5.7
File-URL: http://hdl.handle.net/10.2469/faj.v66.n5.7
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Author-Name: Clifford Asness
Author-X-Name-First: Clifford
Author-X-Name-Last: Asness
Title: “Speculative Leverage: A False Cure for Pension Woes”: A Comment
Abstract: 
 This material comments on “Speculative Leverage: A False Cure for Pension Woes” (May/June 2010).
Journal: Financial Analysts Journal
Pages: 14-15
Issue: 5
Volume: 66
Year: 2010
Month: 9
X-DOI: 10.2469/faj.v66.n5.8
File-URL: http://hdl.handle.net/10.2469/faj.v66.n5.8
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Author-Name: William F. Sharpe
Author-X-Name-First: William F.
Author-X-Name-Last: Sharpe
Title: “Adaptive Asset Allocation Policies”: Author Response
Abstract: 
 This material comments on “‘Adaptive Asset Allocation Policies’: A Comment” (September/October 2010).
Journal: Financial Analysts Journal
Pages: 13-14
Issue: 5
Volume: 66
Year: 2010
Month: 9
X-DOI: 10.2469/faj.v66.n5.9
File-URL: http://hdl.handle.net/10.2469/faj.v66.n5.9
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Author-Name: Aleksandar Andonov
Author-X-Name-First: Aleksandar
Author-X-Name-Last: Andonov
Author-Name: Florian Bardong
Author-X-Name-First: Florian
Author-X-Name-Last: Bardong
Author-Name: Thorsten Lehnert
Author-X-Name-First: Thorsten
Author-X-Name-Last: Lehnert
Title: TIPS, Inflation Expectations, and the Financial Crisis
Abstract: 
 The authors show that inefficiencies in the U.S. market for inflation-linked bonds can be
          exploited by informed traders who include survey estimates or inflation model forecasts in
          trades on breakeven inflation. The Treasury Inflation-Protected Securities market has yet
          to fulfill investors’ expectations as a low-risk, efficient, and liquid
          financial instrument. Index-linked government bonds eliminate not only default risk but also inflation risk
          because they adjust cash flows for accrued inflation over time. In the past, the
          governments of many developed countries (e.g., the United Kingdom, Canada, and Sweden)
          issued inflation-linked bonds. In 1997, the U.S. Department of the Treasury followed suit
          by issuing Treasury Inflation-Protected Securities (TIPS). We investigated the TIPS market to improve our understanding of the major factors that
          drive risk and returns in that asset class. Although earlier studies identified liquidity
          premiums as one possible if not major factor driving TIPS returns, the financial crisis of
          2008 allowed us to examine how risk premiums related to index-linked government bonds are
          affected by changes in the perception and pricing of risk. Previous research indicated
          that the TIPS market is inefficient and that market inefficiencies can be exploited by
          informed traders who include survey estimations or inflation model forecasts in trades on
          breakeven inflation. Our results—over a period in which the TIPS market matured and increased in
          depth while the volatility of real yields and inflation also increased—confirm
          that TIPS market inefficiency was not temporary but persisted from 1997 to 2009. Using
          estimations generated by the Survey of Professional Forecasters or forecasts based on an
          inflation-forecasting model to construct a breakeven trading strategy leads to excess
          returns over a static buy-and-hold strategy. These excess returns remain substantial even
          after accounting for trading costs. A more detailed analysis of trading strategy–related excess returns suggests
          that the breakeven strategy performs well during periods of high macroeconomic volatility.
          This finding can be explained by an enhanced attractiveness of TIPS as uncertainty around
          future inflation increases. Thus, in general, TIPS market participants’
          predictions of future inflation rates during periods of macroeconomic uncertainty are
          rather poor. Using a systematic approach to forecast inflation is, therefore, especially
          useful during times of economic uncertainty. Furthermore, our results suggest that the
          TIPS market has yet to fulfill investors’ expectations of being a low-risk,
          efficient, and liquid financial instrument. In particular, TIPS returns include a
          substantial liquidity premium, which, in addition to exposure to changes in real yields,
          may increase, rather than eliminate, risks in investors’ portfolios. With respect to the financial crisis between the last quarter of 2008 and the second
          quarter of 2009, our observations further point to inefficiencies in the TIPS market. The
          most striking evidence from our results is that breakeven inflation turns negative. This
          finding implies that TIPS are not considered equivalent to government bonds, which leads
          to the requirement of a substantial liquidity premium for holding TIPS. Moreover, the
          liquidity premium appears to change significantly over time and to vary with such factors
          as perceived financial market stability.Note: The views and opinions expressed in this article are the
            authors’ own and do not necessarily reflect the views and opinions of
            BlackRock.
Journal: Financial Analysts Journal
Pages: 27-39
Issue: 6
Volume: 66
Year: 2010
Month: 11
X-DOI: 10.2469/faj.v66.n6.1
File-URL: http://hdl.handle.net/10.2469/faj.v66.n6.1
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: The Art of the Better Forecast
Abstract: 
 The editor discusses his views on an issue of interest to FAJ
          readers.Editor’s Note: I thank Xi Li and Larry Siegel for helpful
            discussions.
Journal: Financial Analysts Journal
Pages: 6-9
Issue: 6
Volume: 66
Year: 2010
Month: 11
X-DOI: 10.2469/faj.v66.n6.2
File-URL: http://hdl.handle.net/10.2469/faj.v66.n6.2
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Author-Name: Jason C. Hsu
Author-X-Name-First: Jason C.
Author-X-Name-Last: Hsu
Author-Name: Vitali Kalesnik
Author-X-Name-First: Vitali
Author-X-Name-Last: Kalesnik
Author-Name: Brett W. Myers
Author-X-Name-First: Brett W.
Author-X-Name-Last: Myers
Title: Performance Attribution: Measuring Dynamic Allocation Skill
Abstract: 
 Classical performance attribution methods do not explicitly assess managers’
     dynamic allocation skill in the factor domain. The authors propose a generalized framework for
     performance attribution that decomposes the allocation effect into value added from both static
     and dynamic factor exposures and thus yields additional insight into sources of manager
     alpha.Classical Brinson attribution was designed to analyze manager returns over a single period
     under the assumption of static holdings. It has since been extended to cover multiple periods
     to account for changing portfolio weights over the span of analysis. Commonly used multiperiod
     attribution analyses, however, do not explicitly measure a manager’s ability to
     allocate dynamically in the factor domain. This deficiency is important for a number of
     reasons.For example, value stocks have historically outperformed growth stocks. A particular manager
     may seek to exploit this apparent value premium to generate a higher return against his
     benchmark by increasing the portfolio weights in value stocks. We term this approach
      static factor allocation, and the resulting alpha arises from persistent
     style tilts toward factors with a risk premium. Another manager, skilled in forecasting whether
     value stocks will outperform growth stocks in a given year, may dynamically adjust the
     value/growth tilt in her portfolio by increasing the weights in value stocks when she believes
     value will do well relative to growth, and vice versa. We term this approach dynamic
      factor allocation.Although the sources of added value for these two managers are markedly different,
     traditional multiperiod Brinson-type analyses do not explicitly distinguish between them. The
     existing methods thus provide an incomplete assessment of a portfolio manager’s
     investment style. In this article, we propose a dynamic allocation attribution methodology that
     retains the intuition and familiar characteristics of traditional Brinson attribution analysis.
     In addition to distinguishing between security selection and factor selection, our methodology
     subdivides the allocation effect into static and dynamic components. The static component
     measures performance attributable to the persistent factor profile of the manager’s
     portfolio. The dynamic component measures the performance attributable to the
     manager’s timing ability. Distinguishing between static and dynamic allocation skills
     in the factor domain is important because doing so gives further insight into the investment
     approach of managers and more fully characterizes manager skill and drivers of manager
     alpha.
Journal: Financial Analysts Journal
Pages: 17-26
Issue: 6
Volume: 66
Year: 2010
Month: 11
X-DOI: 10.2469/faj.v66.n6.3
File-URL: http://hdl.handle.net/10.2469/faj.v66.n6.3
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Author-Name: Allen Michel
Author-X-Name-First: Allen
Author-X-Name-Last: Michel
Author-Name: Jacob Oded
Author-X-Name-First: Jacob
Author-X-Name-Last: Oded
Author-Name: Israel Shaked
Author-X-Name-First: Israel
Author-X-Name-Last: Shaked
Title: Not All Buybacks Are Created Equal: The Case of Accelerated Stock Repurchases
Abstract: 
 The authors documented the characteristics and market performance of ASR (accelerated
          share repurchase) stock. They found that post-announcement ASR stock performance is poor,
          unlike that documented in the literature for other repurchase methods, which implies that
          ASRs do not signal undervaluation, a frequently suggested motivation for repurchases. A new and growing practice in which companies repurchase their own shares has been
          adopted by businesses as diverse as Home Depot, HP, and Dollar Tree Stores. Rather than
          use the traditional methods of open-market repurchase (OMR) or self-tender offer
          (“tender offer”), each of these companies used an approach known as an
          accelerated share repurchase (ASR). This repurchase strategy differs from a traditional
          share repurchase in that it enables the acquiring company to accumulate shares
          quickly.In our study, we addressed three issues. First, we characterized ASRs and the companies
          that announced them. Then we assessed how ASRs differ from the prevalent alternative
          methods (OMRs and tender offers). Finally, we assessed the benefits and costs associated
          with the selection of ASRs over alternative methods. In this analysis, we evaluated the
          market performance of ASR-announcing companies and compared their performance with that of
          companies that selected other repurchase methods.Our findings suggest that since their initial use in 2004, both the number and volume of
          ASRs have grown dramatically, reaching a total dollar value of $42 billion in 2007.
          Investment banks commit to complete an ASR within a limited period of time that averages
          approximately six months. ASRs are generally very large repurchases and tend to be
          announced by relatively large companies. The average ASR size is about $570 million, and
          the average market capitalization of an announcing company is $12.5 billion. On average,
          ASRs involve 5.3 percent of the repurchasing company’s outstanding shares, a
          percentage close to what is documented for OMR programs.We reached several conclusions about how ASRs differ from OMRs and tender offers. We
          found that ASRs—like regular OMR programs (and unlike tender offer
          repurchases)—are preceded by a decline in the company’s market-based
          rate of return. Yet, ASR announcements generate small (about 1.2 percent) but positive and
          statistically significant returns. These returns are smaller than the announcement returns
          documented in the literature for other repurchase methods. Several studies have documented
          significant positive long-run cumulative abnormal returns (CARs) after OMR and tender
          offer announcements. Surprisingly, we found that post-announcement performance of ASR
          stocks is poor (about –8.6 percent for the nine months following the
          announcement). When we repeated the analysis with a four-factor model, we found that the
          average CAR is less negative but is still significant at the 5 percent level. The poor
          post-announcement performance is robust. Naive returns and returns net of the market
          return are also negative. This result is very different from that documented in the
          finance literature for other forms of repurchase. Interestingly, we found that the
          majority of ASR announcements (85 percent) are accelerations of existing OMR programs. We
          also found some supporting evidence that companies engage in ASRs to avoid inflation in
          the number of shares originating from accelerated employee and management compensation in
          the form of stock and options.Our interpretation of the relatively low announcement returns and the poor
          post-announcement performance is that unlike OMRs and tender offers, ASRs do not signal
          undervaluation. Our findings suggest that the market recognizes that ASRs are different
          from other repurchase methods and greets them with a lower announcement return. But this
          explanation does not account for the full extent of the negative news. Over the long run,
          this information is revealed and the stock price declines.Our findings also suggest that an ASR’s main advantage is in allowing the
          company to obtain the shares much more quickly than in an OMR program, yet without paying
          the premium required in a tender offer. One possible motivation for obtaining the shares
          quickly is the desire to boost the company’s EPS. Our analysis showed that a
          relatively large number of ASRs are announced in the second and third months of the fiscal
          quarter, consistent with a motivation to affect EPS. We also found that the quarterly
          growth rate for the number of shares outstanding doubles after ASRs, which suggests that
          companies might be using ASRs to offset accelerated inflation in the number of shares
          outstanding that results from management stock and option compensation plans.
Journal: Financial Analysts Journal
Pages: 55-72
Issue: 6
Volume: 66
Year: 2010
Month: 11
X-DOI: 10.2469/faj.v66.n6.4
File-URL: http://hdl.handle.net/10.2469/faj.v66.n6.4
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Author-Name: James Ang
Author-X-Name-First: James
Author-X-Name-Last: Ang
Author-Name: Ansley Chua
Author-X-Name-First: Ansley
Author-X-Name-Last: Chua
Author-Name: Danling Jiang
Author-X-Name-First: Danling
Author-X-Name-Last: Jiang
Title: Is A Better than B? How Affect Influences the Marketing and Pricing of Financial Securities
Abstract: 
 Culture and experience associate A with superior quality. In the
          marketing of dual-class IPOs, issuers are mindful of this preference. For years after IPO
          issuance, inferior voting rights shares labeled Class A enjoy higher market valuations and
          smaller voting premiums than do Class B shares. A evokes a more positive feeling than B among many
          people. This phenomenon is the affect heuristic observed by
          psychologists. The affect for A is a result of both culture and experience. A is
          associated with superior quality—for example, Grade A eggs or honey, a grade of
          A in school, A rated bonds, or A journals. In our study, we asked whether participants in
          the financial market, such as issuers and underwriters, have exploited the affect for A
          over B in the marketing and pricing of financial securities. We conducted a natural
          experiment involving dual-class shares, which are otherwise similar shares issued by the
          same company but with different voting rights. A typical example is a class with 1 vote
          per share and another class with 10 votes per share, with both having equal cash flow
          rights. The former class comprises shares with inferior voting rights, whereas the shares
          in the latter class have superior voting rights. Companies that issue dual-class shares
          can choose to designate one class as Class A shares and the other as Class B shares. The
          issuers and their underwriters may strategically exploit investor affect for A by
          designating shares more frequently as A than as B, particularly when only the inferior
          shares are publicly issued and traded.In our study, we asked the following questions: Is there evidence that issuers of
          dual-voting shares and their underwriters attempt to exploit the affect for A by
          designating the inferior voting rights (IVR) shares A? Do A-designated IVR shares manage
          to mimic A-designated superior voting rights (SVR) shares such that the initial market
          pricing of IVR A shares is more similar to that of SVR A shares than to that of IVR B
          shares? Could these companies realize significantly greater economic gains from less
          underpricing at IPOs, smaller voting premiums, and longer-term combined company
          valuations? Finally, could there be a rational explanation for this affect phenomenon?We found evidence in support of affect’s marketing and pricing role in the
          issuance of dual-voting shares in IPOs. Our sample covered all dual-class companies with
          at least one share class traded on the three major exchanges from 1994 to 2008. When these
          dual-class shares went public, issuers and their underwriters offered more than 87 percent
          of IVR shares as Class A, as opposed to Class B. This finding is consistent with their
          perception that there is an affect for A over B. Investors, however, also confirm their
          affect for A by placing a higher valuation at IPOs. We found that IVR dual shares
          designated Class A experienced close to 70 percent (or 30 percentage points)
            less underpricing at issue than those designated Class B. During the
          first year after IPOs, A-designated shares enjoyed an economically and statistically
          significant price premium relative to that of B-designated shares. For a group of
          companies with both SVR and IVR shares, we found that when SVR shares were designated A
          and IVR shares were designated B or other (e.g., Common Stock), SVR shares traded at a
          premium of 9.82 percent relative to IVR shares. In contrast, this SVR share premium
          (voting premium) was only 3.78 percent when IVR shares were designated Class A. Moving
          from a system that designates superior shares Class A to one that designates inferior
          shares Class A significantly increases the market valuation (measured by market-to-book
          equity) of a typical dual-class company for at least five years after IPOs.Our results support the hypothesis that affect plays a role in the pricing of financial
          assets. Designating a share class A rather than B is a strong explanatory variable of
          dual-class IPO underpricing even after controlling for a host of company characteristics
          or time period dummies known to influence IPO underpricing or to induce a potential sample
          selection bias. We also showed that our results do not support the alternative rational
          explanation—that companies choose an A designation for IVR shares to signal
          quality (i.e., better future performance) such that A is less underpriced than B. We found
          no difference in the share return performance of companies between these two groups up to
          five years after issuance; instead, companies with B-designated IVR shares delivered
          better-than-expected operating performance in the same period. This result echoes our
          findings on the voting premium that investor affect for A is persistent and not limited to
          the period around the IPOs.
Journal: Financial Analysts Journal
Pages: 40-54
Issue: 6
Volume: 66
Year: 2010
Month: 11
X-DOI: 10.2469/faj.v66.n6.5
File-URL: http://hdl.handle.net/10.2469/faj.v66.n6.5
File-Format: text/html
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# input file: UFAJ_A_12048010_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rob Bauer
Author-X-Name-First: Rob
Author-X-Name-Last: Bauer
Author-Name: Robin Braun
Author-X-Name-First: Robin
Author-X-Name-Last: Braun
Title: Misdeeds Matter: Long-Term Stock Price Performance after the Filing of Class-Action Lawsuits
Abstract: 
 Consistent with theory, this study of shareholder litigation found a broad transformation
          in company characteristics and risk exposures and generally negative short- and long-term
          performance effects that differed substantially between two types of allegations. The
          findings have important implications for both regulator and institutional investor
          monitoring and decision-making strategies.Does shareholder litigation pay off for investors over the long term? How much does the
          type of allegation matter? We studied whether a disciplining effect occurs for sued
          companies and their managers and examined two different groups of allegations. Allegations
          of violations of the duty of loyalty affect individuals only, but the duty of care
          pertains to the corporate entity. In general, we observed a post-litigation transformation
          in company characteristics and risk exposures, which is consistent with theory. Although
          generally negative, short- and long-term performance effects differ substantially between
          types of allegations. We observed performance reversals only in companies with individual
          directors accused of insider trading. Effects are similar for companies with triggering
          events that precede the filing of a lawsuit. Our results have important implications for
          the decision-making and monitoring strategies of both regulators and institutional
          investors: whether to use litigation to exert control over managers.
Journal: Financial Analysts Journal
Pages: 74-92
Issue: 6
Volume: 66
Year: 2010
Month: 11
X-DOI: 10.2469/faj.v66.n6.6
File-URL: http://hdl.handle.net/10.2469/faj.v66.n6.6
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# input file: UFAJ_A_12048011_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 6
Volume: 66
Year: 2010
Month: 11
X-DOI: 10.2469/faj.v66.n6.7
File-URL: http://hdl.handle.net/10.2469/faj.v66.n6.7
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# input file: UFAJ_A_12048013_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Haigang Zhou
Author-X-Name-First: Haigang
Author-X-Name-Last: Zhou
Title: Asymmetric Changes in Stock Prices and Investor Recognition around Revisions to the S&P 500 Index
Abstract: 
 This study finds that first-time additions to the S&P 500 Index or its family
                    experience permanent price increases; however, companies upgraded from
                    lesser-known S&P indices, reentering the S&P 500, or dropped from the
                    index experience temporary price changes. These price patterns can be explained
                    by changes in investor recognition.Previous studies have found that stock prices increase after companies are added
                    to the S&P 500 Index and drop after companies are removed from it. Moreover,
                    the price increase is permanent for additions and the price drop is temporary
                    for deletions. These asymmetric price effects are consistent with the investor
                    recognition hypothesis. After companies are added to the S&P 500, their
                    level of recognition among investors increases. But investor recognition does
                    not easily diminish after companies are dropped from the index.Added and deleted companies have different pre-addition and post-deletion
                    statuses. Changes in investor recognition are arguably different between
                    first-time additions to the S&P 500 (as well as to the S&P index family)
                    and companies that are upgraded to the S&P 500 from lesser-known S&P
                    indices. But changes in investor recognition are arguably similar between
                    deletions that are downgraded to lesser-known S&P indices and those that are
                    dropped from the entire S&P index family. Are changes in stock prices
                    different across the companies? The answer is important for investors,
                    especially enhanced index fund managers, who want to optimally time the trading
                    of shares of S&P 500 additions or deletions.I identified three samples of companies with different pre- and post-event
                    statuses and studied their price changes. First-time additions to the S&P
                    500, as well as the S&P index family, experienced higher and permanent price
                    increases, whereas companies upgraded from other S&P indices observed lower
                    and temporary increases in stock prices. Similarly, share revaluation for
                    first-time additions to the S&P 500 was higher and permanent, whereas that
                    for companies reentering the index was lower and transitory. But deleted
                    companies recovered all the losses resulting from the announcements 40 days
                    after Standard & Poor’s implemented the changes, regardless of their
                    post-announcement status. The implication for investors and enhanced fund
                    managers is that they can benefit from postponing the purchase of shares of
                    added companies if the companies are transferred from lesser-known S&P
                    indices or if they are reentering the S&P 500 but not if the companies are
                    newly added to the S&P index family or if they are entering the S&P 500
                    for the first time. For deletions, regardless of their post-deletion status,
                    investors can benefit from postponing the sales of shares of deleted
                    companies.Does the investor recognition hypothesis explain these patterns of price changes?
                    Using three proxies—Merton’s shadow cost, analyst coverage, and
                    ownership breadth—I examined the changes in investor recognition around
                    revisions in the S&P 500. First-time additions to the S&P index family
                    and to the S&P 500 have a greater increase in investor recognition—a
                    greater decrease in shadow cost, a greater increase in analyst coverage, and a
                    greater increase in number of shareholders—than do companies upgraded from
                    other S&P indices and companies reentering the S&P 500. Companies that
                    are dropped from the entire S&P index family have greater increases in
                    shadow cost and lose more analyst coverage and shareholders than do companies
                    downgraded to lesser-known S&P indices. Therefore, my findings are
                    consistent with the investor recognition hypothesis.
Journal: Financial Analysts Journal
Pages: 72-84
Issue: 1
Volume: 67
Year: 2011
Month: 1
X-DOI: 10.2469/faj.v67.n1.1
File-URL: http://hdl.handle.net/10.2469/faj.v67.n1.1
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# input file: UFAJ_A_12048014_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Momtchil Pojarliev
Author-X-Name-First: Momtchil
Author-X-Name-Last: Pojarliev
Author-Name: Richard M. Levich
Author-X-Name-First: Richard M.
Author-X-Name-Last: Levich
Title: Detecting Crowded Trades in Currency Funds
Abstract: 
 Investors and regulators suspect that crowded trades may pose a special risk. The
                    authors propose a methodology to measure crowded trades and apply it to currency
                    managers. This methodology offers useful insights regarding the popularity of
                    certain trades among hedge funds and provides regulators with another tool for
                    monitoring markets.The financial crisis of 2008 highlighted the importance of detecting crowded
                    trades because of the risks they pose to the stability of both the global
                    financial system and the global economy. Crowded trades, however, are perceived
                    as difficult to identify. To date, no single measure that captures the
                    crowdedness of a trade or trading style has been developed.We proposed a methodology to measure crowded trades and applied it to
                    professional currency managers. We investigated three trading strategies: carry,
                    trend, and value. Earlier research has shown that returns on an index of
                    currency hedge funds, as well as returns earned by individual fund managers, are
                    closely related to returns on indices that represent these three trading
                    strategies. Our measure of crowdedness attempts to capture the popularity of a
                    strategy by counting the number of funds whose returns have significant style
                    betas versus the three basic strategies. Specifically, we focused on a measure
                    of net crowdedness defined as the percentage of funds in our sample with
                    positive style betas (with respect to a trading strategy) minus the percentage
                    of funds with negative style betas (“contrarians”).We used daily data from the Deutsche Bank FXSelect currency trading platform to
                    form weekly returns for 107 managers listed on the platform. The data allowed us
                    to control for backfill bias and survivorship bias.Our results show that our measure of crowdedness varied considerably over time.
                    For example, from September 2005 to June 2010, carry crowdedness ranged from a
                    low of –10.5 percent to a high of 32.1 percent, trend crowdedness moved
                    from –3.4 percent to 33.9 percent, and value crowdedness varied between
                    –28.3 percent and 12.2 percent. Moreover, each trading strategy
                    experienced at least two high and two low points of crowdedness as managers
                    alternately adopted and then abandoned a strategy. Our results show that a
                    trading strategy becomes crowded not only because existing managers switch to
                    that strategy but also because newcomers join the database and adopt the
                    strategy. A trading strategy becomes less crowded as managers close their
                    positions and as other managers exit the platform.Specifically, we found that carry became a crowded trading strategy toward the
                    end of the first quarter of 2008, shortly before a massive liquidation of carry
                    trades. The timing suggests a possible adverse relationship between our measure
                    of style crowdedness and the future performance of that trading style.
                    Crowdedness in both the trend and value strategies support this hypothesis.Our sample period covered 63 months, of which 27 were effectively an
                    out-of-sample period. The out-of-sample results confirm the usefulness of our
                    measure of crowdedness. After a period when carry returns were very favorable,
                    the carry strategy became crowded again in the fall of 2009 and then experienced
                    a sharp reversal during the European sovereign debt crises in the spring of 2010
                    and after the “flash crash” of May 2010.Although we applied our approach to currencies, the methodology could be used to
                    measure the popularity or crowdedness of any trade with an identifiable
                    time-series return. Our methodology may offer helpful insights regarding the
                    popularity of certain trades—in currencies, gold, or other
                    assets—among hedge funds. Further research in this area could yield useful
                    findings for investors, managers, and regulators.
Journal: Financial Analysts Journal
Pages: 26-39
Issue: 1
Volume: 67
Year: 2011
Month: 1
X-DOI: 10.2469/faj.v67.n1.2
File-URL: http://hdl.handle.net/10.2469/faj.v67.n1.2
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Author-Name: David Lam
Author-X-Name-First: David
Author-X-Name-Last: Lam
Author-Name: Bing-Xuan Lin
Author-X-Name-First: Bing-Xuan
Author-X-Name-Last: Lin
Author-Name: David Michayluk
Author-X-Name-First: David
Author-X-Name-Last: Michayluk
Title: Demand and Supply and Their Relationship to Liquidity: Evidence from the S&P 500 Change to Free Float
Abstract: 
 In the context of the switch to free-float weighting in the S&P 500 Index,
                    this study of the effect of the availability of shares on liquidity in the
                    medium term found cross-sectional differences in liquidity and price impact
                    measures that gradually narrowed following each phase of the free-float
                    adjustment. The authors showed how the availability of shares affects stock liquidity in the
                    medium term. The two-step change to a free-float weighting in the S&P 500
                    Index provides a natural experiment for measuring liquidity dynamics. Prior to
                    the adjustment, some stocks may have had difficulty absorbing demand because of
                    a limited supply of shares, which may have had adverse affects on liquidity. The
                    authors estimated price impact and liquidity measures for three periods between
                    the two index calculation alterations. They examined periods away from actual
                    changes to lessen the impact of short-term price pressure and to focus on
                    longer-term liquidity differences.The authors found cross-sectional evidence of liquidity differences between
                    stocks in the S&P 500 segregated by their free-float factors (or investable
                    weight factors). They showed a gradual narrowing of the liquidity differences
                    between high- and low-free-float stocks following each phase of the free-float
                    adjustment. These findings suggest that the liquidity of constituent stocks can
                    be influenced when the proportion of shares demanded by index funds is
                    inconsistent with the availability of shares for trading.This study provides evidence that liquidity differences are related to the supply
                    of shares. This simple explanation appears to contradict the EMH, which holds
                    that information alone drives stock prices. Although short-term price pressure
                    has been documented in the literature, this study is the first to measure
                    medium-term supply-and-demand effects. This finding implies that demand and
                    supply may influence pricing mechanisms, and if liquidity reflects demand and
                    supply, this finding gives support to a liquidity component in asset
                    pricing.Another implication of this study is that measurement of liquidity should
                    consider the intrinsic trading ability of a stock. Traditional measures of
                    liquidity may be oversimplified, and without controlling for fundamental
                    differences in supply, any conclusions about liquidity differences may become
                    confounded. A third implication of this study is that the prior findings of
                    studies on S&P 500 changes did not consider the availability of shares for
                    trading (free float) before dismissing the liquidity hypothesis. All these
                    implications suggest avenues for further research.
Journal: Financial Analysts Journal
Pages: 55-71
Issue: 1
Volume: 67
Year: 2011
Month: 1
X-DOI: 10.2469/faj.v67.n1.3
File-URL: http://hdl.handle.net/10.2469/faj.v67.n1.3
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# input file: UFAJ_A_12048016_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Malcolm Baker
Author-X-Name-First: Malcolm
Author-X-Name-Last: Baker
Author-Name: Brendan Bradley
Author-X-Name-First: Brendan
Author-X-Name-Last: Bradley
Author-Name: Jeffrey Wurgler
Author-X-Name-First: Jeffrey
Author-X-Name-Last: Wurgler
Title: Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly
Abstract: 
 Contrary to basic finance principles, high-beta and high-volatility stocks have
                    long underperformed low-beta and low-volatility stocks. This anomaly may be
                    partly explained by the fact that the typical institutional investor’s
                    mandate to beat a fixed benchmark discourages arbitrage activity in both
                    high-alpha, low-beta stocks and low-alpha, high-beta stocks.Although there are many candidates for the greatest anomaly in finance, a
                    particularly compelling one is the long-term success of low-volatility and
                    low-beta stock portfolios. Over 1968–2008, low-volatility and low-beta
                    portfolios have offered an enviable combination of high average returns and
                    small drawdowns. This runs counter to the fundamental principle that risk is
                    compensated with higher expected return. We applied principles of behavioral
                    finance to shed light on the drivers of this anomalous performance and to assess
                    the likelihood that it will persist. To recap the anomaly, whether risk is defined as volatility or beta and whether
                    we consider all stocks or only large caps, low risk consistently outperformed
                    high risk over this period. A dollar invested in the lowest-volatility portfolio
                    in January 1968 would have increased to $59.55 by the end of 2008. Over this
                    period, inflation eroded the real value of a dollar to about $0.17, meaning that
                    the low-risk portfolio produced a $10.12 gain in real terms. In contrast, a
                    dollar invested in the highest-volatility portfolio would have been worth 58
                    cents at the end of December 2008, assuming no transaction costs. Given the
                    declining value of the dollar, the real value of the high-volatility portfolio
                    declined to less than 10 cents—a 90 percent decline in real terms! The
                    anomaly with respect to beta risk is similar. A dollar invested in the
                    lowest-beta portfolio in January 1968 would have grown to $60.46 ($10.28 in real
                    terms), and a dollar invested in the highest-beta portfolio would have grown to
                    $3.77 (64 cents in real terms). Like the high-volatility investor, the high-beta
                    investor also failed to recover his dollar in real terms and underperformed his
                    “conservative” beta neighbor by 964 percent.Behavioral models of security prices, such as ours, combine two ingredients. The
                    first is that some market participants are irrational in some particular way. In
                    the context of the low-risk anomaly, we believe that an important subset of
                    investors have a preference for risky stocks. This preference derives from the
                    biases that afflict the individual investor. We believe individuals’
                    preferences for lotteries and well-established biases of representativeness and
                    overconfidence lead to demand for risk that is not warranted by fundamentals.
                    This irrational demand causes such high-risk stocks to be overpriced, which, all
                    else equal, leads to lower future returns. The second ingredient is limits to arbitrage—an explanation for why the
                    “smart money” does not step in and offset the price impact of any
                    irrational demand. With respect to the low-risk anomaly, we believe that the
                    underappreciated limit on arbitrage is benchmarking. Many institutional
                    investors who are in a position to offset the irrational demand for risk have
                    fixed-benchmark mandates, typically capitalization weighted, which, by their
                    nature, discourage investments in low-beta and low-volatility stocks. We showed
                    that traditional fixed-benchmark mandates (with a leverage constraint, an
                    assumption that we discuss) cause institutional investors to pass up the
                    superior risk–return trade-off of low-beta and low-volatility portfolios.
                    Rather than being a stabilizing force on prices, the typical institutional
                    contract for delegated portfolio management can induce the manager to hold
                    higher-beta stocks, even those with negative alpha.In this article, we review in more detail the long-term performance of low-risk
                    portfolios, present our behavioral explanation and some associated evidence, and
                    discuss the practical implications for investors and investment managers.
                    Perhaps the most important practical implication is that unless individual
                    investors’ preference for volatile stocks and the use of benchmarks are
                    somehow reversed, the low-risk anomaly is likely to persist.
Journal: Financial Analysts Journal
Pages: 40-54
Issue: 1
Volume: 67
Year: 2011
Month: 1
X-DOI: 10.2469/faj.v67.n1.4
File-URL: http://hdl.handle.net/10.2469/faj.v67.n1.4
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Author-Name: Mark Kritzman
Author-X-Name-First: Mark
Author-X-Name-Last: Kritzman
Title: Post-Crisis Investment Management
Abstract: 
 The author discusses his views on an issue of interest to FAJ readers.
Journal: Financial Analysts Journal
Pages: 4-8
Issue: 1
Volume: 67
Year: 2011
Month: 1
X-DOI: 10.2469/faj.v67.n1.5
File-URL: http://hdl.handle.net/10.2469/faj.v67.n1.5
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# input file: UFAJ_A_12048018_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Roger G. Ibbotson
Author-X-Name-First: Roger G.
Author-X-Name-Last: Ibbotson
Author-Name: Peng Chen
Author-X-Name-First: Peng
Author-X-Name-Last: Chen
Author-Name: Kevin X. Zhu
Author-X-Name-First: Kevin X.
Author-X-Name-Last: Zhu
Title: The ABCs of Hedge Funds: Alphas, Betas, and Costs
Abstract: 
 The authors decomposed their estimated pre-fee 1995–2009 hedge fund
                    return of 11.13 percent into fees (3.43 percent), an alpha (3.00 percent), and a
                    beta (4.70 percent). The year-by-year results show that alphas were positive
                    during every year of the past decade, even during the recent financial crisis.
                Despite the retrenchment of the hedge fund industry in 2008, hedge fund assets
                    under management are currently more than $1.5 trillion. The authors analyzed the
                    potential biases in reported hedge fund returns—in particular,
                    survivorship bias and backfill bias. They then broke the returns down into three
                    components: the systematic market exposure (beta), the value added by hedge
                    funds (alpha), and the hedge fund fees (costs). They analyzed the performance of
                    a universe of about 8,400 hedge funds from the TASS database over January
                    1995–December 2009. Their results suggest that both survivorship bias
                    and backfill bias are potentially serious problems. Adjusting for these biases
                    reduced the net return from 14.88 percent to 7.70 percent for the equal-weighted
                    sample. Over the entire period, this return was slightly lower than the
                    S&P 500 Index return of 8.04 percent but included a statistically
                    significant positive alpha. The authors estimated a pre-fee return of 11.13
                    percent, which they decomposed into fees (3.43 percent), an alpha return (3.00
                    percent), and a beta return (4.70 percent). The positive alpha is quite
                    remarkable because the mutual fund industry, in aggregate, does not produce
                    alpha net of fees. The year-by-year results also show that hedge fund alphas
                    were positive in every year of the last decade, even during the global financial
                    crisis of 2008–2009.
Journal: Financial Analysts Journal
Pages: 15-25
Issue: 1
Volume: 67
Year: 2011
Month: 1
X-DOI: 10.2469/faj.v67.n1.6
File-URL: http://hdl.handle.net/10.2469/faj.v67.n1.6
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: 2010 Report to Readers
Journal: Financial Analysts Journal
Pages: 10-12
Issue: 1
Volume: 67
Year: 2011
Month: 1
X-DOI: 10.2469/faj.v67.n1.7
File-URL: http://hdl.handle.net/10.2469/faj.v67.n1.7
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 96-96
Issue: 1
Volume: 67
Year: 2011
Month: 1
X-DOI: 10.2469/faj.v67.n1.8
File-URL: http://hdl.handle.net/10.2469/faj.v67.n1.8
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Author-Name: Andrew G. Biggs
Author-X-Name-First: Andrew G.
Author-X-Name-Last: Biggs
Title: Proposed GASB Rules Show Why Only Market Valuation Fully Captures Public Pension Liabilities
Abstract: 
 The Governmental Accounting Standards Board has released preliminary views on how
                    public sector pension plans should value benefit liabilities. Because the
                    GASB’s proposals ignore government’s contingent liability to
                    pay plan benefits should assets fall short, they omit the full value of plan
                    liabilities and contradict the GASB’s own standard of
                    “interperiod equity.”In recent years, financial economists have charged that public sector pension
                    accounting methods, which allow plans to discount virtually riskless pension
                    benefits at the interest rate projected for a risky portfolio of assets,
                    understate pension liabilities and encourage plans to take on excessive risk.
                    The Governmental Accounting Standards Board (GASB) recently proposed changes to
                    public pension discounting rules that may be viewed as a middle ground between
                    current actuarial methods and a market valuation approach. In fact, the
                    GASB’s proposals violate its own standard that each generation fully
                    fund its pension commitments and demonstrate why only a true market valuation
                    approach can fully capture the liabilities of taxpayer-supported public pension
                    plans. Under the GASB’s proposed changes, pensions may continue to
                    discount asset-backed liabilities at the expected return on assets but
                    liabilities that are not backed by assets are to be discounted at the interest
                    rate on an index of high-quality municipal bonds. But these revisions ignore the
                    fact that government—and thus taxpayers—has a contingent
                    responsibility to pay benefits that are currently backed by assets should those
                    assets fall short of the value needed to meet liabilities in full. In a sense,
                    the government acts as an implicit put option, the value of which is large but
                    is ignored under both current practices and the GASB’s proposed
                    revisions. This proposal violates the GASB’s own standard of interperiod equity, whereby each generation fully funds its
                    own accrued benefits and does not leave liabilities, contingent or otherwise,
                    for future generations. Under the GASB’s proposed rules, a plan could
                    be considered fully funded even if it imposes a significant contingent liability
                    on future generations. If the value of this contingent liability is included,
                    then full plan liabilities will equal those calculated under a standard market
                    valuation approach, whereby the discount rate is risk adjusted to match the
                    guaranteed nature of accrued pension benefits.
Journal: Financial Analysts Journal
Pages: 18-22
Issue: 2
Volume: 67
Year: 2011
Month: 3
X-DOI: 10.2469/faj.v67.n2.1
File-URL: http://hdl.handle.net/10.2469/faj.v67.n2.1
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:67:y:2011:i:2:p:18-22




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Author-Name: Moshe A. Milevsky
Author-X-Name-First: Moshe A.
Author-X-Name-Last: Milevsky
Author-Name: Huaxiong Huang
Author-X-Name-First: Huaxiong
Author-X-Name-Last: Huang
Title: Spending Retirement on Planet Vulcan: The Impact of Longevity Risk Aversion on Optimal Withdrawal Rates (corrected July 2011)
Abstract: 
 Recommendations from the media and financial planners regarding retirement
                    spending rates deviate considerably from utility maximization models. This study
                    argues that wealth managers should advocate dynamic spending in proportion to
                    survival probabilities, adjusted up for exogenous pension income and down for
                    longevity risk aversion. In our study, we attempted to derive, analyze, and explain the optimal retirement
                    spending policy for a utility-maximizing consumer facing (only) a stochastic
                    lifetime. We deliberately ignored financial market risk by assuming that all
                    investment assets are allocated to risk-free bonds (e.g., Treasury
                    Inflation-Protected Securities [TIPS]). We made this simplifying assumption in
                    order to focus attention on the role of longevity risk aversion
                    in determining optimal consumption and spending rates during a retirement period
                    of stochastic length.Indeed, the impact of financial risk aversion on optimal asset allocation has
                    been the subject of many studies and is intuitively well understood. In
                    contrast, the impact of longevity risk aversion on retirement spending rates has
                    not received as much attention, nor are most practitioners even familiar with
                    the concept. More than 75 million Baby Boomers are (still) hoping to retire one
                    day—with their own stochastic remaining life spans—and will
                    likely demand advice from their wealth managers on this very issue.Although neither our framework nor our mathematical solution is
                    original—they can be traced back almost 80 years—we believe
                    that the insights from a normative life-cycle model are worth emphasizing in the
                    current environment, which has grown jaded by economic models and their
                    prescriptions. Our pedagogical objective was to contrast the optimal (i.e.,
                    utility-maximizing) retirement spending policy with popular recommendations
                    offered by the investment media and financial planners.Our working hypothesis was that counseling retirees to set initial spending from
                    investable wealth at a constant inflation-adjusted rate (e.g., the widely
                    popular 4 percent rule) is consistent with life-cycle consumption smoothing only
                    under a very limited set of implausible preference parameters—that is,
                    there is no universally optimal or safe retirement spending rate. Rather, the
                    optimal forward-looking behavior in the face of personal longevity risk is to
                    consume in proportion to survival probabilities—adjusted upward for
                    pension income and downward for longevity risk aversion—as opposed to
                    blindly withdrawing constant income for life. This framework also allows one to
                    illustrate the (beneficial) impact of pension income annuities on the optimal
                    plan.We believe that 21st century wealth managers who have grown accustomed to
                    focusing their discussions with clients on the prism of risk and return should
                    advocate dynamic spending policies in this manner. Thus, the intent of our study
                    was not to dismiss or belittle widely used rules of thumb but rather to create a
                    common language and help improve the dialogue between financial economists and
                    the financial planning community. The stakes are simply too high to allow yet
                    another naive rule of thumb to take hold in these complex and uncertain
                    environments.
Journal: Financial Analysts Journal
Pages: 45-58
Issue: 2
Volume: 67
Year: 2011
Month: 3
X-DOI: 10.2469/faj.v67.n2.2
File-URL: http://hdl.handle.net/10.2469/faj.v67.n2.2
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:67:y:2011:i:2:p:45-58




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# input file: UFAJ_A_12048024_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard Roll
Author-X-Name-First: Richard
Author-X-Name-Last: Roll
Title: The Possible Misdiagnosis of a Crisis
Abstract: 
 Most explanations of the 2007–08 financial crisis—including
                    excessive leverage, subprime mortgages, exotic derivatives, reckless risk
                    taking, and easy money that spawned a housing bubble—are inconsistent
                    with elementary principles of finance. The author explains the inconsistencies
                    and suggests an alternative diagnosis that is fully compatible with
                    rationality.The illness underlying the 2007–08 economic crisis might have been
                    misdiagnosed, as is strongly suggested by some elementary principles of finance
                    and development economics. Moreover, there is an explanation for the crisis that
                    is fully consistent with rational beliefs and well-functioning markets. If this
                    explanation is true, public policy prescriptions should be reexamined because
                    there is a danger that the attempted cure is worse than the disease.Various diagnoses have been proposed. They include, but are not limited to, the
                    following:The subprime mortgage meltdownToo much leverage in financial institutionsInadequate regulationExcessive use of complex derivativesExcessive risk taking induced by agency conflictsA housing bubble induced by lax mortgage underwriting standardsEasy money (i.e., low interest rates that triggered a housing bubble)The last of these diagnoses, easy money leading to a housing bubble, is
                    inconsistent with the simple fact that real interest rates were not low by
                    historical standards and actually increased concurrently with real estate prices
                    over the alleged period of bubble expansion.The other aforementioned explanations are incompatible with the following
                    financial principles:
                    The total value of all debt is zero.The total value of all derivative contracts is zero.
                Globally, there is a lender for every borrower and a seller for every buyer of a
                    derivative contract. A liability on the balance sheet of some entity, whether it
                    is a person, a business, or a government, is matched exactly by an asset on the
                    balance sheet of some other entity or entities. The same is true for
                    derivatives, including all forms of futures, options, and swaps.Consequently,
                    any change in the value of outstanding debt or of derivative contracts has no
                        direct impact on total real wealth. For example, every
                    default is simply a wealth transfer from lender to borrower. This is true of all
                    “credit” events, including delinquencies in mortgages,
                    insolvencies in banks, and bankruptcies. Similarly, every derivative event, such
                    as an option exercise or a default on a swap, is simply a wealth transfer and
                    has no effect on the combined balance sheet of the two parties to the
                    contract.Yet there is no doubt that real estate prices started falling in 2007,
                    thereby triggering a cascade of credit events. What induced this real estate
                    crash? One possibility that cannot be ruled out is that an irrational housing
                    bubble suddenly burst. But the problem with a psychological diagnosis is the
                    diagnostic difficulty and the danger of prescribing a palliative when a more
                    serious non-psychological malady is actually present. There is an alternative
                    explanation based on the following two principles:Financial markets are forward looking.A country’s prosperity is positively related to the extent of
                            economic liberalization.Economic liberalization is an increase in the fraction of GDP spent by the
                    private sector relative to the fraction spent by the public sector. Markets are
                    forward looking, and in 2007, global market participants began to notice a major
                    sea change washing ashore in many countries. Reversing the trend of at least the
                    previous decade, the private sector’s fraction of GDP began to
                    perceptibly decline relative to the public sector’s fraction.This new trend suggests a different explanation for the crisis: a 2007 reduction
                    in the anticipated growth rate of private incomes and an accompanying drastic
                    reduction in the value of human capital. Human capital is the most important
                    determinant of real estate values. People will pay what they can afford for
                    housing.Increased government spending and a decreased role for the private sector are
                    simply going to prolong the malady; indeed, so long as that improper treatment
                    continues, the patient will not improve. Fortunately, beginning in 2009 and
                    continuing recently, there are signs that a better treatment might actually be
                    attempted.
Journal: Financial Analysts Journal
Pages: 12-17
Issue: 2
Volume: 67
Year: 2011
Month: 3
X-DOI: 10.2469/faj.v67.n2.3
File-URL: http://hdl.handle.net/10.2469/faj.v67.n2.3
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Handle: RePEc:taf:ufajxx:v:67:y:2011:i:2:p:12-17




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Author-Name: Quentin C. Chu
Author-X-Name-First: Quentin C.
Author-X-Name-Last: Chu
Author-Name: Deborah N. Pittman
Author-X-Name-First: Deborah N.
Author-X-Name-Last: Pittman
Author-Name: Linda Q. Yu
Author-X-Name-First: Linda Q.
Author-X-Name-Last: Yu
Title: When Do TIPS Prices Adjust to Inflation Information?
Abstract: 
 This event study of market efficiency found that prices of Treasury
                    Inflation-Protected Securities (TIPS) adjust to inflation information without
                    delay during the U.S. Consumer Price Index (CPI) survey period and even before
                    the beginning of the survey period. The cumulative effect of unexpected
                    inflation on the TIPS holding period returns peaks at the end of the survey
                    period. After the CPI announcement, there is no discernible price
                    adjustment.A basic tenet of financial theory is that the market-determined price of a
                    security that promises future cash flows should incorporate changes in inflation
                    expectations over the life of the security. The degree of market efficiency in
                    this regard, however, has been difficult to measure. Tests of how quickly new
                    information about future inflation is incorporated into security prices have
                    been complicated by the presence of many factors other than inflation that
                    affect market prices on a daily basis. Moreover, demonstrating the efficiency of
                    the response of security prices to inflation as it occurs and before its
                    announcement has been difficult.Given the direct link between future cash flows and the ex post
                    U.S. Consumer Price Index (CPI), Treasury Inflation-Protected Securities (TIPS)
                    are uniquely structured to aggregate inflation information before the monthly
                    public announcement. Because the cash flows associated with TIPS depend on
                    actual inflation and a contractual real return, TIPS prices react far
                    differently over time than do conventional bond prices, which respond to changes
                    in the expected rate of inflation until maturity and in the expected real rate.
                    Assuming contemporaneous adjustment of the contractual cash flow to the current
                    CPI, TIPS prices respond to changes in actual inflation and in the expected real
                    rate.Using pooled time-series, cross-sectional data from three recently matured TIPS
                    issues, the authors investigated how quickly TIPS prices respond to the monthly
                    update of the CPI. Their results suggest that TIPS prices efficiently aggregate
                    near-term inflation information. The evidence supports a market that is highly
                    informed about upcoming inflation starting 44 business days before the CPI
                    announcement date. In fact, using the pooled data of all three issues, the
                    authors found that 29 percent of the cumulative adjustment to information about
                    the upcoming month’s inflation is already incorporated into the TIPS
                    prices before the survey period begins. Moreover, the cumulative effect of
                    unexpected inflation on TIPS returns peaks on the last day of the month as the
                    sampling ends, with 98 percent of the inflation adjustment already in the TIPS
                    prices. On the announcement date, the TIPS prices make the final adjustment to
                    correct a reversing trend during the compilation period. The significant
                    adjustment on the announcement date returns the cumulative effect to a level
                    slightly higher than the level at the end of the month. Thus, the market is very
                    efficient at monitoring and responding to changes in consumer prices.Using the monthly CPI survey published by the Blue Chip Financial
                        Forecasts instead of the breakeven inflation rate to measure
                    expected inflation, the authors found no significant difference in the timing of
                    TIPS price adjustments. This finding suggests that the market-determined measure
                    of expected inflation, even for securities with a five-year maturity, is robust
                    in capturing near-term inflation surprises.To isolate the timing parameters of the TIPS price adjustments to inflation
                    information, the authors used a regression model with three control variables
                    based on TIPS trading and indexing characteristics. The three control variables
                    contribute to an overall improvement in modeling TIPS holding period returns
                    (HPRs). One important construct in the modeling of the TIPS HPR is an expected
                    one-to-one response between the TIPS HPR and the total effect of inflation. The
                    authors found that the hypothesis of a one-to-one relationship holds, and they
                    demonstrated that TIPS prices move directly with past inflation (a proxy for
                    “ongoing” inflation) and the arrival of new inflation
                    information during the observation window.The authors’ results are consistent with profit-motivated inflation
                    forecasting by economists and financial analysts that speeds up the TIPS price
                    adjustment process.
Journal: Financial Analysts Journal
Pages: 59-73
Issue: 2
Volume: 67
Year: 2011
Month: 3
X-DOI: 10.2469/faj.v67.n2.4
File-URL: http://hdl.handle.net/10.2469/faj.v67.n2.4
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:67:y:2011:i:2:p:59-73




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Author-Name: James X. Xiong
Author-X-Name-First: James X.
Author-X-Name-Last: Xiong
Author-Name: Thomas M. Idzorek
Author-X-Name-First: Thomas M.
Author-X-Name-Last: Idzorek
Title: The Impact of Skewness and Fat Tails on the Asset Allocation Decision
Abstract: 
 The authors modeled the non-normal returns of multiple asset classes by using a
                    multivariate truncated Lévy flight distribution and incorporating
                    non-normal returns into the mean-conditional value at risk (M-CVaR) optimization
                    framework. In a series of controlled optimizations, they found that both
                    skewness and kurtosis affect the M-CVaR optimization and lead to substantially
                    different allocations than do the traditional mean–variance
                    optimizations. They also found that the M-CVaR optimization would have been
                    beneficial during the 2008 financial crisis.Although practitioners are well aware that asset returns are not normally
                    distributed and that investor preferences often go beyond mean and variance, the
                    implications for portfolio choice are not well known.In a series of controlled traditional mean–variance optimizations
                    (MVOs) and mean-conditional value at risk (M-CVaR) optimizations, we gained
                    insights into the ramifications of skewness and kurtosis for optimal asset
                    allocations. In our first four scenarios, prior to running the optimizations, we
                    used the multivariate TLF distribution model to simulate a large number of
                    returns with appropriate variance, skewness, and kurtosis, which, in turn,
                    enabled us to more accurately measure the downside risk of a portfolio by using
                    the CVaR.In our first example, in which returns are symmetrically distributed and have
                    uniform tails, the MVO and the M-CVaR lead to the same results. When there are
                    varying levels of skewness and kurtosis in the opportunity set of assets, the
                    MVO and the M-CVaR lead to significantly different asset allocations. In
                    particular, the combination of a negative skewness and a fat tail has the
                    greatest impact on the optimal asset allocation weights. Intuitively, the M-CVaR
                    prefers assets with higher positive skewness, lower kurtosis, and lower
                    variance.Over the last 20 years, global high yield, U.S. REITs, U.S. TIPS, and value
                    stocks have had significant negative skewness, whereas non-U.S. government bonds
                    have had positive skewness. The kurtosis for global high yield, U.S. REITs, and
                    U.S. TIPS is higher than it is for other asset classes. In a 14-asset-class
                    bootstrapping analysis, the M-CVaR, relative to the MVO, leads to significantly
                    higher allocations to non-U.S. government bonds and U.S. nominal bonds and lower
                    allocations to global high yield, U.S. REITs, and commodities.An out-of-sample test showed that the M-CVaR outperformed the MVO in the
                    financial crisis of 2008, with excess gains ranging from 0.84 percentage point
                    to 1.44 percentage points across the efficient frontier. This outperformance
                    suggests that higher-moment information embedded in historical returns had some
                    predictive power in the crisis.Although we are just beginning to understand the impact of higher moments on
                    asset allocation policy and further study is needed, these optimizations drive
                    home a critical implication of modern portfolio theory: What matters is the
                    overall impact on the portfolio’s characteristics.
Journal: Financial Analysts Journal
Pages: 23-35
Issue: 2
Volume: 67
Year: 2011
Month: 3
X-DOI: 10.2469/faj.v67.n2.5
File-URL: http://hdl.handle.net/10.2469/faj.v67.n2.5
File-Format: text/html
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Author-Name: Steven L. Heston
Author-X-Name-First: Steven L.
Author-X-Name-Last: Heston
Author-Name: Robert A. Korajczyk
Author-X-Name-First: Robert A.
Author-X-Name-Last: Korajczyk
Author-Name: Ronnie Sadka
Author-X-Name-First: Ronnie
Author-X-Name-Last: Sadka
Author-Name: Lewis D. Thorson
Author-X-Name-First: Lewis D.
Author-X-Name-Last: Thorson
Title: Are You Trading Predictably?
Abstract: 
 The authors find predictable patterns in stock returns. Stocks whose relative
                    returns are high in a given half hour today exhibit similar outperformance in
                    the same half hour on subsequent days. The effect is stronger at both the
                    beginning and the end of the trading day. These results suggest that
                    strategically shifting the timing of trades can significantly reduce execution
                    costs for institutional traders.Anecdotal evidence suggests that some institutional traders concentrate trades at
                    particular times of the day. For example, index funds may execute
                    market-on-close orders to minimize tracking error relative to their benchmarks.
                    Active managers may choose to hand trades to the trading desk at particular
                    times of the day. In addition, trading algorithms that imply particular
                    time-of-day trading patterns under certain assumptions have been proposed. A
                    separate literature suggests that flows of funds to institutional managers are
                    autocorrelated and that institutional trading is highly persistent—that
                    is, institutional investment managers tend to buy or sell the same stocks on
                    successive days.These two observations (time-of-day trading patterns and autocorrelated fund
                    flows) suggest the existence of time-of-day patterns in both volume and order
                    imbalances. If these patterns were fully anticipated by traders, however, one
                    would not expect time-of-day patterns in stock prices. But we found persistent
                    patterns in stock returns: Stocks whose relative returns are high in a given
                    half hour today tend to exhibit similar outperformance in the same half hour on
                    subsequent days. Although the effect is stronger at the beginning and the end of
                    the trading day, it exists throughout the day. This periodicity is also stronger
                    for small-cap stocks, but it exists for both large and small companies. The
                    magnitude of the return pattern is sizable relative to several components of
                    transaction costs, including commissions and effective spreads.The return patterns that we documented are consistent with investors’
                    predictable trading patterns. At a minimum, randomizing trades, rather than
                    trading predictably, should help investors avoid buying high and selling low.
                    More strategically, shifting trades to certain periods can substantially reduce
                    execution costs for institutional traders.
Journal: Financial Analysts Journal
Pages: 36-44
Issue: 2
Volume: 67
Year: 2011
Month: 3
X-DOI: 10.2469/faj.v67.n2.6
File-URL: http://hdl.handle.net/10.2469/faj.v67.n2.6
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Author-Name: Larry Harris
Author-X-Name-First: Larry
Author-X-Name-Last: Harris
Title: The Increasing Need for Financial Analysis in Public Accounting Standards
Abstract: 
 The author discusses his views on an issue of interest to FAJ
                    readers.
Journal: Financial Analysts Journal
Pages: 6-9
Issue: 2
Volume: 67
Year: 2011
Month: 3
X-DOI: 10.2469/faj.v67.n2.7
File-URL: http://hdl.handle.net/10.2469/faj.v67.n2.7
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 80-80
Issue: 2
Volume: 67
Year: 2011
Month: 3
X-DOI: 10.2469/faj.v67.n2.8
File-URL: http://hdl.handle.net/10.2469/faj.v67.n2.8
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Author-Name: Clifford S. Asness
Author-X-Name-First: Clifford S.
Author-X-Name-Last: Asness
Author-Name: Roni Israelov
Author-X-Name-First: Roni
Author-X-Name-Last: Israelov
Author-Name: John M. Liew
Author-X-Name-First: John M.
Author-X-Name-Last: Liew
Title: International Diversification Works (Eventually)
Abstract: 
 Critics of international diversification observe that it does not protect
                    investors against short-term market crashes because markets become more
                    correlated during downturns. Although true, this observation misses the big
                    picture. Over longer horizons, underlying economic growth matters more than
                    short-lived panics with respect to returns, and international diversification
                    does an excellent job of protecting investors.Investors and financial economists have long debated the benefits of global
                    equity market diversification. Fans have argued that diversifying globally
                    reduces portfolio risk without harming long-term returns. Some critics have
                    countered that because markets become more correlated during downturns, most of
                    the diversification occurs on the upside, when it is not needed, and vanishes on
                    the downside, when it is needed most. A related and perhaps more distressing
                    observation is simply that markets tend to crash at the same time.In our study, we argued that those who dismiss diversification on the basis of
                    these critiques miss the bigger point. Long-term investors with planning
                    horizons measured in decades should not devote a great deal of anxiety to the
                    risk of common, short-term crashes. A much greater concern is a long, drawn-out
                    bear market, which can be significantly more damaging to investors’
                    wealth.Going back to 1950, we examined the benefits of diversification over long-term
                    holding periods by examining the real returns of 22 countries. We found evidence
                    that the observed co-skewness of markets is a short-term phenomenon. Over the
                    long run, markets do not tend to crash together.To understand the difference between the short- and long-term benefits of
                    diversification, we decomposed returns into two pieces: (1) a component arising
                    from multiple expansion and (2) a component arising from economic performance.
                    We found that short-term stock returns tend to be dominated by multiple
                    expansion, which is consistent with the idea that a sharp, systemic decline in
                    investors’ appetite for risk can explain why markets crash at the
                    same time. Over the long term, however, economic performance drives returns. We
                    showed that countries exhibit significant idiosyncratic variation in long-run
                    economic performance. Hence, country-specific (not global) long-run economic
                    performance is the most important determinant of long-run returns.At times, short-term investors may be justifiably disappointed by international
                    diversification, which does little to protect against systemic global panics.
                    International diversification, however, successfully protects long-term
                    investors from being overexposed to a country that has a lost decade (or two).
                    We should not allow investors’ short-term disappointment to dissuade
                    us from realizing the long-term benefits of international diversification.
Journal: Financial Analysts Journal
Pages: 24-38
Issue: 3
Volume: 67
Year: 2011
Month: 5
X-DOI: 10.2469/faj.v67.n3.1
File-URL: http://hdl.handle.net/10.2469/faj.v67.n3.1
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Author-Name: Richard Roll
Author-X-Name-First: Richard
Author-X-Name-Last: Roll
Title: “The Possible Misdiagnosis of a Crisis”: Author Response
Abstract: 
 This material comments on “The Possible Misdiagnosis of a
                    Crisis”.
Journal: Financial Analysts Journal
Pages: 13-14
Issue: 3
Volume: 67
Year: 2011
Month: 5
X-DOI: 10.2469/faj.v67.n3.10
File-URL: http://hdl.handle.net/10.2469/faj.v67.n3.10
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Author-Name: Noël Amenc
Author-X-Name-First: Noël
Author-X-Name-Last: Amenc
Author-Name: Felix Goltz
Author-X-Name-First: Felix
Author-X-Name-Last: Goltz
Author-Name: Abraham Lioui
Author-X-Name-First: Abraham
Author-X-Name-Last: Lioui
Title: Practitioner Portfolio Construction and Performance Measurement: Evidence from Europe
Abstract: 
 Responses to a survey of investment management practitioners in Europe show that
                    most practitioners are aware of key academic concepts in portfolio construction.
                    But they still resort to ad hoc heuristics when they construct
                    portfolios. Consideration of risk–return matters is less common in
                    performance evaluation than in portfolio construction. An economically
                    significant firm-size effect plays a role in the use of sophisticated (versus
                    unsophisticated) portfolio construction but not in performance measurement.We surveyed 229 investment management practitioners in Europe for information on
                    their methods of constructing portfolios and measuring performance. Our purpose
                    was to assess the impact of academic finance research on investment industry
                    practices. The responses show that most practitioners are well aware of key
                    academic concepts in portfolio construction and frequently consider
                    risk–return trade-offs. They often resort to ad hoc
                    heuristics, however, when they construct their portfolios. For example,
                    investment managers are aware of the importance of extreme risks, but the
                    instruments they use to measure them are inadequate. To deal with estimation
                    risk, practitioners use arbitrary weight restrictions rather than portfolio
                    construction methods that explicitly address estimation risk. Responses relating to measurement of ex post performance show
                    that risk–return considerations are less common in this area than in
                    portfolio construction. Extreme risks are hardly taken into account in
                    performance measurement, and adjustments for risk are crude. In general, practitioners use both sophisticated and unsophisticated techniques.
                    When we analyzed the response patterns to determine what drives the differences
                    in sophistication, we found an economically significant firm-size effect for
                    portfolio construction. That is, response patterns from large institutions are
                    markedly different from those from small institutions; small firms tend to use
                    less sophisticated tools than large firms use. For performance measurement, we
                    found a firm-size effect, but it is less pronounced than it is for portfolio
                    construction.In view of the current failure of the industry to adopt sophisticated measures,
                    one is compelled to wonder why investors do not demand better risk assessment in
                    portfolio construction and performance evaluation. Some would argue that greater
                    financial literacy of investors is key in improving matters; others would call
                    for external regulators to mandate the use of appropriate risk measures.
                    Although the evidence reported in this article does not allow us to take a
                    stance on that issue, we believe that ensuring a sufficient transfer of
                    knowledge about portfolio and risk management concepts from research results to
                    practice is a necessary condition for sound investment processes in the
                    industry.
Journal: Financial Analysts Journal
Pages: 39-50
Issue: 3
Volume: 67
Year: 2011
Month: 5
X-DOI: 10.2469/faj.v67.n3.2
File-URL: http://hdl.handle.net/10.2469/faj.v67.n3.2
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Title: Another Clue to Volatility
Abstract: 
 Financial economists treat volatility as a function of investors’
                    responses to new information. They generally presume that if an asset class is
                    more volatile in one geographical region than in another, it is attributable to
                    a difference in either the local version of the asset class or the economic
                    environment. A case study involving high-yield bond volatility in Europe and the
                    United States suggests that cultural differences may also contribute to
                    disparities in volatility.Despite considerable stabilization of financial markets since the recent
                    financial crisis, volatility remains a major worry of investors. Particularly
                    troubling is the absence of satisfactory explanations for cases of extreme
                    volatility. A prime example is the Dow Jones Industrial Average’s sudden
                    700-point drop on 6 May 2010. More than a dozen instances of mysterious plunges
                    in individual stocks have occurred, including a decline of nearly 90 percent in
                    the price of North Carolina electric utility Progress Energy in a matter of
                    seconds on 27 September 2010.Undeterred by the incomplete understanding of the causes of volatility, market
                    participants expend considerable energy in efforts to avoid or control it.
                    Investors diversify their portfolios and pay premium prices for assets that
                    deliver steady returns. Public companies try to avert big price swings in their
                    shares, using strategies that make good business sense as well as aggressive
                    interpretations of accounting rules that enable them to report unrealistically
                    stable earnings growth. Consultants evaluate money managers on the basis of
                    measures of return versus variance, and the managers, in turn, gear their
                    investment processes toward scoring well on such measures. Some managers cross
                    the line in their attempts to demonstrate high yet stable returns, as
                    demonstrated most dramatically by Bernard Madoff’s unparalleled Ponzi
                    scheme. Finally, regulators consider containing volatility to be part of their
                    natural mandate. Their attempted solutions, which include circuit breakers and
                    short-selling restrictions, have not always had salutary results.Basic analytical tools, including bond duration and earnings per share
                    variability, shed some light on the sources of volatility. Environmental
                    factors, such as the amplitude of business cycles, demonstrably play a role. In
                    such constructs as the capital asset pricing model and arbitrage pricing theory,
                    changes in objective information regarding such factors drive price movements
                    and hence volatility. Empirical research in behavioral finance, however, has
                    found greater volatility than information-based models predict. Behaviorists
                    have developed a keen interest in neuroscience, linking investors’
                    overreactions to the evolution of the human brain.Both the classical models based on a rational Homo economicus
                    and behavioral models claim universality. Wherever in the world investors may be
                    based, they are operating with brains of the same basic design. It would seem to
                    follow that interregional differences in the volatility of an asset class must
                    reflect differences in either the local variants of the asset class or the
                    investment setting rather than differences among the investors’ thought
                    processes.This inference is challenged by a case study involving the statistically
                    significant difference in volatility between the European and U.S. high-yield
                    bond markets. The researchers rejected several explanations typically offered by
                    market participants. These included differences in interest rate sensitivity,
                    quality mix, concentration in “fallen angels,” number of issues in
                    the index, average issue size, degree of issuer concentration, expected
                    recoveries on defaulted bonds, age of the market, economic stability, and
                    interest rate volatility.Another category of explanations emerged from discussions with syndicate and
                    sales professionals familiar with both the European and U.S. high-yield markets.
                    They maintained that European portfolio managers respond differently from their
                    U.S. counterparts when a credit problem comes to light. According to these
                    sources, European investors are more willing to sell at a substantial loss and
                    few of them seek to profit from market overreactions by scooping up bonds at
                    distressed prices. Observation of the marketplace cast doubt on the
                    informants’ further assertion that European high-yield investors either
                    lack experience in credit analysis or sell in the face of bad news without
                    undertaking thorough credit work.Alternatively, the tendency of some European managers to react swiftly might be
                    culturally instilled. Perhaps attitudes toward risk vary geographically
                    according to experience with such events as wars, natural disasters, massive
                    currency devaluations, nationalizations, and security price collapses that
                    follow speculative excesses. Furthermore, the narratives about such occurrences
                    passed down from generation to generation may be shaped by each nation’s
                    concepts of cause and effect, blame, and appropriate responses to hardship. In
                    summary, cultural factors are potentially one of the missing pieces in
                    explaining the persistent phenomenon of price volatility.
Journal: Financial Analysts Journal
Pages: 16-22
Issue: 3
Volume: 67
Year: 2011
Month: 5
X-DOI: 10.2469/faj.v67.n3.3
File-URL: http://hdl.handle.net/10.2469/faj.v67.n3.3
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Author-Name: Kwok-Yuen Ng
Author-X-Name-First: Kwok-Yuen
Author-X-Name-Last: Ng
Author-Name: Bruce D. Phelps
Author-X-Name-First: Bruce D.
Author-X-Name-Last: Phelps
Title: Capturing Credit Spread Premium
Abstract: 
 Despite high spread volatility, investment-grade credit portfolios have generated
                    an average annual spread premium (returns net of U.S. Treasury returns and
                    defaults) of 48 bps over the past 20 years. The authors show that relaxing a
                    common portfolio constraint that requires selling downgraded bonds would have
                    allowed investors to capture an average annual spread premium of 86 bps, with
                    similar risk. Thus, adopting a downgrade-tolerant credit benchmark could
                    generate a higher credit spread premium.At year-end 2009, despite a strong credit market rally, the average annual
                    reported excess return on duration-matched U.S. Treasuries since 1990 for the
                    Barclays Capital U.S. Corporate Investment Grade Index (IG Corporate Index) was
                    only 27 bps, with an annual standard deviation of 741 bps. For investors looking
                    to investment-grade credit bonds as a way to clip more coupons with modest
                    additional risk, this performance was not particularly attractive. In response,
                    investors began to ask whether they should abandon persistent allocations to
                    credit and rely on that asset class solely as a market-timing tool.We showed that investment-grade credit bonds, as proxied by the IG Corporate
                    Index, have generated a substantial average annual spread premium (i.e., returns
                    net of duration-matched Treasuries and defaults) of 48 bps over the past 20
                    years despite a high level of spread volatility. Investors willing to tolerate
                    the spread volatility may be able to harvest this spread premium over time.
                    Credit investors, however, could do better.To try to capture as much spread premium as possible, investors need to ensure
                    that their credit portfolios do not have self-imposed constraints that may
                    inadvertently restrict the realization of any premium. We showed that many
                    credit portfolios, which we modeled by using a common portfolio benchmark (the
                    IG Corporate Index), have various constraints that have historically hampered
                    their ability to capture a larger credit spread premium.We measured the cost of these constraints by constructing alternative credit
                    benchmarks and examining their realized spread premium from 1990 to 2009. In
                    particular, we found that a common portfolio constraint that requires investors
                    to sell bonds downgraded below investment grade has significant implications for
                    earning the spread premium. In fact, portfolios that are “downgrade
                    tolerant” would have allowed investors with a persistent credit
                    allocation to capture an annual spread premium of 86 bps, almost 80 percent
                    larger than that offered by the IG Corporate Index (48 bps), with similar risk.
                    Although these results are not guaranteed to recur over the next 20 years,
                    adopting a downgrade-tolerant credit benchmark may allow investors to capture
                    more credit spread premium in the future.
Journal: Financial Analysts Journal
Pages: 63-75
Issue: 3
Volume: 67
Year: 2011
Month: 5
X-DOI: 10.2469/faj.v67.n3.4
File-URL: http://hdl.handle.net/10.2469/faj.v67.n3.4
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Author-Name: Xiaoxia Lou
Author-X-Name-First: Xiaoxia
Author-X-Name-Last: Lou
Author-Name: Ronnie Sadka
Author-X-Name-First: Ronnie
Author-X-Name-Last: Sadka
Title: Liquidity Level or Liquidity Risk? Evidence from the Financial Crisis
Abstract: 
 Although 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.In our study, we highlighted the difference between liquidity level and liquidity
                    risk and showed that the latter is a better predictor of performance during a
                    crisis. We defined the level of a stock’s liquidity as the ability to
                    trade large quantities of its shares quickly and at low cost, on average. In
                    contrast, we defined the liquidity risk (beta) of a stock as the covariation of
                    its returns with unexpected changes in aggregate liquidity. The two measures
                    capture different attributes of a stock’s liquidity profile. For
                    example, liquidity level may be considered a mean effect, whereas liquidity beta
                    may signify a volatility or correlation effect. Although 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 than by their historical liquidity levels. Furthermore, stocks with
                    different historical levels of liquidity did not experience different returns
                    after controlling for liquidity risk. With some benefit of hindsight, these
                    results are perhaps not particularly surprising. After all, which stocks are
                    more likely to suffer during a liquidity crisis? We suggest that portfolio
                    managers should worry about liquid stocks with high liquidity risk because their
                    liquidity is likely to dry up during a crisis whereas the illiquid stocks will
                    continue to be illiquid. Liquidity beta offers a way to measure this type of
                    risk. Moreover, because variances are more persistent than means, liquidity beta
                    could provide more accurate out-of-sample signals for risk management than could
                    liquidity level. Finally, the U.S. SEC and the U.S. Commodity Futures Trading Commission recently
                    published a report on the “flash crash” of 6 May 2010. Once
                    again, large companies, such as Procter & Gamble and Accenture, were
                    among the most affected by that crisis, which lends our argument further
                    support. Because the correlation between stock liquidity variations has been
                    increasing over the past few decades, these results highlight the importance of
                    accounting for liquidity risk in risk management applications.
Journal: Financial Analysts Journal
Pages: 51-62
Issue: 3
Volume: 67
Year: 2011
Month: 5
X-DOI: 10.2469/faj.v67.n3.5
File-URL: http://hdl.handle.net/10.2469/faj.v67.n3.5
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Author-Name: Mitsuru Mizuno
Author-X-Name-First: Mitsuru
Author-X-Name-Last: Mizuno
Author-Name: Isaac T. Tabner
Author-X-Name-First: Isaac T.
Author-X-Name-Last: Tabner
Title: The Margin of Safety and Turning Points in House Prices: Observations from Three Developed Markets
Abstract: 
 Using quarterly data from 1960 (United Kingdom), 1963 (United States), and 1977
                    (Japan) through the second quarter (Q2) of 2010 (all three markets), the authors
                    examined long-run mean-reverting relationships between house prices and
                    inflation, disposable income, GDP, and rents. At the end of Q2 2010, U.S. prices
                    were below their mean-reverting levels and at the lower end of their historical
                    range. Equivalent U.K. and Japanese prices were at or slightly above their
                    mean-reverting levels. Using quarterly data from 1960 (for the United Kingdom), 1963 (for the United
                    States), and 1977 (for Japan, the Tokyo area) through Q2 2010 (all three
                    markets), we examined long-run mean-reverting relationships between new house
                    prices and inflation, disposable income, GDP, and rents. After adjusting for
                    estimated drift and trend coefficients, we found that over the period Q4
                    2006–Q2 2010, on the one hand, U.S. house prices moved from near the
                    top of their historical range toward the bottom relative to inflation,
                    disposable income, and GDP per capita. On the other hand, yields moved from near
                    the bottom to near the top of their historical range. By Q2 2010, the U.K.
                    market was at trend in relation to inflation and disposable income but slightly
                    above trend in relation to GDP per capita and yields. Japanese new house prices
                    were slightly above trend in relation to inflation, disposable income, and GDP
                    per capita but below trend relative to yields. Hence, for investors and
                    households contemplating the purchase of new homes at the end of Q2 2010, the
                    margin of safety was greatest in the U.S. market, close to historical averages
                    in the United Kingdom, and slightly below average in Japan. In terms of rational
                    expectations theory, U.S. prices were factoring in a lot of pessimism regarding
                    future income and per capita GDP growth, U.K. prices were neither particularly
                    pessimistic nor particularly optimistic, and Japanese prices appeared to be
                    factoring in mildly optimistic assumptions concerning income and economic
                    growth.Although prices in the United States and the United Kingdom appeared high by
                    historical standards immediately prior to the 2008 financial crisis, the
                    precrisis expansion was relatively moderate compared with the expansion
                    experienced in Japan between Q4 1990 and Q2 1991. In fact, Japanese prices
                    peaked at 79 percent, 62 percent, 58 percent, and 30 percent away from the
                    whole-sample-period trend values for, respectively, inflation, disposable
                    income, GDP, and yields. These percentages can be compared with equivalent
                    whole-sample deviations of 17 percent, 15 percent, 13 percent, and 21 percent
                    for the U.S. market and 33 percent, 36 percent, 34 percent, and 45 percent for
                    the U.K. market.A comparison of the three markets for new houses shows that the U.S. market has
                    the strongest mean-reverting tendencies relative to trends and also the most
                    statistically significant positive and negative trend coefficients. Furthermore,
                    deviations from trend appear to have a smaller range and standard deviation in
                    the U.S. market than in the other two markets for all the deflated house price
                    series and yields. The reason may be that the U.S. market faces fewer supply
                    constraints than the other two markets, where population density is much
                    greater; hence, the relatively greater price elasticity of supply in the U.S.
                    market has a more moderating effect on price expansions relative to the
                    underlying macroeconomy than it does in Japan and the United Kingdom.To speculate that house prices are to rise or fall indefinitely is to speculate
                    that per capita wealth will also rise or fall indefinitely. Given technological
                    advances, this assumption may not be unrealistic, but history has shown that
                    long-term trends in economic growth are punctuated by cyclical expansions and
                    contractions. For most people, housing investment provides a geared (levered)
                    but, in the medium term, imperfectly correlated exposure to economic growth.
                    Neglect of this final observation is liable to result in a failure to provide an
                    adequate margin of safety when making decisions on housing choice, investment,
                    and housing policy. Despite apparent extremes of relative over- and
                    undervaluation, no instances occurred in the past sample periods when prices
                    failed to revert to either the rolling or the whole-sample trend in any of the
                    three markets studied.
Journal: Financial Analysts Journal
Pages: 76-93
Issue: 3
Volume: 67
Year: 2011
Month: 5
X-DOI: 10.2469/faj.v67.n3.6
File-URL: http://hdl.handle.net/10.2469/faj.v67.n3.6
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Author-Name: Robert Litterman
Author-X-Name-First: Robert
Author-X-Name-Last: Litterman
Title: Who Should Hedge Tail Risk?
Abstract: 
 The executive editor discusses his views on an issue of interest to
                        FAJ readers.
Journal: Financial Analysts Journal
Pages: 6-11
Issue: 3
Volume: 67
Year: 2011
Month: 5
X-DOI: 10.2469/faj.v67.n3.7
File-URL: http://hdl.handle.net/10.2469/faj.v67.n3.7
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 3
Volume: 67
Year: 2011
Month: 5
X-DOI: 10.2469/faj.v67.n3.8
File-URL: http://hdl.handle.net/10.2469/faj.v67.n3.8
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Author-Name: Paul D. Kaplan
Author-X-Name-First: Paul D.
Author-X-Name-Last: Kaplan
Title: “The Possible Misdiagnosis of a Crisis”: A Comment
Abstract: 
 This material comments on “The Possible Misdiagnosis of a
                    Crisis’.
Journal: Financial Analysts Journal
Pages: 13-13
Issue: 3
Volume: 67
Year: 2011
Month: 5
X-DOI: 10.2469/faj.v67.n3.9
File-URL: http://hdl.handle.net/10.2469/faj.v67.n3.9
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Author-Name: Scott Willenbrock
Author-X-Name-First: Scott
Author-X-Name-Last: Willenbrock
Title: Diversification Return, Portfolio Rebalancing, and the Commodity Return Puzzle
Abstract: 
 Diversification return is an incremental return earned by a rebalanced portfolio of assets.
     The author argues that the underlying source of the diversification return is the rebalancing;
     in contrast, the incremental return of a buy-and-hold portfolio is driven by the fact that the
     best-performing assets become a greater fraction of the portfolio. On the basis of these
     findings, the author resolves two aspects of a puzzle associated with Gorton and
     Rouwenhorst’s index of commodity futures.The term diversification return was coined in the context of a rebalanced
     portfolio—that is, a portfolio with a constant percentage invested in each asset. The
     contribution of each asset to the portfolio’s compound return, dubbed the return
      contribution, exceeds the asset’s compound return by an incremental amount
     called the diversification return. The portfolio’s diversification return is the weighted
     average of the assets’ diversification returns.One is led to wonder whether the diversification return has two separate, perhaps related,
     aspects: diversification and rebalancing. Several authors have argued in favor of this point of
     view to various degrees. For example, some have regarded a portfolio’s diversification
     return as the difference between its geometric average return and the (weighted) geometric
     average returns of its individual assets, regardless of whether the weights are constant.In this article, I revisited the issue of diversification return and portfolio rebalancing. I
     showed that diversification return can be precisely defined in the context of a rebalanced
     portfolio. I argued that the reduction in variance inherent in a diversified portfolio is a
     necessary, but not sufficient, condition to earning a diversification return.I clarified the underlying source of diversification return. The diversification return is
     usually expressed in terms of the difference between the variance of an asset and its
     covariance with the portfolio. Although this approach is elegant and useful, it masks the fact
     that the diversification return stems from selling assets that have appreciated in relative
     value and buying assets that have declined in relative value, as measured by their weights in
     the portfolio.I also analyzed a buy-and-hold portfolio. Although such a portfolio can have no
     diversification return, it can have an incremental return relative to the initially weighted
     average of the compound returns of the assets. This result stems from the fact that, over time,
     a buy-and-hold portfolio will increase the weights of the best-performing assets. This result,
     however, also changes the risk profile of the portfolio. In contrast, an investor earns a
     diversification return in a rebalanced portfolio while maintaining a constant risk profile.Finally, I used these results to resolve two aspects of the commodity return puzzle. I argued
     that the excess return (above the risk-free rate) of a commodity futures index, which is
     rebalanced monthly, can be largely accounted for by the diversification return. If the index is
     not rebalanced, however, it generates a significant incremental excess return as a buy-and-hold
     portfolio because the compound returns of the underlying commodity futures in the index have a
     wide range of values. Thus, no contradiction exists; the commodity futures index generates an
     excess return in both its rebalanced and unrebalanced incarnations but for totally different
     and unrelated reasons.
Journal: Financial Analysts Journal
Pages: 42-49
Issue: 4
Volume: 67
Year: 2011
Month: 7
X-DOI: 10.2469/faj.v67.n4.1
File-URL: http://hdl.handle.net/10.2469/faj.v67.n4.1
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Author-Name: Charles Cao
Author-X-Name-First: Charles
Author-X-Name-Last: Cao
Author-Name: Fan Yu
Author-X-Name-First: Fan
Author-X-Name-Last: Yu
Author-Name: Zhaodong Zhong
Author-X-Name-First: Zhaodong
Author-X-Name-Last: Zhong
Title: Pricing Credit Default Swaps with Option-Implied Volatility
Abstract: 
 Using the industry benchmark CreditGrades model to analyze credit default swap (CDS) spreads
     across a large number of companies during the 2007–09 credit crisis, the authors
     demonstrate that the performance of the model can be significantly improved by calibrating it
     with option-implied volatility rather than with historical volatility. Moreover, the advantage
     of using option-implied volatility is greater among companies with more volatile CDS spreads,
     more actively traded options, and lower credit ratings.Structural credit risk models are important tools in relative value trading strategies
     because they use equity market information to price such credit-risky securities as corporate
     bonds and credit default swaps (CDSs). One of the most important inputs for such models is
     equity volatility, which can be estimated from either historical returns or equity option
     prices. We examined the relative performance of historical versus option-implied volatility in
     CDS pricing through the lens of an industry benchmark model called CreditGrades, which was
     jointly developed by the RiskMetrics Group, J.P. Morgan, Goldman Sachs, and Deutsche Bank in
     2002.Using CDS and options market data on 332 companies over January 2007–October 2009
     (which encompasses the recent credit crisis), we found that option-implied volatility generally
     dominates historical volatility in both in-sample and out-of-sample pricing performance. This
     finding is robust to the horizon of the historical volatility estimator and the initial burn-in
     period for calibrating the CreditGrades model. It also remains qualitatively unchanged during
     the earlier and less chaotic sample period of 2001–2004.Perhaps more interestingly, we identified significant cross-sectional variations in such
     relative performance. For instance, option-implied volatility provides much more added value in
     terms of improved CDS pricing performance when the company in question has a lower credit
     rating, a more volatile CDS spread, and larger options-trading volume. Our interpretation is
     that these characteristics are associated with a higher signal-to-noise ratio of options market
     information.Our findings are important to market participants who need to monitor their credit risk
     exposures constantly. The improvement in pricing performance is likely to result in fewer false
     trading signals and superior profitability for capital structure arbitrageurs. On a more
     fundamental level, our findings suggest that having forward-looking inputs from the market
     could be as important as having the right model for pricing credit risk.
Journal: Financial Analysts Journal
Pages: 67-76
Issue: 4
Volume: 67
Year: 2011
Month: 7
X-DOI: 10.2469/faj.v67.n4.2
File-URL: http://hdl.handle.net/10.2469/faj.v67.n4.2
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Author-Name: Charles D. Ellis
Author-X-Name-First: Charles D.
Author-X-Name-Last: Ellis
Title: The Winners’ Game
Abstract: 
 Practitioners of the investment management profession are underperforming for their
          clients and for their profession because of three errors: defining their mission as
          “beating the market,” allowing the values of their profession to be eclipsed
          by the economics of the business, and not providing much-needed investment counseling. The
          solution is to incorporate investment counseling into the heart of their
          client–manager relationship.Practitioners of the investment management profession, despite their manifest talents and
          notoriously hard work, risk underperforming for their clients and for themselves because
          of three errors—two errors of commission and one error of omission.The first error of commission is to define our professional role as beating the market.
          Increasingly extensive data show that markets have changed and most managers are not
          succeeding at this task.The second error of commission is that the values of our profession are increasingly
          eclipsed by the profoundly different disciplines of our business. Significantly, because
          investors can obtain market-matching index funds at very low fees (less than 10 bps), what
          investors really buy from active managers is risk-adjusted incremental returns. Therefore,
          we need to recognize a daunting reality: 1 percent fees as a percentage of assets equals
          over 10 percent of returns and 100 percent of incremental, risk-adjusted fees. This is not
          an easily defended position, particularly if we define our mission as
          “beat-the-market performance.”Our third and most important error is an error of omission. Investors make repetitive
          mistakes that investment professionals could easily help them avoid by providing sensible
          investment counseling as part—ideally the lead part—of the overall
          relationship.Incorporating investment counseling into the heart of the client–manager
          relationship greatly increases the chances for good results for the client and
          professional satisfaction for the manager and, therefore, longer-lasting and better
          business for investment managers.
Journal: Financial Analysts Journal
Pages: 11-17
Issue: 4
Volume: 67
Year: 2011
Month: 7
X-DOI: 10.2469/faj.v67.n4.3
File-URL: http://hdl.handle.net/10.2469/faj.v67.n4.3
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Author-Name: Boris Groysberg
Author-X-Name-First: Boris
Author-X-Name-Last: Groysberg
Author-Name: Paul Healy
Author-X-Name-First: Paul
Author-X-Name-Last: Healy
Author-Name: Nitin Nohria
Author-X-Name-First: Nitin
Author-X-Name-Last: Nohria
Author-Name: George Serafeim
Author-X-Name-First: George
Author-X-Name-Last: Serafeim
Title: What Factors Drive Analyst Forecasts?
Abstract: 
 Using survey data to judge how analyst forecasts are related to evaluations of
     companies’ industry competitiveness, strategic choices, and internal capabilities, the
     authors found that analyst forecasts are associated with many of the factors that money
     managers rate as important in their assessments of analyst contributions. They also found wide
     variation in ratings consistency across variables among analysts covering the same company. On
     average, consistency is higher for sell-side analysts than for buy-side analysts. Although extensive research has been conducted on analysts’ earnings forecasts and
     recommendations, relatively little has been written about the factors that underlie them. In
     our study, we examined which industry, leadership, and company factors are related to
     analysts’ forecasts of financial and stock performance. We also examined whether analysts
     covering the same company make consistent assessments of its industry, leadership, and company
     capabilities.To study these questions, we used data from a survey of 967 analysts who rated 837 companies
     on their projected future performance, industry economics, company capabilities, and
     leadership. Analysts were asked to provide forecasts of growth in revenues, earnings, and stock
     price, as well as gross margins, for up to three companies they covered. For each company, they
     were also asked to rate industry, company, and leadership factors that prior research suggests
     influence future performance. These factors include the competitiveness and growth of each
     company’s industry, whether it competes primarily on the basis of innovation or price,
     its strategy execution and communication, its innovativeness, existing financial resources, the
     quality of its top management, whether management sets high performance standards, and its
     governance.We found a strong relationship between analysts’ forecasts of a company’s
     performance and their assessments of its industry growth, industry competition, quality of its
     management, commitment to high performance expectations, ability to execute strategy, and
     innovation. We found that several factors are generally unimportant, including governance,
     transparent strategy communication (especially for buy-side analysts), competition via superior
     products/services, financial strength, and understanding one’s competitors.Considerable variation in ratings consistency exists across factors among analysts who cover
     the same company. Analyst ratings are relatively more consistent for company revenue forecasts,
     balance sheet strength, strategy execution, and strategy communication than for industry
     competitiveness, forecasted stock appreciation, low-price strategy, and understanding
     one’s competitors. Consistency is significantly higher for sell-side analysts than for
     their buy-side peers, perhaps reflecting sell-side pressure to herd. Finally, we found no
     evidence that analysts are more consistent on financial forecast factors than on internal
     capability factors.
Journal: Financial Analysts Journal
Pages: 18-29
Issue: 4
Volume: 67
Year: 2011
Month: 7
X-DOI: 10.2469/faj.v67.n4.4
File-URL: http://hdl.handle.net/10.2469/faj.v67.n4.4
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Author-Name: Xi Li
Author-X-Name-First: Xi
Author-X-Name-Last: Li
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: The Limits to Arbitrage Revisited: The Accrual and Asset Growth Anomalies
Abstract: 
 Using idiosyncratic volatility as a proxy for arbitrage costs, the authors found that the
     highly publicized accrual and asset growth anomalies exist because of high barriers to
     arbitrage, occurring predominantly in the universe of stocks with higher arbitrage risks.
     Therefore, investors who seek to profit from the accrual and asset growth anomalies must bear
     greater uncertainty in outcomes than was previously understood.Recent research has examined the viability of such simple, fundamental anomalies as accruals
     and asset growth. For the asset growth effect, research findings generally suggest that periods
     of significant asset expansion or capital expenditures tend to be followed by periods of
     negative abnormal stock returns. A negative relationship between accruals and subsequent stock
     returns has also been found to exist, which suggests that company managers seek to manage
     earnings in the short term through discretionary accruals.A central question for informed practitioners concerns the extent to which various alpha
     signals can be effectively used to generate trading profits. In a perfect world, the arbitrage
     risk arising from the lack of close substitutes can be completely hedged away; thus, any
     investment signal with a link to excess returns can generate real trading profits. In reality,
     however, arbitrageurs are unable to fully hedge away all risks associated with a perfect
     arbitrage.In our study, we focused on the risks of arbitraging the well-known accrual and asset growth
     effects. We found that the mispricing associated with these two anomalies is largely driven by
     investor demands for greater compensation for bearing increased arbitrage risk. In particular,
     we examined whether the highly publicized accrual and asset growth anomalies exist because of
     mispricing associated with high barriers to arbitrage arising from a lack of close substitutes.
     Using idiosyncratic volatility as a proxy for these arbitrage costs, we found that both
     anomalies exist predominantly in the universe of stocks with high idiosyncratic volatility.
     Therefore, investors who seek to profit from the accrual and asset growth anomalies must bear
     greater uncertainty in outcomes than was previously understood. This uncertainty comes in the
     form of high idiosyncratic risk, which raises costs and hinders the profitable arbitrage of
     these two anomalous effects.We contribute to the literature by showing that the arbitrage risk arising from the lack of
     close substitutes can create significant limits to arbitrage for investors who seek to reap
     profits from asset mispricing. Investors may be unable to outperform the market on an
     after-cost basis even if seemingly significant mispricings are identified and persist over
     time. Most significantly, our findings highlight the importance of thoroughly investigating the
     arbitrage risk arising from the lack of close substitutes when exploring and implementing alpha
     signals. Our straightforward methodology could be a useful approach for practitioners who wish
     to verify the realistic opportunities to profit from an array of identified investment
     signals.Editor’s Note: Rodney N. Sullivan, CFA, is editor of the
       Financial Analysts Journal. He recused himself from the referee and
      acceptance processes and took no part in the scheduling and placement of this article. See the
       FAJ policies section of cfapubs.org for more information.
Journal: Financial Analysts Journal
Pages: 50-66
Issue: 4
Volume: 67
Year: 2011
Month: 7
X-DOI: 10.2469/faj.v67.n4.5
File-URL: http://hdl.handle.net/10.2469/faj.v67.n4.5
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Author-Name: James D. Peterson
Author-X-Name-First: James D.
Author-X-Name-Last: Peterson
Author-Name: Michael J. Iachini
Author-X-Name-First: Michael J.
Author-X-Name-Last: Iachini
Author-Name: Wynce Lam
Author-X-Name-First: Wynce
Author-X-Name-Last: Lam
Title: Identifying Characteristics to Predict Separately Managed Account Performance
Abstract: 
 The authors analyzed a large sample of domestic equity separately managed accounts over the
     1991–2009 period and found evidence that manager skill persists. They also found that
     managers who were more active had better returns, and they documented a strong negative
     relationship between assets under management and future performance, even for large-cap
     strategies. Large cash inflows and a high number of accounts under management hindered
     subsequent performance for small-cap strategies.The purpose of this study was to identify characteristics that help predict the performance
     of separately managed accounts (SMAs), also known as separate accounts. Although numerous
     studies have been conducted on the topic of explaining or predicting mutual fund returns, far
     less research has been carried out on explaining or predicting SMA returns.Previous studies that used SMA return data can generally be grouped into three areas of
     emphasis. First, several papers examined performance and performance persistence. The second
     group consists of studies of the relationship between asset flow and SMA performance. Third,
     SMA data have been used to study performance subsequent to selection and termination decisions
     by plan sponsors. We believe ours is the first broad-based study to focus on identifying the
     predictive characteristics of SMA returns.As in many of the studies that use SMA return data, we obtained separate account data from
     Informa Investment Solutions’ PSN Investment Manager Database. The PSN database is a
     comprehensive, global database consisting of approximately 2,000 organizations, representing
     more than 10,000 investment strategies. We focused on domestic equity strategies because of
     their popularity in the marketplace and the relative ease with which they can be categorized
     into investment styles. The PSN database’s U.S. Equity Universe was launched in 1984, but
     it has been survivorship-bias free since 1991; therefore, our analysis of separate account
     returns covers 1991–2009.Our analysis of domestic equity SMA returns suggests that manager skill persists. We used two
     measures that serve as proxies for the level of active management: manager selectivity and
     portfolio turnover (although turnover may consist of both information- and
     non-information-based trading activity). We measured manager selectivity as a function of the
     regression R2, and it is a returns-based proxy for the
     holdings-based measure of “active share.” R2 is the
     proportion of the return variance that is explained by the regression, so 1 –
      R2 is a measure of manager selectivity. Our results indicate that
     manager selectivity is positively correlated with subsequent returns. In addition, we found
     that portfolio turnover is positively related to subsequent returns; this effect, however,
     appears to be driven by managers implementing a momentum strategy.Consistent with the argument that having more assets under management in a strategy results
     in diminishing returns, we found that assets under management are negatively related to
     subsequent performance. Interestingly, this result applies even to large-cap strategies, which
     contrasts with the results of other researchers who found that fund size affects subsequent
     mutual fund performance only for small-cap growth funds. Large cash inflows and a large number
     of accounts under management also appear to hinder performance, but these effects appear to be
     limited to small-cap strategies.
Journal: Financial Analysts Journal
Pages: 30-40
Issue: 4
Volume: 67
Year: 2011
Month: 7
X-DOI: 10.2469/faj.v67.n4.6
File-URL: http://hdl.handle.net/10.2469/faj.v67.n4.6
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Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Title: Alpha Orbits
Abstract: 
 The author discusses his views on an issue of interest to FAJ readers.
Journal: Financial Analysts Journal
Pages: 4-7
Issue: 4
Volume: 67
Year: 2011
Month: 7
X-DOI: 10.2469/faj.v67.n4.7
File-URL: http://hdl.handle.net/10.2469/faj.v67.n4.7
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Author-Name: Ben Giele
Author-X-Name-First: Ben
Author-X-Name-Last: Giele
Title: “The Possible Misdiagnosis of a Crisis”: A Comment
Abstract: 
 This material comments on “The Possible Misdiagnosis of a Crisis” (March/April 2011).
Journal: Financial Analysts Journal
Pages: 8-8
Issue: 4
Volume: 67
Year: 2011
Month: 7
X-DOI: 10.2469/faj.v67.n4.8
File-URL: http://hdl.handle.net/10.2469/faj.v67.n4.8
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 80-80
Issue: 4
Volume: 67
Year: 2011
Month: 7
X-DOI: 10.2469/faj.v67.n4.9
File-URL: http://hdl.handle.net/10.2469/faj.v67.n4.9
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Author-Name: Jose Menchero
Author-X-Name-First: Jose
Author-X-Name-Last: Menchero
Author-Name: Andrei Morozov
Author-X-Name-First: Andrei
Author-X-Name-Last: Morozov
Title: Decomposing Global Equity Cross-Sectional Volatility
Abstract: 
 The authors present an exact methodology for decomposing cross-sectional volatility into
     contributions from various factors. Treating country, industry, and style factors equally, they
     used their framework to investigate several relevant issues in the global equity markets,
     including the importance of country versus industry, emerging markets versus developed markets,
     and the strength of style factors vis-à-vis country and industry factors.Cross-sectional volatility (CSV) represents the degree of return dispersion within a universe
     of stocks and is computed as the standard deviation of returns over a single period. CSV is
     critical because it represents the opportunity to outperform a benchmark. On the one hand, if
     dispersion is small, all stocks behave similarly and security selection is of limited value. On
     the other hand, if dispersion is large, portfolio managers can add significant value by
     overweighting outperformers and underweighting underperformers.In this article, we present an exact methodology for decomposing cross-sectional volatility.
     We show that the contribution of an individual factor to CSV is given by the product of the
     factor return, the cross-sectional standard deviation of the factor exposures, and the
     cross-sectional correlation between the factor exposures and stock returns. Our approach treats
     country, industry, and style factors equally and enables one to identify the main drivers of
     global equity returns. We constructed a global factor model consisting of 48 country factors,
     24 industry factors, and 8 style factors. We used our framework to investigate the relative
     importance of these factors over 1994–2010.We found that country factors dominated industry factors over 1994–1999, whereas
     industry factors surpassed country factors over 2000–2003. Since 2004, industry factors
     and country factors have been roughly equally important, with country factors perhaps retaining
     a slight edge. Surprisingly, style factors dominated both industry factors and country factors
     in the aftermath of the internet bubble (2000–2004), as well as during the financial
     crisis of 2008–2009.In addition, we used our methodology to investigate the relative importance of emerging
     markets vis-à-vis developed markets. We found that developed markets dominated emerging
     markets over most of the sample history, although the situation reversed over
     2007–2009.We also drilled into each category of factors to identify the individual factors driving the
     CSV contributions. For industry factors, we found that the semiconductor industry was
     particularly strong during the internet bubble period whereas the energy industry was dominant
     over 2005–2010. For style factors, we found that the most important factor was usually
     volatility, which represents a good proxy for market beta. The contribution of the volatility
     factor to CSV was particularly strong in times of financial turmoil, such as in 2001 and
     2009.Furthermore, we tested our results for robustness by considering different models with
     varying numbers of industry or style factors. In general, we found that our results are quite
     robust, with reasonable variations in factor structure leading to only small changes in CSV
     contributions.Finally, we generalized our methodology to investigate the main drivers of root mean squared
     (RMS) returns, which are more relevant for absolute return managers. We found that the world
     factor generally makes significant contributions to RMS returns. In fact, during the financial
     crisis of 2008–2009, the world factor was by far the main driver of RMS returns.
Journal: Financial Analysts Journal
Pages: 58-68
Issue: 5
Volume: 67
Year: 2011
Month: 9
X-DOI: 10.2469/faj.v67.n5.1
File-URL: http://hdl.handle.net/10.2469/faj.v67.n5.1
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Author-Name: Donald J. Smith
Author-X-Name-First: Donald J.
Author-X-Name-Last: Smith
Title: Hidden Debt: From Enron’s Commodity Prepays to Lehman’s Repo 105s
Abstract: 
 Enron Corporation’s commodity prepays and Lehman Brothers’ Repo 105s are
          recent examples of hidden debt intended to improve the appearance of a company’s
          financial condition. Enron used derivatives to “transform” cash flow from
          financing to cash flow from operations; Lehman used sale-repurchase (repo) agreements to
          remove debt from its balance sheet for dates surrounding quarterly reporting periods. Both
          tactics relied on external auditors’ narrowly focusing on internal procedures and
          accounting rules. Companies have historically used a variety of means to reduce reported financial
          leverage. This article demonstrates two new methods—Enron Corporation’s
          commodity prepays and Lehman Brothers’ Repo 105s—and suggests some
          improvements in financial reporting. Enron used derivatives to “transform”
          cash flow from financing into cash flow from operations. Lehman used sale-repurchase
          (repo) agreements to reduce its recognized debt for dates surrounding quarterly reporting
          periods. Their outside auditors—Arthur Andersen and Ernst & Young,
          respectively—were aware of these activities but focused narrowly on internal
          procedures and accounting rules and did not deter the misrepresentations to investors.
          Analysts looking at only the (audited) financials had no idea of Enron’s or
          Lehman’s true financial condition prior to their bankruptcies.Enron used trilateral commodity prepays to borrow funds from banks without recognizing
          the liability as debt on the balance sheet. The role of the third party in the structure
          was to provide the appearance of separate transactions between unrelated
          entities. A bank subsidiary, typically a shell company, entered a commodity prepay
          transaction with Enron. The bank subsidiary made a payment in cash on Day 0 for the future
          delivery, on Day T, of some commodity (e.g., natural gas). Separately,
          the bank agreed to sell the same natural gas back to Enron on Day T,
          receiving the future spot price. In addition, the bank and Enron entered a commodity swap,
          thereby eliminating the price risk. Enron agreed to pay the bank the preset forward price
          on the natural gas, and the bank paid the future spot price. When combined, the
          transactions produced a simple cash payment on Day 0 and a repayment on Day
            T that included interest. The trilateral nature of the deal, however,
          “allowed” Enron to report the cash receipt as arising from operations and not
          from financing.The Roach Report on the Enron bankruptcy stated that the company had about $10 billion in
          recognized debt on its books in 2000 and about $4 billion in unrecognized prepays. If the
          commodity prepays were correctly accounted for, debt liabilities would have gone up by 40
          percent and cash flow from operations would have been halved. Arthur Andersen,
          Enron’s external auditor, not only was aware of the commodity prepay program but
          also offered guidance on the rules so that the transactions would not have to be
          considered loans (and the cash received would not have to be considered as arising from
          debt financing).A repo is the functional equivalent of a collateralized loan. Standard repos are
          accounted for as secured financing: The collateral remains an asset on the balance sheet
          of the borrower, and the amount of the loan becomes the debt liability. Paragraph 218 of
          Statement of Financial Accounting Standards No. 140, however, opens the door to an
          exception when the amount of the “haircut” (the difference between the market
          value of the security and the amount of the repo borrowing) is larger than the normal
          1–2 percent. Lehman used Paragraph 218 to build its Repo 105 program. When it
          entered a repo and gave a larger-than-normal haircut (at least 5 percent), it would
          “have to” characterize the transaction as a sale of inventory and forward
          agreement to repurchase. Conveniently, these exceptions to the norm typically spanned a
          quarterly reporting period, often by no more than a couple days on either side.Lehman used Repo 105s in massive amounts to reduce its leverage ratio in 2008 as the
          global financial crisis worsened, especially after the collapse of Bear Stearns in March.
          The Valukas Report on the Lehman bankruptcy stated that Lehman removed over $50 billion
          from its balance sheet at the end of the fiscal quarter in May 2008, which reduced net
          leverage to 12.1. If the repo financings had instead been treated as secured borrowings,
          net leverage would have been 13.9. Ernst & Young, Lehman’s auditor, was aware of
          the Repo 105 program. It surely should have insisted that accounting for repos in two
          drastically different manners depending of the relative degree of overcollateralization is
          something that should be conveyed to investors, either in a footnote or in some
          accompanying statement.We see in these examples more than the usual “airbrushing” of the snapshot of
          the company on a reporting date; we see outright “photo-shopping.” Suggested
          improvements to financial reporting include increased use of averages, ranges, and
          standard deviations for key variables and a more principles-based approach to auditing.
          Instead of just affirming that the financials are in accordance with generally accepted
          accounting standards, auditors should state that, to the best of their knowledge, the
          statements reflect true financial condition.
Journal: Financial Analysts Journal
Pages: 15-22
Issue: 5
Volume: 67
Year: 2011
Month: 9
X-DOI: 10.2469/faj.v67.n5.2
File-URL: http://hdl.handle.net/10.2469/faj.v67.n5.2
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Author-Name: Roni Israelov
Author-X-Name-First: Roni
Author-X-Name-Last: Israelov
Author-Name: Michael Katz
Author-X-Name-First: Michael
Author-X-Name-Last: Katz
Title: To Trade or Not to Trade? Informed Trading with Short-Term Signals for Long-Term Investors
Abstract: 
 When long-term investors trade slowly changing portfolios, they are not particularly
     sensitive to when they should place or modify their bets. Short-term information can be used to
     guide investors on how to time their trades. Strategic trade modification provides exposure to
     short-term signals without imposing additional transaction costs or capacity limits. Long-term
     investors should not ignore short-term information simply because it is too expensive to trade
     on.When a long-term investor trades a slowly changing portfolio, she is not particularly
     sensitive to when she should place or change her bet. The value of the embedded optionality
     provided by this flexibility may be extracted by using short-term information to choose when to
     trade (i.e., exercise the option).In this article, we show that strategic trade modification provides exposure to short-term
     signals without having to pay additional transaction costs and without capacity limits. We
     implement a parsimonious informed-trading algorithm on real and simulated
     portfolios to illustrate its effect on portfolio performance. The algorithm delays long-term
     trades when they are in conflict with the short-term information about the direction of asset
     returns.We show that realistic portfolios can achieve a 5 percent exposure to a short-term signal. In
     addition to providing a desirable exposure to the short-term signal, informed trading has two
     additional benefits: reduced transaction costs and increased exposure to the long-term view.
     Because all views tend to revert with some probability, trading less often reduces transaction
     costs. Informed trading allows investors to strategically select the time and the assets to
     trade aggressively, which reduces transaction costs that arise from unprofitable round-trips.
     Second, this baseline reduction in transaction costs makes trading more aggressively profitable
     for the investor, on average. In turn, more aggressive trading results in a portfolio that has
     higher exposure not only to the short-term signals but also to the long-term view. Long-term
     investors should no longer ignore short-term information just because it is too expensive to
     trade on.
Journal: Financial Analysts Journal
Pages: 23-36
Issue: 5
Volume: 67
Year: 2011
Month: 9
X-DOI: 10.2469/faj.v67.n5.3
File-URL: http://hdl.handle.net/10.2469/faj.v67.n5.3
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “Spending Retirement on Planet Vulcan:
            The Impact of Longevity Risk Aversion on Optimal Withdrawal Rates,” by
          Moshe A. Milevsky and Huaxiong Huang, in the March/April 2011 issue of the
            Financial Analysts Journal.
Journal: Financial Analysts Journal
Pages: 12-
Issue: 5
Volume: 67
Year: 2011
Month: 9
X-DOI: 10.2469/faj.v67.n5.4
File-URL: http://hdl.handle.net/10.2469/faj.v67.n5.4
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Author-Name: Tzee-man Chow
Author-X-Name-First: Tzee-man
Author-X-Name-Last: Chow
Author-Name: Jason Hsu
Author-X-Name-First: Jason
Author-X-Name-Last: Hsu
Author-Name: Vitali Kalesnik
Author-X-Name-First: Vitali
Author-X-Name-Last: Kalesnik
Author-Name: Bryce Little
Author-X-Name-First: Bryce
Author-X-Name-Last: Little
Title: A Survey of Alternative Equity Index Strategies
Abstract: 
 After reviewing the methodologies behind the more popular quantitative investment strategies
     offered to investors as passive equity indices, the authors devised an integrated evaluation
     framework. They found that the strategies outperform their cap-weighted counterparts largely
     owing to exposure to value and size factors. Almost entirely spanned by market, value, and size
     factors, any one of these strategies can be mimicked by combinations of the others. Thus,
     implementation cost is a better evaluation criterion than returns.A number of quantitative investment strategies (informally designated alternative betas) are
     being offered to investors as passive, “more-efficient” alternatives to standard
     market-capitalization-weighted indices. This article provides a review of the methodologies and
     investment beliefs behind several of the more popular alternative betas and provides an
     integrated framework for understanding the linkage between them. Some of these strategies, such
     as equal weighting and minimum-variance, have been around for decades but have only recently
     garnered meaningful interest, whereas other approaches are relatively new entrants to the world
     of passive investing. U.S. and global equity data were used in simulated horse races between
     the various investment strategies. The Carhart four-factor and Fama–French three-factor
     models were used to measure the risk-adjusted alphas of the alternative betas. The alternative
     betas do outperform their cap-weighted counterparts, but the outperformances are driven largely
     by exposure to value and size factors. Given this insight, these strategies are similar to
     naive equal weighting and are, in fact, similar to each other; one alternative beta can often
     be mimicked by combinations of others. Nonetheless, the alternative betas represent efficient
     and potentially low-cost means to access the value and size premiums because traditional style
     indices tend to have negative Fama–French alpha and direct replication of
     Fama–French factors is often impractical and costly. At the same time, the excess
     turnover, reduced portfolio liquidity, and reduced investment capacity in addition to the fees
     and expenses associated with managing a more complex index portfolio strategy may erode too
     much of the anticipated performance advantage. Therefore, in choosing an alternative equity
     index, implementation cost should be an important evaluation criterion.Editor’s Note: The authors are affiliated with Research Affiliates, which has
       a commercial interest in Research Affiliates Fundamental Index.
Journal: Financial Analysts Journal
Pages: 37-57
Issue: 5
Volume: 67
Year: 2011
Month: 9
X-DOI: 10.2469/faj.v67.n5.5
File-URL: http://hdl.handle.net/10.2469/faj.v67.n5.5
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Author-Name: Robert Litterman
Author-X-Name-First: Robert
Author-X-Name-Last: Litterman
Title: Pricing Climate Change Risk Appropriately
Abstract: 
 The executive editor discusses his views on an issue of interest to FAJ
          readers.
Journal: Financial Analysts Journal
Pages: 4-10
Issue: 5
Volume: 67
Year: 2011
Month: 9
X-DOI: 10.2469/faj.v67.n5.6
File-URL: http://hdl.handle.net/10.2469/faj.v67.n5.6
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# input file: UFAJ_A_12048056_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 88-
Issue: 5
Volume: 67
Year: 2011
Month: 9
X-DOI: 10.2469/faj.v67.n5.7
File-URL: http://hdl.handle.net/10.2469/faj.v67.n5.7
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Handle: RePEc:taf:ufajxx:v:67:y:2011:i:5:p:88-




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Author-Name: Robert Snigaroff
Author-X-Name-First: Robert
Author-X-Name-Last: Snigaroff
Author-Name: David Wroblewski
Author-X-Name-First: David
Author-X-Name-Last: Wroblewski
Title: A Network Value Theory of a Market, and Puzzles
Abstract: 
 By considering the stock market as a network that impounds liquidity and information
     production, the authors were able to study its influence on aggregate stock value and value
     from dividends. Market participants and practitioners impart value through the network of
     activity they form. The authors offer a network value model that can price this value and help
     solve such financial economic puzzles as the equity premium, stocks’ inverse inflation
     relationship, and lack of news. We argue that the supply of activities of market participants (the market’s network
     value) produces value, which is added value apart from the dividend stream produced by the
     listed companies. In other words, the market’s mere existence and proper functioning
     raise the prices of securities. In our study, we measured the value of this network that arises
     from network traffic: trading activity. This value not only describes aggregated stock market
     prices better than it would were it not included, but it also helps explain such well-known
     puzzles as the equity premium puzzle, the inverse inflation puzzle, and the news puzzle (i.e.,
     the stock market’s propensity for large movements without any material news about a
     prospective change in earnings).By considering the stock market as a network that impounds liquidity and information
     production, we were able to study the network’s influence on aggregate stock value, in
     addition to value from dividend cash flows. We built a network value model to price this value,
     and we then used real-world data to fit our model. By not making the limiting assumption that
     markets are perfectly complete, we were able to see that changes in the value of a
     market’s function are useful for describing prices and for solving financial economic
     puzzles. Because we focused explicitly on the production function of the investment
     sector—and because we assumed that this value grows and shrinks similarly to that of
     other networks (e.g., communication networks) or products—we referred to this concept not
     as an “externality” but, rather, as a “network value.” We made a strong
     case that the investment sector contributes real value in its provision of information,
     liquidity, and even confidence; we measured this value over 100 years for the U.S. market.
Journal: Financial Analysts Journal
Pages: 69-85
Issue: 5
Volume: 67
Year: 2011
Month: 9
X-DOI: 10.2469/faj.v67.n5.8
File-URL: http://hdl.handle.net/10.2469/faj.v67.n5.8
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Author-Name: Robert Pozen
Author-X-Name-First: Robert
Author-X-Name-Last: Pozen
Author-Name: Theresa Hamacher
Author-X-Name-First: Theresa
Author-X-Name-Last: Hamacher
Title: Most Likely to Succeed: Leadership in the Fund Industry
Abstract: 
 The authors’ review of mutual fund industry rankings over the past two
                    decades suggests critical factors for success in the business. Surprisingly, the
                    critical factors are not fund performance or marketing. Instead, the firms that
                    are most likely to succeed are dedicated to the asset management business and
                    are structured as partnership-like organizations controlled by their investment
                    professionals. View a webinar based on this article. We review mutual fund industry rankings over the past two decades to determine
                    critical factors for success in the business. We conclude that the critical
                    factors are not fund performance or marketing. Instead, in our view, the firms
                    that are most likely to succeed are dedicated to the asset management business
                    and are structured as partnership-like organizations controlled by their
                    investment professionals. Fourteen of the top 25 mutual fund sponsors in 2010
                    were dedicated to asset management, and the market share of these sponsors has
                    increased dramatically from 1990 to 2010.Diversified financial firms lost share in the fund business over the past 20
                    years despite their attempts to expand in it. We review those attempts, which
                    relied principally on mergers and acquisitions, during three time periods:
                    1993–2001, when diversified financial firms acquired fund sponsors;
                    2002–2006, when dedicated asset managers became buyers; and
                    2007–2010, when the credit crisis forced diversified firms to divest
                    fund management subsidiaries.We conclude that little support is left for the theory of the financial
                    supermarket that drove diversified firms into the asset management industry in
                    the first of the three periods. Expected revenue synergies failed to materialize
                    because of high-net-worth investors’ preference for open architecture
                    over proprietary products, intense regulatory scrutiny of potential conflicts of
                    interest, the ease of comparison shopping on the internet, and the difficulty of
                    cross-selling financial products. Many diversified firms also had trouble
                    retaining investment professionals and living with the volatility of investment
                    performance.We examine the reasons for the success of the dedicated asset managers, focusing
                    on the three largest firms in the U.S. fund industry: Fidelity, Vanguard, and
                    Capital Group. These firms are focused on asset management, have nonhierarchical
                    organizational structures that appeal to investment professionals, and have
                    developed compensation programs that help retain those professionals. Also,
                    these firms are privately held.Although private ownership insulates firms from the pressures of the public
                    market, it also creates challenges. Specifically, privately held firms have
                    difficulty in valuing their equity interests and transferring them from one
                    generation to another. And they must grow organically because the absence of
                    shares as a noncash currency makes acquisitions harder.Most other dedicated asset managers that ranked among the 25 largest mutual fund
                    managers have publicly traded stock but are controlled by their own investment
                    professionals, using a variety of ownership structures. This
                    public–private hybrid approach makes it easier to transfer ownership
                    from one generation of owners to the next, as part of a management succession,
                    and allows these firms to grow through acquisitions. But these firms must cope
                    with the disadvantages of public ownership.We believe the advantages of public ownership outweigh its costs. We conclude
                    that the fastest-growing firms in the mutual fund industry in the future will be
                    dedicated managers that have a public float but that are controlled by their own
                    financial professionals.Authors’ Note: This article is based on research
                        for The Fund Industry: How Your Money Is Managed (John
                        Wiley & Sons, 2011).
Journal: Financial Analysts Journal
Pages: 21-28
Issue: 6
Volume: 67
Year: 2011
Month: 11
X-DOI: 10.2469/faj.v67.n6.1
File-URL: http://hdl.handle.net/10.2469/faj.v67.n6.1
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 96-96
Issue: 6
Volume: 67
Year: 2011
Month: 11
X-DOI: 10.2469/faj.v67.n6.10
File-URL: http://hdl.handle.net/10.2469/faj.v67.n6.10
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Author-Name: Hao Jiang
Author-X-Name-First: Hao
Author-X-Name-Last: Jiang
Author-Name: Takeshi Yamada
Author-X-Name-First: Takeshi
Author-X-Name-Last: Yamada
Title: The Impact of International Institutional Investors on Local Equity Prices: Reversal of the Size Premium
Abstract: 
 Using comprehensive company-level ownership data from Japan, the authors found
                    that the equity size premium correlates strongly with the investment flows of
                    international institutional investors. When investment flows intensified and
                    shifted into larger stocks in the mid-1990s, the equity size premium was
                    reversed. Their findings suggest that a large fraction of the time variation in
                    the size premium is driven by price pressures, regardless of any shift in the
                    fundamentals of small and large companies.We investigated the behavior of international institutional investors and its
                    impact on the size premium (or small-stock premium) of the Japanese equity
                    market. In many equity markets around the world, the size premium has
                    disappeared or even been reversed in the past decades. We argue that the growing
                    presence of global institutional investors contributed to this reversal of the
                    size effect. We found that international institutional investors prefer holding
                    large-cap stocks; when they expand their investments in the local equity market,
                    their demand shocks exert price pressures on large stocks, which increases the
                    stocks’ valuation and contributes to a reversal of the size premium.
                    Our results suggest that a large fraction of the time variation in the size
                    premium reflects mispricing driven by price pressures.The Japanese equity market offers a unique opportunity to explore the impact of
                    international institutional investors on local equity prices. After the
                    mid-1990s, international investors significantly increased their holdings of
                    Japanese equities, particularly large-cap stocks. From the mid-1990s to around
                    2001, the Japanese government introduced various liberalization measures under
                    the so-called Financial Big Bang Program. These liberalization measures,
                    together with the institutionalization of the global financial markets,
                    contributed to the expansion of international institutional investors into
                    Japan. In particular, the value-weighted average ownership of foreign investors
                    in Japan increased almost threefold, from 9.1 percent in 1995 to 27.1 percent in
                    2008. Not only did the level of international institutional ownership increase
                    over this period, but also preferences for large-cap stocks intensified
                    dramatically.Concurrent with the expansion of international institutional investors, we have
                    seen a reversal of the size premium in the Japanese market since the mid-1990s.
                    We examined the net demand of international institutional investors for small
                    stocks as compared with large stocks and found that it positively correlates
                    with the size premium. This correlation cannot be explained by the momentum
                    trading pattern of international institutional investors. We also examined the
                    fundamentals of Japanese companies in various size groups and found no
                    compelling evidence that fundamentals explain the reversal of the size premium
                    in the Japanese market.We also studied the association between international institutional investments
                    and future stock returns at the individual company level. We found that the
                    level of international institutional ownership positively predicts future
                    returns after the mid-1990s but not before, which suggests the existence of
                    price pressures from international institutional investors after the mid-1990s.
                    We also found that the return forecasting power of international institutional
                    ownership is strong for non-keiretsu companies but is
                    nonexistent for keiretsu companies. This finding is consistent
                    with international institutions investing more aggressively in non-keiretsu
                    companies, whereas the stable cross-holdings of keiretsu companies and the
                    substantial business ties within their corporate groups may deter outside
                    investments in those companies.
Journal: Financial Analysts Journal
Pages: 61-76
Issue: 6
Volume: 67
Year: 2011
Month: 11
X-DOI: 10.2469/faj.v67.n6.2
File-URL: http://hdl.handle.net/10.2469/faj.v67.n6.2
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Author-Name: Zhipeng Yan
Author-X-Name-First: Zhipeng
Author-X-Name-Last: Yan
Author-Name: Yan Zhao
Author-X-Name-First: Yan
Author-X-Name-Last: Zhao
Title: When Two Anomalies Meet: The Post–Earnings Announcement Drift and the Value–Glamour Anomaly
Abstract: 
 This study of the post–earnings announcement drift and the
                    value–glamour anomaly finds that value stocks have greater information
                    uncertainty, exhibit more-muted initial market reactions to earnings surprises,
                    and have better (more positive or less negative) post–earnings
                    announcement drifts than do glamour stocks. A trading strategy based on these
                    findings can generate an average annual abnormal return of 16.6–18.8
                    percent before transaction costs.For decades, the post–earnings announcement drift and the
                    value–glamour anomaly have fascinated both academics and practitioners
                    in the field of finance. The goal of our study was to link these two anomalies
                    directly by studying the different initial market reactions to earnings
                    announcements and the drift patterns of various value and glamour portfolios and
                    to design a new trading strategy based on the signs of the earnings surprise
                    (+/–/0) and the instant stock price reaction to the earnings news
                    (+/–).We built our study on prior research that explored behavioral and rational
                    explanations for the existence of these two anomalies. In particular, we
                    investigated how information uncertainty may lead to different initial and
                    subsequent reactions to earnings news. We developed several testable
                    predictions. We first predicted that value stocks have greater information
                    uncertainty than glamour stocks. We then predicted that, owing to greater
                    information uncertainty, value stocks have more-muted initial reactions to
                    earnings surprises than do glamour stocks. Finally, we predicted that when
                    earnings news is good, value stocks have better (more positive)
                    post-announcement drifts than glamour stocks; but when earnings news is bad,
                    whether value stocks have better (less negative) drifts than glamour stocks
                    owing to the two opposite effects—the risk premium effect and the
                    delayed reaction effect—is unknown ex ante.To test our predictions, we used data for 1984–2008 from Capital IQ
                    Compustat, CRSP, and I/B/E/S. We sorted the companies into five
                    value–glamour quintiles for each quarter contingent on the sign of the
                    earnings surprise (defined by the difference between the actual earnings and the
                    analyst consensus forecast) and the sign of the instant stock price reaction to
                    the earnings news (measured by the abnormal return over a three-day window
                    around the quarterly earnings announcement—the earnings announcement
                    abnormal return, or EAAR).We made a number of new findings. First, we observed that value stocks have
                    higher information uncertainty than glamour stocks. Second, we found evidence
                    that value stocks have more-muted initial reactions to earnings surprises than
                    do glamour stocks. When three-day EAARs are positive, value stocks have lower
                    (less positive) EAARs than glamour stocks. When EAARs are negative, value stocks
                    have higher (less negative) EAARs than glamour stocks. Third, consistent with
                    our understanding of the delayed reaction effect and the risk premium effect,
                    when earnings news is good, value stocks have better (more positive) drifts than
                    glamour stocks. Fourth, our empirical results suggest, ex post,
                    that when earnings news is bad, value stocks still have better (less negative)
                    drifts than glamour stocks. For value stocks, the risk premium effect induced by
                    high information uncertainty signals dominates the delayed reaction effect
                    arising from the uncertainty. Finally, when EAARs and earnings surprises move in
                    opposite directions, the drift patterns are mixed and smaller in magnitude for
                    both value and glamour stocks.A trading strategy of taking a long position in value stocks when both earnings
                    surprises and EAARs are positive and a short position in glamour stocks when
                    both are negative can generate annual returns (before transaction costs) of
                    16.6–18.8 percent. This anomaly is mainly a long-side phenomenon;
                    preventing investors from short selling glamour stocks will not prevent them
                    from earning a value premium.
Journal: Financial Analysts Journal
Pages: 46-60
Issue: 6
Volume: 67
Year: 2011
Month: 11
X-DOI: 10.2469/faj.v67.n6.3
File-URL: http://hdl.handle.net/10.2469/faj.v67.n6.3
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Author-Name: Jacob S. Sagi
Author-X-Name-First: Jacob S.
Author-X-Name-Last: Sagi
Author-Name: Robert E. Whaley
Author-X-Name-First: Robert E.
Author-X-Name-Last: Whaley
Title: Trading Relative Performance with Alpha Indexes
Abstract: 
 Relative performance is central to investment management, and yet relative
                    performance securities do not trade directly. Complex trading strategies must be
                    devised to capture relative gains. The authors introduce a suite of relative
                    performance indexes and index derivatives that offer new and attractive payoff
                    structures. They demonstrate a variety of ways in which these products can
                    provide a more efficient and cost-effective means of realizing investment
                    objectives than can traditional futures and option markets.Relative performance is at the heart of investment management. Many stock
                    portfolio managers focus on identifying under- and overpriced stocks in hopes of
                    “beating the market.” Commonly referred to as
                    “stock pickers,” these managers take long and short
                    positions in stocks on the basis of their company-specific analyses and price
                    predictions. Other stock portfolio managers operate globally and focus on
                    identifying under- and overpriced stock markets; these managers are also stock
                    pickers, but of country-specific rather than company-specific performance. Large
                    institutional investors, such as pension fund managers and university
                    endowments, spread fund wealth across many asset categories, including stocks,
                    bonds, and real estate. They constantly monitor the relative performance of each
                    asset category in deciding how to allocate fund wealth.As these examples illustrate, investment managers pit the performances of
                    individual securities and security portfolios, both domestic and international,
                    against one another. Although relative performance remains the central focus of
                    investment management, relative performance securities do not exist. To create
                    the payoff contingencies that relative performance securities would offer,
                    investors sometimes piece together different positions in exchange-traded
                    securities to structure a relative performance position. Typically, these
                    strategies are complex and, in many instances, very risky. For example, if a
                    stock picker believes that a particular stock will outperform the market, she
                    can buy the stock and sell the market by using such index products as
                    exchange-traded funds and index futures. But such a position has unlimited
                    liability. To avoid the downside, the investor can dynamically manage the
                    position by shifting from stocks to risk-free bonds as the market rises (and
                    vice versa). But constantly migrating funds from one security to another in
                    response to a change in expected performance is cumbersome and costly.
                    Alternatively, the investor can go long relative performance and limit the
                    downside by buying a call on the stock and a put on the market. Although this
                    strategy limits the downside, it is unduly expensive because it entails paying
                    unnecessarily for the market volatility embedded in both the call and the put
                    option premiums. Exchange-traded products for relative performance promise to be
                    a simple and cost-effective means for providing investors with investment
                    opportunities that are otherwise inaccessible.In October 2010, NASDAQ OMX laid the groundwork for introducing relative
                    performance index product markets by computing and disseminating in real time
                    several indexes, each measuring the relative total return of a single stock
                    against the Standard & Poor’s Depositary Receipt
                    exchange-traded fund. Among the names currently available are AAPL, GE, GOOG,
                    IBM, and WMT. Although these indexes themselves do not trade, the U.S. SEC
                    approved NASDAQ OMX PHLX’s application to list exchange-traded option
                    contracts on 7 February 2011, and the first relative performance index option
                    market was launched on 18 April 2011. In our study, we analyzed a suite of
                    relative performance indexes and associated derivatives (futures and options).
                    To begin, we proposed a specific measure for calculating a “relative
                    performance index” of a target security versus a benchmark security.
                    We then described how futures and option contracts written on relative
                    performance indexes might be structured and how such contracts could be valued.
                    Finally, we provided a set of scenarios in which relative performance index
                    derivatives are shown to be a more cost-effective means of trading relative
                    performance than are traditional futures and option markets.
Journal: Financial Analysts Journal
Pages: 77-93
Issue: 6
Volume: 67
Year: 2011
Month: 11
X-DOI: 10.2469/faj.v67.n6.4
File-URL: http://hdl.handle.net/10.2469/faj.v67.n6.4
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Author-Name: Robert C. Jones
Author-X-Name-First: Robert C.
Author-X-Name-Last: Jones
Author-Name: Russ Wermers
Author-X-Name-First: Russ
Author-X-Name-Last: Wermers
Title: Active Management in Mostly Efficient Markets
Abstract: 
 This survey of the literature on the value of active management shows that the
                    average active manager does not outperform but that a significant minority of
                    active managers do add value. Further, studies suggest that investors may be
                    able to identify superior active managers (SAMs) in advance by using public
                    information. Investors who can identify SAMs should be able to improve their
                    overall Sharpe ratio by including a meaningful exposure to active
                    strategies.Our review of academic studies of active management has produced the following
                    findings and recommendations:Active returns across managers and time probably average close to zero,
                            net of fees and other expenses. This finding is what we should expect in
                            a mostly efficient market, in which fierce competition among active
                            managers drives average (net) active returns toward zero in equilibrium.
                            By keeping markets efficient, however, active management provides a
                            critical function in modern capitalist economies: Efficient, rational
                            capital allocation improves economic growth and leads to increased
                            wealth for society as a whole.Thus, to keep the competition fierce, the rewards to superior (as opposed
                            to average) active management must be rich indeed, as in fact they
                            are—for both the manager and the ultimate investor. Superior
                            managers earn high fees and often share in their added value, whereas
                            inferior managers are soon bereft of both clients and fees. Investors
                            who engage active managers can earn positive alphas with modest
                            additional risk on a total portfolio basis (i.e., an attractive
                            incremental return–risk ratio). But this benefit comes at a
                            cost—the risk that active returns may prove negative and lead to
                            lower terminal wealth.Investors can lessen this risk by using some of the research we discuss
                            in the article. In particular, studies suggest that investors may be
                            able to identify superior active managers (SAMs) ex
                                ante by considering (1) past performance (properly
                            adjusted), (2) macroeconomic correlations, (3) fund/manager
                            characteristics, and (4) analyses of fund holdings. We suspect that
                            using a combination of these approaches will produce better results than
                            following any one approach exclusively.Active management will always have a place in
                            “mostly efficient” markets. Hence, investors who can
                            identify SAMs should always expect to earn a relative
                            return advantage. Further, this alpha can have a substantial impact on
                            returns with only a modest impact on total portfolio risk. Finding such
                            managers is not easy or simple—it requires going well beyond
                            assessing past returns—but academic studies indicate that it can
                            be done.
Journal: Financial Analysts Journal
Pages: 29-45
Issue: 6
Volume: 67
Year: 2011
Month: 11
X-DOI: 10.2469/faj.v67.n6.5
File-URL: http://hdl.handle.net/10.2469/faj.v67.n6.5
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: Deploying Financial Emotional Intelligence
Abstract: 
 The editor discusses his views on an issue of interest to FAJ
                    readers.
Journal: Financial Analysts Journal
Pages: 4-10
Issue: 6
Volume: 67
Year: 2011
Month: 11
X-DOI: 10.2469/faj.v67.n6.6
File-URL: http://hdl.handle.net/10.2469/faj.v67.n6.6
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Author-Name: The Editors
Title: Errata
Journal: Financial Analysts Journal
Pages: 11-11
Issue: 6
Volume: 67
Year: 2011
Month: 11
X-DOI: 10.2469/faj.v67.n6.7
File-URL: http://hdl.handle.net/10.2469/faj.v67.n6.7
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Author-Name: Noël Amenc
Author-X-Name-First: Noël
Author-X-Name-Last: Amenc
Author-Name: Felix Goltz
Author-X-Name-First: Felix
Author-X-Name-Last: Goltz
Author-Name: Lionel Martellini
Author-X-Name-First: Lionel
Author-X-Name-Last: Martellini
Title: “A Survey of Alternative Equity Index Strategies”: A Comment
Abstract: 
 This material comments on “A Survey of Alternative Equity Index
                    Strategies”.
Journal: Financial Analysts Journal
Pages: 14-16
Issue: 6
Volume: 67
Year: 2011
Month: 11
X-DOI: 10.2469/faj.v67.n6.8
File-URL: http://hdl.handle.net/10.2469/faj.v67.n6.8
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Author-Name: Tzee-man Chow
Author-X-Name-First: Tzee-man
Author-X-Name-Last: Chow
Author-Name: Jason Hsu
Author-X-Name-First: Jason
Author-X-Name-Last: Hsu
Author-Name: Vitali Kalesnik
Author-X-Name-First: Vitali
Author-X-Name-Last: Kalesnik
Author-Name: Bryce Little
Author-X-Name-First: Bryce
Author-X-Name-Last: Little
Title: “A Survey of Alternative Equity Index Strategies”: Author Response
Abstract: 
 This material comments on “A Survey of Alternative Equity Index
                    Strategies”.
Journal: Financial Analysts Journal
Pages: 16-20
Issue: 6
Volume: 67
Year: 2011
Month: 11
X-DOI: 10.2469/faj.v67.n6.9
File-URL: http://hdl.handle.net/10.2469/faj.v67.n6.9
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Author-Name: Clifford S. Asness
Author-X-Name-First: Clifford S.
Author-X-Name-Last: Asness
Author-Name: Andrea Frazzini
Author-X-Name-First: Andrea
Author-X-Name-Last: Frazzini
Author-Name: Lasse H. Pedersen
Author-X-Name-First: Lasse H.
Author-X-Name-Last: Pedersen
Title: Leverage Aversion and Risk Parity
Abstract: 
 The authors show that leverage aversion changes the predictions of modern
                    portfolio theory: Safer assets must offer higher risk-adjusted returns than
                    riskier assets. Consuming the high risk-adjusted returns of safer assets
                    requires leverage, creating an opportunity for investors with the ability to
                    apply leverage. Risk parity portfolios exploit this opportunity by equalizing
                    the risk allocation across asset classes, thus overweighting safer assets
                    relative to their weight in the market portfolio. In our article, we show that leverage aversion changes the predictions of modern
                    portfolio theory: It implies that safer assets must offer higher risk-adjusted
                    returns than riskier assets because leverage-averse investors tilt their
                    portfolio toward riskier assets to achieve high unleveraged returns, thus
                    pushing up the prices of risky assets and reducing the expected return on those
                    assets. Therefore, safer assets are in relatively low demand and offer high
                    risk-adjusted returns. Consuming the high risk-adjusted returns offered by safer
                    assets requires leverage, which creates an opportunity for investors with the
                    ability and willingness to apply leverage.A risk parity (RP) portfolio exploits the high risk-adjusted returns of safer
                    assets in a simple way—namely, by equalizing the risk allocation
                    across asset classes and thus overweighting safer assets and underweighting
                    riskier assets relative to their weights in the market portfolio. Although an
                    unleveraged RP portfolio has a lower risk than the market portfolio (and the
                    60/40 portfolio) owing to the higher allocation to safer assets, the RP
                    portfolio can be leveraged to achieve the same risk as the market portfolio and
                    a higher expected return.Consistent with our theory of leverage aversion, we found empirically that risk
                    parity has outperformed the market over the last century by a statistically and
                    economically significant amount. Indeed, in the United States, an RP portfolio
                    with the same risk as the market portfolio outperformed the market portfolio by
                    about 4 percent a year over 1926–2010. Furthermore, the RP portfolio
                    delivered higher risk-adjusted returns than the 60/40 portfolio in each of the
                    11 countries covered by the J.P. Morgan Global Government Bond Index over
                    1986–2010. We performed extensive robustness tests and analyzed the
                    related evidence across and within countries and asset classes.Editor’s Note: The authors are affiliated with AQR
                        Capital Management, LLC, which offers risk parity funds.
Journal: Financial Analysts Journal
Pages: 47-59
Issue: 1
Volume: 68
Year: 2012
Month: 1
X-DOI: 10.2469/faj.v68.n1.1
File-URL: http://hdl.handle.net/10.2469/faj.v68.n1.1
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 88-88
Issue: 1
Volume: 68
Year: 2012
Month: 1
X-DOI: 10.2469/faj.v68.n1.10
File-URL: http://hdl.handle.net/10.2469/faj.v68.n1.10
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Author-Name: William Reichenstein
Author-X-Name-First: William
Author-X-Name-Last: Reichenstein
Author-Name: Stephen M. Horan
Author-X-Name-First: Stephen M.
Author-X-Name-Last: Horan
Author-Name: William W. Jennings
Author-X-Name-First: William W.
Author-X-Name-Last: Jennings
Title: Two Key Concepts for Wealth Management and Beyond (corrected March 2012)
Abstract: 
 Asset allocation is profoundly influenced by at least two underappreciated
                    concepts. First, tax-deferred accounts—for example,
                    401(k)s—are like partnerships in which the investor owns (1
                    – tn) of the partnership principal and the government owns
                    the remainder, where tn is the marginal tax rate when the funds are
                    withdrawn. Second, the government shares in both the return and the risk of
                    assets held in taxable accounts. The authors discuss these concepts’
                    implications for wealth management.In this study, we presented two key concepts and discussed some of their
                    investment implications. The first concept is that a tax-deferred account (TDA),
                    such as a 401(k), is like a partnership in which the investor owns (1
                    – tn) of the partnership principal and the
                    government owns the remaining tn of principal, where
                            tn is the marginal tax rate when the funds
                    are withdrawn. The second concept is that the government shares in both the
                    return and risk of assets held in taxable accounts, unlike
                    funds in TDAs or tax-exempt accounts (e.g., Roth IRAs). These concepts have
                    important implications for several areas in wealth management.The after-tax value of funds in a tax-deferred account
                            grows tax exempt. The calculation of an individual’s or a couple’s
                            asset allocation should be based on after-tax balances in each savings
                            vehicle. In contrast, the traditional approach fails to distinguish
                            between pretax and after-tax dollars.When calculating an individual’s or a couple’s asset
                            allocation, pretax balances in TDAs should be converted to after-tax
                            dollars by multiplying the pretax balances by (1 –
                                    tn).There is an optimal asset location, which is inextricably linked to
                            portfolio optimization. Individuals should locate lightly taxed
                            securities in taxable accounts and heavily taxed securities in
                            tax-advantaged retirement accounts to the highest degree possible, while
                            maintaining their risk–return preference.The main factor in the decision to save in a tax-deferred account or a
                            tax-exempt account is a comparison of the marginal tax rates in the
                            deposit year and in the withdrawal year. In general, if the expected
                            marginal tax rate in retirement is lower than this year’s tax
                            rate, then the individual should save in a TDA, and vice versa.Similarly, the most important factor in a Roth conversion decision is the
                            comparison of the marginal tax rates in the conversion year and in the
                            withdrawal year in retirement. If this year’s marginal tax
                            rate is lower than the withdrawal tax rate, it pays to convert funds to
                            a Roth account this year. The optimal conversion amount would push an
                            investor to the top of the tax bracket just below his or her estimated
                            marginal tax rate in retirement. To convert all of an
                            individual’s pretax TDAs to after-tax dollars in the same year
                            is seldom appropriate.Suppose a U.S. retiree faces a 25 percent marginal tax rate. To make the
                            portfolio last as long as possible, he or she generally should withdraw
                            funds from taxable accounts before TDAs or tax-exempt accounts. This
                            rule has exceptions, however, most of which are based on our first key
                            concept.For estate tax planning, choosing whether to gift or bequeath assets is
                            analogous to choosing between a traditional IRA and a Roth
                            IRA—that is, a comparison of the tax rates today and those
                            expected in the future is the critical factor. 
Journal: Financial Analysts Journal
Pages: 14-22
Issue: 1
Volume: 68
Year: 2012
Month: 1
X-DOI: 10.2469/faj.v68.n1.2
File-URL: http://hdl.handle.net/10.2469/faj.v68.n1.2
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Author-Name: Konan Chan
Author-X-Name-First: Konan
Author-X-Name-Last: Chan
Author-Name: David L. Ikenberry
Author-X-Name-First: David L.
Author-X-Name-Last: Ikenberry
Author-Name: Inmoo Lee
Author-X-Name-First: Inmoo
Author-X-Name-Last: Lee
Author-Name: Yanzhi (Andrew) Wang
Author-X-Name-First: Yanzhi (Andrew)
Author-X-Name-Last: Wang
Title: Informed Traders: Linking Legal Insider Trading and Share Repurchases
Abstract: 
 Logic suggests that a link might exist between insider trades and share
                    repurchases because of their potential to signal mispricing when market prices
                    deviate from fair value; both events emanate from essentially the same set of
                    decision makers. Using the overall repurchase sample, adding insider-trading
                    information is generally not helpful. For “value” buyback
                    companies, however, where perceived mispricing may be a more important factor,
                    insider trading provides a strong complement to the repurchase signal.Logic suggests that a link might exist between insider trades and share
                    repurchases because of their potential to signal mispricing when market prices
                    deviate from fair value; both events emanate from essentially the same set of
                    decision makers. A rich set of literature suggests that executives have timing
                    ability with respect to both events. Long-horizon equity return drifts are
                    evident subsequent to both classes of announcements. Several researchers,
                    however, view this collective evidence with suspicion. Certainly, repurchases
                    occur for a wide array of economic motivations, some not specifically related to
                    mispricing. Moreover, insiders trade their stock for various reasons that are
                    not directly related to private information about their companies. Some
                    researchers are suspicious of the evidence supporting mispricing given the
                    difficulty in measuring long-term abnormal stock returns. We addressed this debate by considering these two transactions jointly. We used
                    publicly available information to form portfolios and evaluated their
                    performance by using performance metrics common to the asset management industry
                    as well as those commonly used in academic studies. For
                    “value” buyback companies, where the likelihood of
                    undervaluation is seemingly a more plausible economic motivation for
                    repurchases, insider trading provided a strong complement to the repurchase
                    signal. The same was not true for other buyback cases, where factors aside from
                    mispricing may be motivating repurchase decisions. Our evidence is consistent
                    with that of prior studies that concluded that some managers do exhibit timing
                    ability. The results suggest that investors can combine these two independent
                    corporate events made by essentially the same set of decision makers to better
                    identify mispriced companies.
Journal: Financial Analysts Journal
Pages: 60-73
Issue: 1
Volume: 68
Year: 2012
Month: 1
X-DOI: 10.2469/faj.v68.n1.3
File-URL: http://hdl.handle.net/10.2469/faj.v68.n1.3
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Author-Name: Denis B. Chaves
Author-X-Name-First: Denis B.
Author-X-Name-Last: Chaves
Title: Demographic Changes, Financial Markets, and the Economy
Abstract: 
 Using a large sample of countries and 60 years of data, the authors found a
                    strong and intuitive link between demographic transitions and both GDP growth
                    and capital market returns. Unlike previous researchers, who used ad
                        hoc and restrictive demographic variables, the authors imposed a
                    smooth and parsimonious polynomial curve across all age groups. They also
                    performed robustness checks and produced forecasts for the coming decade, with
                    all the necessary caveats.
                    View a webinar of this article. It seems natural that the shifting composition of a nation’s population
                    ought to influence GDP growth and perhaps capital market returns as well. As the
                    Baby Boomers have aged, many people have studied past demographic data in an
                    effort to extract indications for the future influence of the Boomers on many
                    aspects of the economy. We extend this body of literature by analyzing the
                    effect of demographic changes on three measures of great importance for
                    countries all over the world: real per capita PPP-adjusted GDP growth, stock
                    market excess returns, and bond market excess returns.We confirmed what others have already demonstrated, but we extracted markedly
                    stronger statistical significance by adapting a polynomial curve–fitting
                    technique to this new purpose. In our study, we found that a growing roster of
                    young adults (15–49) is very good for GDP growth, a growing roster of
                    older workers is a little bad for GDP growth, and a growing roster of young
                    children or senior citizens is very bad for GDP growth.We found surprisingly powerful results when we applied the same technique to
                    exploring the links between demography and capital market returns, net of the
                    strong and well-documented effects of valuation and yield levels. Stocks perform
                    best when the roster of people aged 35–59 is particularly large and when
                    the roster of people aged 45–64 is fast growing. Bonds follow a similar
                    pattern, with an age shift: They are best when the roster of people aged
                    50–69 is growing quickly. We carried out three different forms of
                    robustness tests, each of which provided statistical significance in different
                    ways: by applying different country weights, testing alternative demographic
                    variables, and confirming GDP results on out-of-sample countries.Forecasting the future on the basis of these results would be dangerous. We would
                    tacitly be assuming that past relationships between demography and either GDP
                    growth or capital market returns will remain unaltered in the future. Given the
                    high levels of statistical significance in the historical relationships,
                    however, exploring the possible implications for future GDP growth and capital
                    market returns is too tempting to resist. These implications—with all the
                    caveats that must necessarily be offered—are sobering, to say the
                    least.
Journal: Financial Analysts Journal
Pages: 23-46
Issue: 1
Volume: 68
Year: 2012
Month: 1
X-DOI: 10.2469/faj.v68.n1.4
File-URL: http://hdl.handle.net/10.2469/faj.v68.n1.4
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Author-Name: Robert Litterman
Author-X-Name-First: Robert
Author-X-Name-Last: Litterman
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: Future Directions for Investment Management—Call for Papers
Abstract: 
 The executive editor  and editor discuss their views on an issue of interest to
                        FAJ readers.
Journal: Financial Analysts Journal
Pages: 4-6
Issue: 1
Volume: 68
Year: 2012
Month: 1
X-DOI: 10.2469/faj.v68.n1.5
File-URL: http://hdl.handle.net/10.2469/faj.v68.n1.5
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: 2011 Report to Readers
Journal: Financial Analysts Journal
Pages: 8-9
Issue: 1
Volume: 68
Year: 2012
Month: 1
X-DOI: 10.2469/faj.v68.n1.6
File-URL: http://hdl.handle.net/10.2469/faj.v68.n1.6
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Author-Name: Stephen C. Sexauer
Author-X-Name-First: Stephen C.
Author-X-Name-Last: Sexauer
Author-Name: Michael W. Peskin
Author-X-Name-First: Michael W.
Author-X-Name-Last: Peskin
Author-Name: Daniel Cassidy
Author-X-Name-First: Daniel
Author-X-Name-Last: Cassidy
Title: Making Retirement Income Last a Lifetime
Abstract: 
 To enable investors to spend down the assets in their defined contribution
                    accounts more easily, the authors propose a decumulation benchmark comprising a
                    laddered portfolio of TIPS for the first 20 years (consuming 88 percent of
                    available capital) and a deferred life annuity purchased with the remaining 12
                    percent. This portfolio can be used directly by the investor (akin to indexing)
                    or as a benchmark for evaluating the performance of a more aggressive
                    strategy.In the field of personal finance, a great deal of attention has been paid to
                    asset accumulation, but much less attention has been paid to asset decumulation,
                    which is the planned spending down of one’s accumulated savings in
                    retirement. We designed a prototype strategy for post-retirement investing and
                    used the cash flows from that strategy as a decumulation benchmark. Because this
                    benchmark is most likely to be applied to a defined contribution (DC) savings
                    plan, we call it the DCDB (defined contribution–decumulation
                    benchmark). We believe that a well-engineered DC plan should be experienced by
                    the participant in much the same way as the participant experiences a defined
                    benefit plan.Our benchmark is intended to embody the lowest-risk strategy available for
                    converting accumulated capital into post-retirement income while satisfying two
                    essential conditions: The strategy must protect the investor against longevity
                    risk and be appealing enough that it is likely to be used by a broad cross
                    section of investors. Immediate life annuities achieve the first condition but
                    not the second. The apparent reason that investors shy away from immediate life
                    annuities is that the loss of liquidity from transferring one’s
                    capital irrevocably to an insurance company is too onerous. Thus, the benchmark
                    strategy preserves most of the investor’s liquidity while achieving
                    the goals of longevity protection and minimal investment risk.The strategy that forms our benchmark is to buy, with most of one’s
                    capital, a portfolio of laddered Treasury Inflation-Protected Securities (TIPS)
                    out to the latest TIPS effective maturity date, currently about 20 years. The
                    remainder of the capital is used to buy a deferred annuity that begins its
                    payout when the cash flows from the TIPS ladder end. The proportions invested in
                    each asset class—TIPS and a deferred annuity—are set in such
                    a way as to make the first deferred annuity payout equal to the last TIPS payout
                    (plus an allowance for inflation). The resulting benchmark differs from ordinary
                    benchmarks by consisting of a set of future cash flows produced
                    by a given amount invested. As of 30 September 2010, a single 65-year-old male who invests $100,000 in the
                    benchmark portfolio can expect to receive a first-year payment of $5,118,
                    increasing at the U.S. Consumer Price Index (CPI) rate until Year 20.
                    Thereafter, the deferred life annuity pays $7,332 (in today’s money)
                    annually until the participant dies. This schedule of expected cash flows can be compared with the those from other
                    post-retirement investment strategies to determine which one a given investor
                    might prefer. We evaluated three alternatives to the benchmark strategy: an
                    immediate, real life annuity purchased from an insurance company; a target-date
                    portfolio of risky assets; and an immediate, nominal life annuity purchased from
                    an insurance company. The immediate real annuity pays $4,856 in the first year, almost exactly the same
                    as the first year’s payout in the DCDB. The cash flows from both
                    strategies inflate at the CPI rate until the 21st year, when the DCDB stops
                    inflating but the inflation-indexed annuity continues to inflate. Thus, over any
                    life span, the inflation-indexed annuity either matches or dominates the DCDB if
                    the investor does not care about liquidity or counterparty risk. But most
                    investors are strongly averse to such risks, potentially tipping the choice to
                    the benchmark strategy.The target-date portfolio produces cash flows that cannot be accurately
                    forecasted. Given today’s low yields, however, these cash flows are
                    likely to be much lower than those from the benchmark in the initial years. Over
                    time, however, the target-date portfolio should yield more than the benchmark
                    owing to growth in earnings and dividends. The participant must thus decide
                    which cash flow pattern she prefers: front-loaded (the benchmark) or both more
                    uncertain and more back-loaded (the target-date fund).The immediate nominal annuity pays $6,811 (nominal) every year. The participant
                    must weigh this certainty—and high current income—against
                    the likelihood that inflation will erode his purchasing power unacceptably in
                    later years.The benchmark strategy is not only useful as a measuring stick for evaluating
                    alternatives but is also potentially an investment in itself, akin to indexing.
                    Such an investment would have to be offered by an entity that can issue or sell
                    deferred annuities as well as conventional investment portfolios.
Journal: Financial Analysts Journal
Pages: 74-84
Issue: 1
Volume: 68
Year: 2012
Month: 1
X-DOI: 10.2469/faj.v68.n1.7
File-URL: http://hdl.handle.net/10.2469/faj.v68.n1.7
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Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Richard L. Meyer
Author-X-Name-First: Richard L.
Author-X-Name-Last: Meyer
Title: “Fault the Tax Code for Low Dividend Payouts”: A Comment
Abstract: 
 This material comments on “Fault the Tax Code for Low Dividend
                    Payouts”.
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 1
Volume: 68
Year: 2012
Month: 1
X-DOI: 10.2469/faj.v68.n1.8
File-URL: http://hdl.handle.net/10.2469/faj.v68.n1.8
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# input file: UFAJ_A_12048081_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rajesh K. Aggarwal
Author-X-Name-First: Rajesh K.
Author-X-Name-Last: Aggarwal
Author-Name: Philippe Jorion
Author-X-Name-First: Philippe
Author-X-Name-Last: Jorion
Title: Is There a Cost to Transparency?
Abstract: 
 Conducting the first direct tests for the cost of private transparency, the
                    authors examined whether a willingness to offer transparency to investors is
                    beneficial or costly in terms of hedge fund returns. Transparency is implicit
                    when a fund accepts managed accounts because such accounts are directly
                    controlled by investors. Overall, the authors found no evidence that
                    transparency harms fund returns. They also found no support for concerns that
                    managers offering transparency suffer from selection bias. As a result of the 2008 financial crisis, investors have been pushing for more
                    transparency for their hedge fund investments. Position-level transparency
                    requires full disclosure of all fund positions to the investor on a regular
                    basis. Such transparency is useful for several purposes. First, it makes it
                    easier to monitor the underlying financial risks and the actions of the manager,
                    which should help alleviate agency problems between investors and portfolio
                    managers. Second, it allows risk measurement and aggregation across the entire
                    portfolio. Third, it can also be used to optimize the portfolio management
                    process.Many hedge fund managers, however, fiercely resist offering transparency for a
                    number of reasons, ranging from the potential loss of a competitive advantage by
                    the reverse engineering of their strategy to the possibility of
                    others’ front running their portfolio. In addition, it is sometimes
                    asserted that the very best hedge fund managers have sufficient assets and thus
                    do not need to offer transparency. Hence, requiring transparency could create a
                    “selection bias” among hedge fund managers. Both arguments
                    imply that transparency creates a cost to the investor in terms of lower hedge
                    fund returns.This hypothesis, however, has never been directly tested. Ours is the first study
                    that directly tests for the costs of private transparency. We measured a
                    fund’s willingness to offer transparency by whether it accepts managed
                    accounts (MACs) for specific strategies. Because MACs are generally run
                        pari passu with the main commingled fund, they indirectly
                    reveal positions in the main fund to the investors in the MACs. Therefore, hedge
                    fund managers who accept MACs do offer transparency, at least to some investors.
                    Such transparency can be called “private” because it is
                    limited to investors in the fund, in contrast to “public”
                    transparency, whereby fund positions are revealed to the general public.We investigated whether this willingness to provide transparency is related to
                    differences in the investment performance of hedge funds. Using the TASS
                    database, we classified funds into a sample in which managers accept MACs and
                    another in which managers do not accept MACs. Because the database does not
                    report MAC returns, however, we analyzed only the returns for commingled funds.
                    Thus, we compared the performances of the commingled funds of managers who
                    provide transparency with the performances of those funds that do not. We found
                    that the performances of these two groups cannot be distinguished from each
                    other. This absence of significance holds for raw returns, abnormal returns, and
                    alphas from a multiple-factor model, as well as across different hedge fund
                    sectors. This result also holds regardless of whether the fund is open or closed
                    to new investment.We also examined whether managers who provide transparency are more or less
                    likely to be involved with fraud later on. We would expect that managers who
                    accept the additional monitoring made possible by transparency would be less
                    likely to commit fraud. We could not confirm this conjecture in the data,
                    however, owing to the small sample of fraud cases. Nevertheless, we found that
                    the duration of the fraud is longer by more than 14 months, on average, for
                    managers who do not provide transparency. This result is consistent with the
                    fact that transparency provides faster detection of fraud, which is
                    opportunistic rather than premeditated for managers who provide
                    transparency.Overall, we found no evidence that transparency harms fund returns. In addition,
                    we found no empirical support for concerns that managers who offer transparency
                    suffer from selection bias.
Journal: Financial Analysts Journal
Pages: 108-123
Issue: 2
Volume: 68
Year: 2012
Month: 3
X-DOI: 10.2469/faj.v68.n2.1
File-URL: http://hdl.handle.net/10.2469/faj.v68.n2.1
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:68:y:2012:i:2:p:108-123




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# input file: UFAJ_A_12048082_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Scott Richardson
Author-X-Name-First: Scott
Author-X-Name-Last: Richardson
Author-Name: Richard Sloan
Author-X-Name-First: Richard
Author-X-Name-Last: Sloan
Author-Name: Haifeng You
Author-X-Name-First: Haifeng
Author-X-Name-Last: You
Title: What Makes Stock Prices Move? Fundamentals vs. Investor Recognition
Abstract: 
 The authors synthesized and extended recent research demonstrating that investor
                    recognition is a distinct, significant determinant of stock price movements.
                    Realized stock returns are strongly positively related to changes in investor
                    recognition, and expected returns are strongly negatively related to the level
                    of investor recognition. Moreover, companies time their financing and investing
                    decisions to exploit changes in investor recognition. Investor recognition
                    dominates stock price movements over short horizons, whereas fundamentals
                    dominate over longer horizons.A basic tenet of security valuation is that the intrinsic value of a security is
                    equal to the discounted value of its expected future cash distributions. Yet, it
                    is well established that variability in cash distributions and expectations
                    thereof account for less than half the variation in realized security returns.
                    The remaining “nonfundamental” variation in security returns
                    remains the subject of intense debate. Efficient market aficionados attribute it
                    to time-varying risk. Value investors attribute it to irrational
                    “animal spirits.” But neither camp has made much progress in
                    elucidating its respective explanation. As such, much of the variation in stock
                    prices remains poorly understood.Our objective in this article was to synthesize and extend research on the
                    importance of investor recognition in explaining variation in stock prices.
                    Investor recognition of a security is defined as the number of investors who
                    know about the security. The investor recognition hypothesis posits that some
                    securities are known to many investors. These securities are, therefore, in high
                    demand, leaving other securities relatively neglected. In order for security
                    markets to clear, neglected securities must offer higher expected returns to
                    induce the remaining investors to overweight them. This situation leads to a
                    negative relationship between the level of investor recognition and expected
                    security returns and a positive relationship between changes in investor
                    recognition and realized stock returns.Using a crude measure of investor recognition, we showed that investor
                    recognition is of the same order of importance as fundamentals in explaining
                    annual stock returns. Our results indicate that expected stock returns are
                    strongly negatively related to the level of investor recognition and realized
                    stock returns are strongly positively related to changes in investor
                    recognition. Moreover, investor recognition dominates stock price movements over
                    short horizons (e.g., one quarter), and fundamentals dominate over longer
                    horizons (e.g., five years).We also showed that investor recognition is an important determinant of resource
                    allocation. Companies time their financing and investing decisions to exploit
                    changes in investor recognition. Specifically, we showed that
                    companies’ security issuances and capital expenditures increase
                    significantly following increases in investor recognition. These findings
                    vindicate the significant resources that corporations allocate to investor
                    relations and investment banking services. To the extent that such services
                    increase investor recognition, they result in significantly higher stock prices
                    and lower costs of capital.Finally, our findings provide a rationale for the existence of
                    “growth” investors, who select securities with a primary
                    focus on product innovation and growth potential and a secondary focus on price.
                    To the extent that such investors are able to identify securities that will
                    experience increases in investor recognition, they should generate superior
                    investment performance.
Journal: Financial Analysts Journal
Pages: 30-50
Issue: 2
Volume: 68
Year: 2012
Month: 3
X-DOI: 10.2469/faj.v68.n2.2
File-URL: http://hdl.handle.net/10.2469/faj.v68.n2.2
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Handle: RePEc:taf:ufajxx:v:68:y:2012:i:2:p:30-50




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# input file: UFAJ_A_12048083_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Stacy L. Cuffe
Author-X-Name-First: Stacy L.
Author-X-Name-Last: Cuffe
Author-Name: Lisa R. Goldberg
Author-X-Name-First: Lisa R.
Author-X-Name-Last: Goldberg
Title: Allocating Assets in Climates of Extreme Risk: A New Paradigm for Stress Testing Portfolios
Abstract: 
 The authors extended the standard paradigm for portfolio stress testing in two
                    ways. First, they introduced a toolkit that enables investors to envision and
                    administer extreme scenarios. The risk model is integral to the stress test.
                    They demonstrated the substantial impact of using historical and hypothetical
                    covariance matrices in scenario construction. Second, they used a
                    scenario-constrained optimization to incorporate the output of a portfolio
                    stress test directly into an investment decision.Over the past five years, financial markets have been dealt a steady series of
                    blows, including the implosion of massive and seemingly invulnerable investment
                    banks, the collapse of the U.S. housing market, the sovereign debt crisis in
                    Europe, and the downgrade of U.S. debt. As unprecedented scenarios continue to
                    unfold, investors face the daunting task of positioning their portfolios to
                    perform well in extreme situations. As a result, stress testing has become an
                    important facet of the investment process.Investors stress test their portfolios to analyze the impact of extreme events,
                    which tend to lie outside the purview of statistical risk measures. Stress tests
                    can detect a portfolio’s vulnerabilities and assess its expected reaction
                    to market scenarios and, consequently, can add significant value to an
                    investment process. No prescription exists, however, for determining the most
                    salient scenarios or for translating scenario profits and losses into an
                    investment decision. We addressed both of these issues.First, consider that most stress tests are based on shocks to a core set of
                    factors. For example, an investor concerned about the impact of inflation may
                    want to stress interest rates and spreads between nominal and real rates.
                    However, an inflation shock may propagate to equities, exchange rates, and other
                    risk factors in different ways. A covariance matrix is commonly used to infer
                    shocks to those risk factors for which an investor does not have a view. In this
                    way, a risk model plays a central role in specifying a scenario. We demonstrated
                    the importance of using a stressed covariance matrix in combination with
                    explicit shocks to a core set of factors, and we provided a simple framework for
                    generating both historical and hypothetical stressed covariance matrices.
                    Stressed historical covariance matrices can be easily generated by sampling from
                    periods of market instability and by varying the responsiveness of the
                    estimation process. Stressed hypothetical covariance matrices can be created by
                    modifying volatilities and shocking correlations. The latter can be done safely
                    with a latent variable methodology that does not compromise the statistical
                    integrity of the matrix.Second, we showed how to incorporate an exogenous market shock in an investment
                    decision, which amounts to a trade-off between the competing objectives of
                    minimizing risk and maximizing return. Using a constrained mean–variance
                    optimization, we perturbed portfolio weights to mitigate losses under the
                    specified shock. To do this, we reverse optimized expected returns that are
                    consistent with the optimality of an investor’s starting portfolio. Then,
                    we ran a constrained optimization yielding perturbed portfolio weights that are
                    optimal given that losses are capped if the shock occurs.Although precisely measuring the likelihood of an extreme event may not be
                    possible, assessing the impact of such events on a portfolio is nevertheless a
                    valuable exercise. We introduced a new paradigm for translating extreme events
                    into asset class scenarios and highlighted the integral role that the covariance
                    matrix plays in the translation. With memories of autumn 2008 still vivid and
                    the market still reeling from subsequent shocks and ensuing periods of high
                    volatility, investors are increasingly concerned about extreme events and have
                    begun to quantify the losses that they can withstand. Investors who are
                    cognizant that bouts of turbulence are endemic to markets can use our paradigm
                    to perturb allocations so as to be better positioned for what may lie ahead.
Journal: Financial Analysts Journal
Pages: 85-107
Issue: 2
Volume: 68
Year: 2012
Month: 3
X-DOI: 10.2469/faj.v68.n2.3
File-URL: http://hdl.handle.net/10.2469/faj.v68.n2.3
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Handle: RePEc:taf:ufajxx:v:68:y:2012:i:2:p:85-107




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# input file: UFAJ_A_12048084_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Xavier Gerard
Author-X-Name-First: Xavier
Author-X-Name-Last: Gerard
Title: Information Uncertainty and the Post–Earnings Announcement Drift in Europe
Abstract: 
 Investigating the effect of earnings announcement abnormal return and of abnormal
                    trading volume on future returns for a large sample of European companies with
                    both annual and interim announcements over 1997–2010, the author found
                    that the two measures of market surprise are positively related to future
                    abnormal returns, especially when information uncertainty is high. These two
                    effects also appear to be complementary in that each retains some incremental
                    predictive power for future returns.This article investigates the relationship between earnings announcement abnormal
                    returns, abnormal trading volume, and subsequent returns for a large sample of
                    European companies with annual as well as interim announcements from January
                    1997 to June 2010. By quantifying the degree of surprise with some
                    market-related information, I was able to alleviate several data issues, such as
                    differences of accounting practices across European countries, and capture a
                    wide range of information released at the time of the earnings announcement. In
                    addition to bringing new insights for the dynamics of the abnormal return and
                    abnormal trading volume effects, my analysis provides out-of-sample
                    confirmations of several prior U.S. findings. I showed that each measure of
                    market surprise is positively related to future abnormal returns. These two
                    effects also appear to be relatively independent phenomena because each retains
                    some incremental predictive power for future returns. Moreover, I found that
                    information uncertainty plays an important role in determining the magnitude of
                    the premiums earned by these strategies. I used the idiosyncratic volatility of
                    stock returns as an outcome measure of information uncertainty and showed that
                    both anomalies generate stronger abnormal returns in those stocks that
                    experience larger degrees of specific risk. I also found that the positive
                    premiums of a trading strategy based on the abnormal return and abnormal volume
                    effects tend to cluster around periods that follow an increase in aggregate
                    idiosyncratic risk. These results are in line with the view that behavioral
                    biases are exacerbated in settings of heightened information uncertainty. An
                    alternative, but not necessarily conflicting, explanation is that idiosyncratic
                    volatility constitutes a limit to arbitrage that prevents investors from
                    eliminating the premiums. Finally, I demonstrated that the main findings of my
                    analysis are not limited to small illiquid stocks and are also robust to
                    controlling for potential market microstructure biases. 
Journal: Financial Analysts Journal
Pages: 51-69
Issue: 2
Volume: 68
Year: 2012
Month: 3
X-DOI: 10.2469/faj.v68.n2.4
File-URL: http://hdl.handle.net/10.2469/faj.v68.n2.4
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Handle: RePEc:taf:ufajxx:v:68:y:2012:i:2:p:51-69




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# input file: UFAJ_A_12048085_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: André F. Perold
Author-X-Name-First: André F.
Author-X-Name-Last: Perold
Title: Negative Real Interest Rates: The Conundrum for Investment and Spending Policies
Abstract: 
 The author discusses his views on an issue of interest to FAJ
                    readers.Editor’s Note: The author has a commercial
                        interest in the strategies discussed in this article.
Journal: Financial Analysts Journal
Pages: 6-12
Issue: 2
Volume: 68
Year: 2012
Month: 3
X-DOI: 10.2469/faj.v68.n2.5
File-URL: http://hdl.handle.net/10.2469/faj.v68.n2.5
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Handle: RePEc:taf:ufajxx:v:68:y:2012:i:2:p:6-12




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# input file: UFAJ_A_12048086_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Andrew W. Lo
Author-X-Name-First: Andrew W.
Author-X-Name-Last: Lo
Title: Adaptive Markets and the New World Order (corrected May 2012)
Abstract: 
 In the adaptive markets hypothesis (AMH) intelligent but fallible investors learn
                    from and adapt to changing economic environments. This implies that markets are
                    not always efficient but are usually competitive and adaptive, varying in their
                        degree of efficiency as the environment and investor
                    population change over time. The AMH has several implications, including the
                    possibility of negative risk premiums, alpha converging to beta, and the
                    importance of macro factors and risk budgeting in asset allocation policies.The traditional investment paradigm consists of the following beliefs: (1) There
                    is a positive trade-off between risk and reward across all financial
                    investments—assets with higher risk offer higher expected return; (2)
                    this trade-off is linear, risk is best measured by equity
                    “beta,” and excess returns are measured by
                    “alpha,” the average deviation of a portfolio’s
                    return from the capital asset pricing model benchmark; (3) reasonably attractive
                    investment returns may be achieved by passive, long-only, highly diversified
                    market-cap-weighted portfolios of equities (i.e., those containing only equity
                    betas and no alpha); (4) strategic asset allocation among asset classes is the
                    most important decision that an investor makes in selecting a portfolio best
                    suited to his risk tolerance and long-run investment objectives; and (5) all
                    investors should be holding stocks for the long run. Collectively, these basic
                    principles have become the foundation of the investment management industry,
                    influencing virtually every product and service offered by professional
                    portfolio managers, investment consultants, and financial advisers.Underlying these beliefs are several key assumptions involving rational
                    investors, stationary probability laws, and a positive linear relationship
                    between risk and expected return with parameters that are constant over time and
                    can be accurately estimated. These assumptions were plausible during the Great
                    Modulation—the six decades spanning the 1940s to the early 2000s, when
                    equity markets exhibited relatively stable risk and expected
                    returns—but they have broken down over time owing to major changes in
                    population, technological innovation, and global competition. As investors adapt
                    to these changes, temporary but significant violations of rational pricing
                    relationships may occur. This tension between rational and behavioral market
                    conditions is captured by the adaptive markets hypothesis (AMH), an evolutionary
                    perspective on market dynamics in which self-interested investors—who
                    are intelligent but not infallible—learn from and adapt to changing
                    environments. Under the AMH, markets are not always efficient, but they are
                    usually highly competitive and adaptive, varying in their
                        degree of efficiency as the economic environment and
                    investor population change over time.The AMH has several practical implications for financial analysis. First, the
                    trade-off between risk and reward is not necessarily stable over time or
                    circumstances but varies as a function of the population of market participants
                    and the business environment in which they are immersed. During normal
                    environments, the market reflects the “wisdom of crowds,”
                    but during periods of excessive fear or greed, the market is driven more by the
                    “madness of mobs” and the usual positive relationship
                    between risk and reward need not hold. Second, market efficiency is not an
                    all-or-nothing characteristic but is a continuum that spans the entire range
                    between perfect efficiency and complete irrationality. Some markets are more
                    efficient than others, and a market’s degree of efficiency can be
                    measured and managed. Third, investors should be aware of changes in their
                    economic environment and adapt their investment policies accordingly. A case in
                    point is diversification, a worthy objective that is much harder to achieve
                    under current market conditions than before; hence, new assets and techniques
                    must be considered. Fourth, the traditional separation between unique investment
                    performance, or “alpha,” and widely held commoditized risk
                    premiums, or “beta,” is now more complex. Competition,
                    innovation, and natural selection among investors and portfolio managers will
                    turn alpha into either beta—in which case the risks associated with
                    its exploitation are sufficient to limit the number of willing participants to a
                    stable equilibrium—or zero as these unique opportunities are
                    permanently eliminated. Finally, the traditional approach to asset allocation
                    must be revised under the AMH to adapt to changing environments as well as
                    investor behavior. During the Great Modulation, static portfolios, such as 60
                    percent equities and 40 percent bonds, may have performed reasonably well, but
                    when the volatility of volatility becomes significant, fixed portfolio weights
                    may not be ideal. A more productive alternative for long-term investments may be
                    to construct portfolios according to risk allocations and to vary portfolio
                    weights so as to keep risk levels stable. Such an approach earns positive risk
                    premiums during normal markets just as traditional approaches do, but differs
                    from them in two important respects during periods of market dislocation:
                    Risk-denominated asset allocation strategies decrease market exposures during
                    high-volatility periods, when risk premiums tend to be lower than usual, and
                    stable risk levels reduce the likelihood of emotional overreactions when they
                    are most likely to be triggered.
Journal: Financial Analysts Journal
Pages: 18-29
Issue: 2
Volume: 68
Year: 2012
Month: 3
X-DOI: 10.2469/faj.v68.n2.6
File-URL: http://hdl.handle.net/10.2469/faj.v68.n2.6
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# input file: UFAJ_A_12048087_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Author-Name: James X. Xiong
Author-X-Name-First: James X.
Author-X-Name-Last: Xiong
Title: How Index Trading Increases Market Vulnerability
Abstract: 
 The authors found that the rise in popularity of index trading—assets
                    invested in index funds reached more than $1 trillion at the end of
                    2010—contributes to higher systematic equity market risk. More equity
                    index trading corresponds to increased cross-sectional trading commonality,
                    which precipitates higher return correlations among stocks. Consistent with the
                    accelerating growth of passive trading, the authors found that equity betas have
                    not only risen but also converged in recent years.Assets invested in passively managed equity mutual funds and exchange-traded
                    funds (ETFs) have grown steadily in recent years, reaching more than $1 trillion
                    by the end of 2010. The level of passively managed assets now reaches more than
                    half the level of assets in actively managed mutual funds. ETF trading now
                    accounts for roughly one-third of all trading in the United States. This
                    increased popularity and level of trading associated with passive investing,
                    however, is not inconsequential.In our study, we investigated the impact on market risk of increased
                    index-related trading. We found that the growth in passively managed equity
                    assets meaningfully corresponds to a decrease in the ability of investors to
                    diversify risk in recent decades. We discovered that this is due, in part, to an
                    increase in cross-sectional trading commonality associated with the rise in
                    passive investing.As evidence, we found that both pairwise correlations and cross-correlations
                    between return volatility and volume volatility have significantly increased
                    since 1997. Furthermore, we showed that the diversification benefits of equity
                    investing have decreased for all styles of stock portfolios (small-cap,
                    large-cap, growth, and value). These findings are particularly important for
                    investors because the decline in diversification benefits can be coupled with
                    increased market volatility and company-specific volatility. These changes have
                    introduced additional challenges for risk management in equity portfolio
                    construction.Also consistent with the accelerating growth of passive equity assets, we found
                    that in the past decade, equity betas for all styles of stock portfolios have
                    not merely risen but have converged to similar values. Therefore, for both
                    large- and small-cap portfolios, the diversification benefits for investors have
                    diminished dramatically since 1997. This finding suggests that an investor who
                    wishes to maintain the same excess return volatility level after 1997 would need
                    to meaningfully increase the number of stocks in her portfolio, both large- and
                    small-cap stocks.Taken together, our results suggest that the fragility of the U.S. equity market
                    has risen over recent decades. Furthermore, the ability of investors to
                    diversify risk by holding an otherwise well-diversified U.S. equity portfolio
                    has markedly decreased in recent decades. All equity investing, indexed or
                    otherwise, is thus plainly a more risky prospect for investors. Investors can
                    improve their investment processes by incorporating the impact of increased
                    trading commonality into their risk-modeling framework.Editor’s Note: Rodney N. Sullivan, CFA, is editor
                        of the Financial Analysts Journal. He recused himself from
                        the referee and acceptance processes and took no part in the scheduling and
                        placement of this article. See the FAJ policies section of
                        cfapubs.org for more information.
Journal: Financial Analysts Journal
Pages: 70-84
Issue: 2
Volume: 68
Year: 2012
Month: 3
X-DOI: 10.2469/faj.v68.n2.7
File-URL: http://hdl.handle.net/10.2469/faj.v68.n2.7
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# input file: UFAJ_A_12048088_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 128-128
Issue: 2
Volume: 68
Year: 2012
Month: 3
X-DOI: 10.2469/faj.v68.n2.8
File-URL: http://hdl.handle.net/10.2469/faj.v68.n2.8
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Author-Name: The Editors
Title: Errata
Journal: Financial Analysts Journal
Pages: 13-13
Issue: 2
Volume: 68
Year: 2012
Month: 3
X-DOI: 10.2469/faj.v68.n2.9
File-URL: http://hdl.handle.net/10.2469/faj.v68.n2.9
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# input file: UFAJ_A_12048091_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Gerben de Zwart
Author-X-Name-First: Gerben
Author-X-Name-Last: de Zwart
Author-Name: Brian Frieser
Author-X-Name-First: Brian
Author-X-Name-Last: Frieser
Author-Name: Dick van Dijk
Author-X-Name-First: Dick
Author-X-Name-Last: van Dijk
Title: Private Equity Recommitment Strategies for Institutional Investors
Abstract: 
 Institutional investors must deal with irrevocable commitments, cash flow
                    uncertainty, and illiquidity when making new commitments to maintain their
                    portfolio exposure to private equity funds. This study develops a dynamic
                    recommitment strategy to preserve the strategic allocation to private equity.
                    For each period, the level of new commitments is determined by characteristics
                    of the existing private equity portfolio, including received distributions,
                    uncalled capital from old commitments, and the current allocation relative to
                    its target level.Today, private equity is included in the investment portfolios of many
                    endowments, foundations, pension funds, and insurance companies. These
                    institutional investors typically target a specific allocation to private equity
                    as part of their strategic policy portfolio. The large majority of institutional
                    investors fulfill this allocation indirectly through private equity funds. The
                    unpredictable cash flows, in combination with the illiquidity of the market and
                    irrevocable commitments, challenge institutional investors to achieve and
                    maintain this strategic allocation. In 2008, the liquidity crisis and its
                    aftermath showed that investors can become significantly overinvested by making
                    commitments that are too large. Consequently, a liquidity shortfall may occur
                    when investors do not have the cash available to honor a new capital call. In
                    that case, the investor typically risks involuntary liquidation such that the
                    economic value of her existing fund investment is instantly lost and distributed
                    among the other participants in the fund. Clearly, investors will do their
                    utmost to avoid this situation and would rather sell their fund investment in
                    the secondary market at a (very) large discount. Although an efficient
                    investment strategy mitigates liquidity shortfall, in the case of overinvesting,
                    and opportunity costs, in the case of underinvesting, recommitment strategies
                    for institutional investors who allocate to private equity funds have received
                    very little attention in the literature.In this article, we present a dynamic recommitment strategy that enables
                    institutional investors to maintain a private equity fund portfolio that matches
                    their strategic target allocation. We argue that these investors face a
                    multiperiod dynamic portfolio optimization problem in which each period requires
                    a decision on new commitments that affects the level of investments in all
                    future periods. The solution of the corresponding single-period problem forms
                    the basis of our recommitment strategy. The key feature of our strategy is that
                    the level of new commitments in a given period depends on the characteristics of
                    the current private equity portfolio. In particular, new commitments are set
                    equal to the received distributions and the uncalled capital from old
                    commitments, scaled by the ratio of the target allocation to its current
                    allocation.Using the Thomson Venture Economics database over 1980–2005, we
                    empirically evaluated our recommitment strategy by means of historical
                    simulations. Our main finding is that our dynamic recommitment strategy is
                    capable of maintaining a stable investment level that is close to the allocation
                    target (86% realized versus 100% target) while keeping the probability of being
                    overinvested limited (8%). In addition, our sensitivity analyses showed that
                    this strategy remains equally successful when the portfolio is restricted to a
                    certain private equity segment (buyout or venture capital), a specific region
                    (the United States or Europe), or varying fund manager experience (first-time or
                    follow-on funds). Furthermore, we found that achieving the target exposure is
                    possible only when commitments during the buildup phase of a new portfolio are
                    30% higher than the desired strategic allocation (overcommitment). This finding
                    can be explained by the fact that disinvestments occur before the final
                    investments are made and that, on average, 10% of the committed capital is never
                    invested by the private equity fund. Finally, an investor with enough liquidity
                    for a (temporarily) higher allocation should also consider overcommitment in
                    recommitment plans.
Journal: Financial Analysts Journal
Pages: 81-99
Issue: 3
Volume: 68
Year: 2012
Month: 5
X-DOI: 10.2469/faj.v68.n3.1
File-URL: http://hdl.handle.net/10.2469/faj.v68.n3.1
File-Format: text/html
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Author-Name: Thomas M. Idzorek
Author-X-Name-First: Thomas M.
Author-X-Name-Last: Idzorek
Author-Name: James X. Xiong
Author-X-Name-First: James X.
Author-X-Name-Last: Xiong
Title: “The Impact of Skewness and Fat Tails on the Asset Allocation Decision”: Author Response
Abstract: 
 This material comments on “The Impact of Skewness and Fat Tails on the
                    Asset Allocation Decision”.
Journal: Financial Analysts Journal
Pages: 10-12
Issue: 3
Volume: 68
Year: 2012
Month: 5
X-DOI: 10.2469/faj.v68.n3.10
File-URL: http://hdl.handle.net/10.2469/faj.v68.n3.10
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: “The Impact of Skewness and Fat Tails on the Asset Allocation Decision”: Editor Response
Abstract: 
 This material comments on “The Impact of Skewness and Fat Tails on the
                    Asset Allocation Decision”.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 3
Volume: 68
Year: 2012
Month: 5
X-DOI: 10.2469/faj.v68.n3.11
File-URL: http://hdl.handle.net/10.2469/faj.v68.n3.11
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# input file: UFAJ_A_12048094_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: James P. Dowd
Author-X-Name-First: James P.
Author-X-Name-Last: Dowd
Title: “Two Key Concepts for Wealth Management and Beyond”: A Comment
Abstract: 
 This material comments on “Two Key Concepts for Wealth Management and
                    Beyond”.
Journal: Financial Analysts Journal
Pages: 12-14
Issue: 3
Volume: 68
Year: 2012
Month: 5
X-DOI: 10.2469/faj.v68.n3.12
File-URL: http://hdl.handle.net/10.2469/faj.v68.n3.12
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Author-Name: William Reichenstein
Author-X-Name-First: William
Author-X-Name-Last: Reichenstein
Author-Name: Stephen M. Horan
Author-X-Name-First: Stephen M.
Author-X-Name-Last: Horan
Author-Name: William W. Jennings
Author-X-Name-First: William W.
Author-X-Name-Last: Jennings
Title: “Two Key Concepts for Wealth Management and Beyond”: Author Response
Abstract: 
 This material comments on “Two Key Concepts for Wealth Management and
                    Beyond”.
Journal: Financial Analysts Journal
Pages: 14-14
Issue: 3
Volume: 68
Year: 2012
Month: 5
X-DOI: 10.2469/faj.v68.n3.13
File-URL: http://hdl.handle.net/10.2469/faj.v68.n3.13
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Author-Name: Charles D. Ellis
Author-X-Name-First: Charles D.
Author-X-Name-Last: Ellis
Title: Investment Management Fees Are (Much) Higher Than You Think
Abstract: 
 The author discusses his views on an issue of interest to FAJ readers.
Journal: Financial Analysts Journal
Pages: 4-6
Issue: 3
Volume: 68
Year: 2012
Month: 5
X-DOI: 10.2469/faj.v68.n3.2
File-URL: http://hdl.handle.net/10.2469/faj.v68.n3.2
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# input file: UFAJ_A_12048098_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark Kritzman
Author-X-Name-First: Mark
Author-X-Name-Last: Kritzman
Author-Name: Sébastien Page
Author-X-Name-First: Sébastien
Author-X-Name-Last: Page
Author-Name: David Turkington
Author-X-Name-First: David
Author-X-Name-Last: Turkington
Title: Regime Shifts: Implications for Dynamic Strategies (corrected)
Abstract: 
 Regime shifts present significant challenges for investors because they cause
                    performance to depart significantly from the ranges implied by long-term
                    averages of means and covariances. But regime shifts also present opportunities
                    for gain. The authors show how to apply Markov-switching models to forecast
                    regimes in market turbulence, inflation, and economic growth. They found that a
                    dynamic process outperformed static asset allocation in backtests, especially
                    for investors who seek to avoid large losses.Investors have long recognized that economic conditions frequently undergo regime
                    shifts. The economy often oscillates between a steady, low-volatility state
                    characterized by economic growth and a panic-driven, high-volatility state
                    characterized by economic contraction. These regime shifts present significant
                    challenges for risk management and portfolio construction. Many authors have
                    used Markov-switching models to “fit” a dataset and uncover
                    evidence of regimes in sample, but far fewer authors have attempted
                    out-of-sample forecasting. The goal of our research was to build
                    regime-dependent investment strategies and backtest their performance out of
                    sample. In contrast to previous studies, we did not model regimes directly on
                    asset returns nor did we rely on a specific asset-pricing model. Instead, we
                    forecasted regimes in the important drivers of asset returns and then
                    reallocated assets accordingly.When dealing with regime shifts, we expect Markov-switching models to perform
                    better than simple data partitions based on thresholds. Arbitrary thresholds
                    give false signals because they fail to capture the persistence in regimes and
                    changing volatilities. Markov-switching models are designed to capture these
                    features of the data. We built a simple Markov-switching model to identify and
                    forecast regimes characterized by market turbulence, inflation, and economic
                    growth. Our results revealed the presence of a “normal” and
                    an “event” regime in each series. The event regimes are
                    characterized by more challenging investment conditions, on average, and by
                    greater volatility in those conditions. Both the normal and event regimes
                    exhibited meaningful persistence.Next, we turned to out-of-sample forecasting and backtesting. First, we tested
                    the performance of the regime-switching approach for tactical asset allocation.
                    We used regime forecasts to scale exposure to specific risk premiums over time
                    and found that a dynamic process outperformed constant exposures. We then
                    applied the same methodology to dynamic asset allocation across stocks, bonds,
                    and cash. Again, we found that a dynamic process outperformed static asset
                    allocation, especially for investors who seek to avoid large losses.Authors’ Note: Sébastien Page, CFA, worked on
                            this article while at State Street Global Markets.
Journal: Financial Analysts Journal
Pages: 22-39
Issue: 3
Volume: 68
Year: 2012
Month: 5
X-DOI: 10.2469/faj.v68.n3.3
File-URL: http://hdl.handle.net/10.2469/faj.v68.n3.3
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# input file: UFAJ_A_12048099_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Xi Li
Author-X-Name-First: Xi
Author-X-Name-Last: Li
Author-Name: Ying Becker
Author-X-Name-First: Ying
Author-X-Name-Last: Becker
Author-Name: Didier Rosenfeld
Author-X-Name-First: Didier
Author-X-Name-Last: Rosenfeld
Title: Asset Growth and Future Stock Returns: International Evidence
Abstract: 
 The authors found strong return predictive power for measures related to asset
                    growth in the MSCI World Universe. The predictive power applies to abnormal
                    returns for up to four years after the initial measurement period, is
                    particularly strong for two-year total asset growth rates, and is robust to size
                    and book-to-market adjustments. It is also robust for various sample periods,
                    various geographic regions, and both large- and small-cap stocks. We studied the return predictive power of asset growth–related measures in
                    the MSCI World Universe, which includes all developed markets. We found a high
                    level of return predictive power for asset growth–related measures in
                    these markets, particularly for two-year total asset growth rates. This
                    predictive power is robust to size and book-to-market adjustments. It is also
                    robust for different subperiods, various geographic regions, and both large- and
                    small-stocks. We also found that two-year total asset growth rates have the
                    ability to generate abnormal returns for up to four years after their initial
                    measurement period.
Journal: Financial Analysts Journal
Pages: 51-62
Issue: 3
Volume: 68
Year: 2012
Month: 5
X-DOI: 10.2469/faj.v68.n3.4
File-URL: http://hdl.handle.net/10.2469/faj.v68.n3.4
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Handle: RePEc:taf:ufajxx:v:68:y:2012:i:3:p:51-62




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# input file: UFAJ_A_12048100_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jose Menchero
Author-X-Name-First: Jose
Author-X-Name-Last: Menchero
Author-Name: Jun Wang
Author-X-Name-First: Jun
Author-X-Name-Last: Wang
Author-Name: D.J. Orr
Author-X-Name-First: D.J.
Author-X-Name-Last: Orr
Title: Improving Risk Forecasts for Optimized Portfolios
Abstract: 
 Sample covariance matrices tend to underestimate the risk of optimized
                    portfolios. In this article, we identify special portfolios, termed
                    “eigenportfolios,” that capture these systematic biases.
                    Further, we present a methodology for estimating eigenportfolio biases and for
                    adjusting the covariance matrix to remove these biases. We show that this
                    procedure effectively removes the biases of optimized portfolios. We demonstrate
                    that the adjusted covariance matrices are effective at reducing the
                    out-of-sample volatilities of optimized portfolios.The Markowitz mean–variance framework provides the foundation for
                    modern portfolio theory. Required inputs include a set of asset expected returns
                    and a covariance matrix. The covariance matrix, in turn, is typically estimated
                    from a finite sample of historical data. One problem with sample covariance
                    matrices, however, is that they tend to systematically underestimate the risk of
                    optimized portfolios. This problem presents an obvious challenge to
                    practitioners of portfolio optimization because portfolio volatility cannot be
                    reliably estimated with covariance matrices.In this article, we provide a practical solution to this investment problem. We
                    investigate the sources of the biases of optimized portfolios. We identify and
                    describe special portfolios, which we call eigenportfolios,
                    that capture these systematic biases. The eigenportfolios are mutually
                    uncorrelated and represent distinct combinations of the original assets. We
                    demonstrate that the biases of eigenportfolios can be reliably estimated by
                    numerical simulation. We found that the lowest-volatility eigenportfolios
                    exhibit the largest underprediction biases and the sample covariance matrix
                    slightly overpredicts the risk of the highest-volatility
                    eigenportfolios. We show that the magnitude of these biases is extremely stable
                    over time and depends on the degree of sampling error in the covariance
                    matrix.We also describe how to adjust the covariance matrix to remove the biases of the
                    eigenportfolios. Furthermore, we show that the adjustment procedure effectively
                    removes the biases of optimized portfolios while still providing accurate
                    forecasts for nonoptimized portfolios.Additionally, we examine the out-of-sample performance of optimized portfolios.
                    We constructed portfolios optimized to have minimum volatility with a fixed
                    alpha constraint. Relative to the conventional sample covariance matrices, we
                    found that the adjusted covariance matrices produce portfolios with lower
                    out-of-sample volatilities and, hence, better risk-adjusted performance.We also study how the performance gains in risk forecasting accuracy and reduced
                    out-of-sample volatility depend on the degree of sampling error in the
                    covariance matrix. A critical determinant of the degree of sampling error is the
                    ratio of the number of stocks, N, to the number of periods,
                        T, used to estimate the covariance matrix. For small values
                    of N/T, the sampling error is relatively
                    small, and we found modest performance gains from the adjustment methodology. As
                        N/T increases, however, sampling error
                    becomes more significant and the performance gains from the covariance
                    adjustments become increasingly important.
Journal: Financial Analysts Journal
Pages: 40-50
Issue: 3
Volume: 68
Year: 2012
Month: 5
X-DOI: 10.2469/faj.v68.n3.5
File-URL: http://hdl.handle.net/10.2469/faj.v68.n3.5
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Author-Name: Ginny W. Frings
Author-X-Name-First: Ginny W.
Author-X-Name-Last: Frings
Author-Name: Michael C. Frings
Author-X-Name-First: Michael C.
Author-X-Name-Last: Frings
Author-Name: M. Christian Mastilak
Author-X-Name-First: M. Christian
Author-X-Name-Last: Mastilak
Title: Does IFRS Stand for InFormation RiSk?
Abstract: 
 In the wake of the recent financial crises, corporations, accounting firms, and
                    regulatory bodies are debating the design of new regulations to improve the
                    integrity of publicly available financial information. Contrary to the positions
                    of the FASB and IASB, the convergence of current U.S. GAAP rules–based
                    standards with proposed IFRS principles–based regulations would increase
                    financial information risk. The veneer of similarity is not enough to ensure
                    comparability of reported financial information across the globe. In the wake of the recent financial crises, corporations, accounting firms, and
                    regulatory bodies are debating the design of new regulations to improve the
                    integrity of publicly available financial information. Proponents of the United
                    States’ adopting the International Financial Reporting Standards (IFRS)
                    cite such benefits as a single, high-quality set of globally implemented
                    financial reporting standards; consistency in reporting across nations; improved
                    capital flow across national borders; and, ultimately, increased competitiveness
                    of U.S. companies in the global capital markets. In our view, however, the
                    ongoing debate over the convergence of IFRS and GAAP (generally accepted
                    accounting principles) is incomplete.Contrary to the positions of the Financial Accounting Standards Board (FASB) and
                    the International Accounting Standards Board (IASB), the convergence of current
                    U.S. GAAP rules–based standards with proposed IFRS principles–based
                    regulations will increase financial information risk. The veneer of similarity
                    is not enough to ensure comparability of reported financial information across
                    the globe. We believe that the adoption of IFRS in the United States would
                    likely increase information risk for users of the financial statements of U.S.
                    companies and that this increased information risk would have ripple effects
                    throughout the capital markets. In this article, we offer a perspective that
                    discusses potential changes in the information available to users of IFRS-based
                    financial statements. We also offer a few high-level predictions about effects
                    on U.S. capital markets were the United States to adopt IFRS.Research to date has demonstrated that important differences among countries and
                    cultures can affect reporting even within common standards. IFRS will not
                    eliminate these real economic and cultural differences. Rather, we fear that
                    common standards will hide significant underlying differences among companies
                    domiciled and operating in different countries, papering over useful,
                    decision-relevant information about country-level differences with a veneer of
                    similarity. We fear that investors will lose information about real,
                    economically significant differences among companies.The reduction in disclosure precision and the increased use of managerial
                    discretion in reporting will lead to a reduction in the correlation between
                    earnings and future cash flows. As a result of the predicted decrease in
                    earnings’ predictive validity and information content regarding cash
                    flows, we predict increased equity price volatility and, in turn, increased cost
                    of capital for U.S. companies. We predict that trading on short-term price
                    changes will become marginally riskier and that buy-and-hold strategies will
                    become marginally more attractive for risk-averse investors. If IFRS is adopted
                    in the United States, there will be no high-quality reporting model competing
                    with IFRS in the broader “market for capital markets.” 
Journal: Financial Analysts Journal
Pages: 17-21
Issue: 3
Volume: 68
Year: 2012
Month: 5
X-DOI: 10.2469/faj.v68.n3.6
File-URL: http://hdl.handle.net/10.2469/faj.v68.n3.6
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# input file: UFAJ_A_12048102_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Haigang Zhou
Author-X-Name-First: Haigang
Author-X-Name-Last: Zhou
Author-Name: John Qi Zhu
Author-X-Name-First: John Qi
Author-X-Name-Last: Zhu
Title: Jump on the Post–Earnings Announcement Drift (corrected)
Abstract: 
 The authors examined the potential profitability of a strategy that exploits the
                    post–earnings announcement drifts contingent on jump dynamics
                    identified in stock prices around earnings announcements. With long positions in
                    positive-jump stocks and short positions in negative-jump stocks, their hedge
                    portfolio achieved an annualized abnormal return of 15.3% and an annualized
                    Sharpe ratio of 1.52 over the last four decades. Neither conventional risk
                    factors nor common company characteristics explain the abnormal return.The post–earnings announcement drift (PEAD), or earnings momentum, is
                    one of the most robust and persistent anomalies challenging the efficient market
                    paradigm. Previous studies have proposed various trading signals to measure and
                    profit from the surprise in an earnings announcement. In our study, we
                    introduced a new measure of company-level informational shocks based on the
                    realized jump dynamics of stock prices over a three-day window around earnings
                    announcements, and we examined the profitability of an earnings momentum
                    strategy that uses extreme price movements, or jumps, as trading signals.The intuition is that companies’ unobserved “extremely good
                    news” is impounded in unexpectedly large and discrete price hikes, or
                    positive jumps, around earnings announcements, whereas companies’
                    unobserved “extremely bad news” is reflected in large and
                    abrupt price plunges, or negative jumps, around earnings announcements.
                    Therefore, we formed a hedge portfolio that took long positions in positive-jump
                    companies and short positions in negative-jump companies. Using a particular
                    jump detection method, we found compelling evidence of post–earnings
                    announcement return drifts in the same direction as jumps over the subsequent
                    three months. This strategy yielded a quarterly excess return of 3.63%,
                    equivalent to a 15.3% annualized return, over the sample period of
                    1971–2009. Our results suggest yet another anomaly associated with
                    PEAD. Market participants seem largely to underreact to, or are simply unaware
                    of, the latent “extremely good (or bad) news” signaled by
                    the direction of jumps around earnings announcements.We conducted an array of tests to show that the jump signal is distinct from two
                    commonly used PEAD trading signals in previous studies: the earnings
                    announcement return and standardized unexpected earnings. We also found evidence
                    that neither common company characteristics (e.g., size, illiquidity, and
                    book-to-market ratio) nor the three Fama–French risk factors,
                    augmented by a momentum factor and a liquidity factor, can explain the abnormal
                    returns.
Journal: Financial Analysts Journal
Pages: 63-80
Issue: 3
Volume: 68
Year: 2012
Month: 5
X-DOI: 10.2469/faj.v68.n3.7
File-URL: http://hdl.handle.net/10.2469/faj.v68.n3.7
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 104-104
Issue: 3
Volume: 68
Year: 2012
Month: 5
X-DOI: 10.2469/faj.v68.n3.8
File-URL: http://hdl.handle.net/10.2469/faj.v68.n3.8
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Author-Name: Steven P. Greiner
Author-X-Name-First: Steven P.
Author-X-Name-Last: Greiner
Title: “The Impact of Skewness and Fat Tails on the Asset Allocation Decision”: A Comment
Abstract: 
 This material comments on “The Impact of Skewness and Fat Tails on the
                    Asset Allocation Decision”.
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 3
Volume: 68
Year: 2012
Month: 5
X-DOI: 10.2469/faj.v68.n3.9
File-URL: http://hdl.handle.net/10.2469/faj.v68.n3.9
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# input file: UFAJ_A_12048106_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Guido Baltussen
Author-X-Name-First: Guido
Author-X-Name-Last: Baltussen
Author-Name: Bart van der Grient
Author-X-Name-First: Bart
Author-X-Name-Last: van der Grient
Author-Name: Wilma de Groot
Author-X-Name-First: Wilma
Author-X-Name-Last: de Groot
Author-Name: Erik Hennink
Author-X-Name-First: Erik
Author-X-Name-Last: Hennink
Author-Name: Weili Zhou
Author-X-Name-First: Weili
Author-X-Name-Last: Zhou
Title: Exploiting Option Information in the Equity Market
Abstract: 
 Public option market information contains exploitable information for equity investors for an
     investable universe of liquid large-cap stocks. Strategies based on several option measures
     predict returns and alphas on the underlying stock. Transaction costs are an important factor
     given the high turnover of these strategies, but significant net alphas can be obtained when
     using a simple approach that reduces transaction costs. These findings suggest that information
     diffuses gradually from the option market into the underlying stock market. In our study, we examined whether public information contained in the option market predicts
     cross-sectional stock returns for a well-investable universe of highly liquid U.S. large-cap
     stocks and, thus, provides valuable, exploitable information for equity investors. We found
     that trading strategies based on worries about negative price movements (i.e., out-of-the-money
     volatility skew), volatility risk (i.e., realized versus implied volatility spread), informed
     trading and jump risk (i.e., at-the-money volatility skew), and the change in informed trading
     (i.e., the change in the at-the-money volatility skew) yield significant returns and alphas.
     The performances remain significant after correcting for market, size, value, momentum,
     reversal, and other return-predicting factors. Hence, we found that these strategies are
     substantially different from other well-known stock selection strategies.Further, a combined option information strategy shows even stronger results, with an
     annualized performance of around 10%, thereby strengthening the relevance of the publicly
     available information contained in option prices for equity investors. Although several studies
     have reported that the predictive power of option market variables decreases over time, we
     found significant returns also in recent out-of-sample years. These results are robust for
     bull, bear, volatile, and calm markets and are generally of similar magnitude for stocks with
     low or high information uncertainty.Exploiting the option information measures requires an extremely high turnover. Therefore,
     all profitability is estimated to be consumed by transaction costs in our investable universe.
     However, when we used our strategy on the largest 100 stocks—stocks that generally have
     the lowest transaction costs—and applied simple turnover-reducing portfolio construction
     rules, we found economically and statistically significant net returns above 7% a year for the
     long–short portfolio. This finding leads us to conclude that the documented strategies
     are exploitable by practitioners and suggests that information diffuses gradually from the
     equity option market into the underlying stock market.
Journal: Financial Analysts Journal
Pages: 56-72
Issue: 4
Volume: 68
Year: 2012
Month: 7
X-DOI: 10.2469/faj.v68.n4.1
File-URL: http://hdl.handle.net/10.2469/faj.v68.n4.1
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:68:y:2012:i:4:p:56-72




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Author-Name: Stephen C. Sexauer
Author-X-Name-First: Stephen C.
Author-X-Name-Last: Sexauer
Author-Name: Michael W. Peskin
Author-X-Name-First: Michael W.
Author-X-Name-Last: Peskin
Author-Name: Daniel Cassidy
Author-X-Name-First: Daniel
Author-X-Name-Last: Cassidy
Title: “Making Retirement Income Last a Lifetime”: Author Response
Abstract: 
 This material comments on “Making Retirement Income Last a Lifetime”.
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 4
Volume: 68
Year: 2012
Month: 7
X-DOI: 10.2469/faj.v68.n4.10
File-URL: http://hdl.handle.net/10.2469/faj.v68.n4.10
File-Format: text/html
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Author-Name: Charles D. Ellis
Author-X-Name-First: Charles D.
Author-X-Name-Last: Ellis
Title: Murder on the Orient Express: The Mystery of Underperformance
Abstract: 
 Evidence increasingly shows that a “crime” of extensive underperformance has
          been committed in mutual funds, pension funds, and endowments. In a pattern reminiscent of
          Agatha Christie’s famous novel Murder on the Orient Express, an
          investigation leads to a surprising, if inevitable, conclusion: The usual
          suspects—investment managers, fund executives, investment consultants, and
          investment committees—are all guilty.Evidence shows that investment results for institutional investors—pension funds,
          endowments, and mutual funds—are below market. Although analysts, portfolio
          managers, broker/dealers, and consultants continue to enjoy high personal incomes and
          profits, we need to understand the causes of the disappointing performance. High
          incremental fees—relative to the value added over and above low-cost index
          funds—are one surprisingly major factor. Correctly stated, fees for active
          management are not “1%,” but 75–150% of the actual benefit. Although
          still “secret,” this specter haunts investment management.A surprisingly large majority of professionally managed funds fall short of their chosen
          benchmarks. And the magnitude of underperformance far exceeds the magnitude of
          outperformance. The shortfall hurts the ultimate clients of institutional funds. So, who
          is at fault?Active managers are obvious suspects. As markets have become increasingly
          professionalized—and thus increasingly efficient—competition has made it
          harder and harder for any manager or any firm to get ahead of the formidable competition.
          Suspicions mount when we see business disciplines and “asset
          gathering” increasingly dominate the values and priorities of the
            profession at investment firms.Investment consultants are surely suspect. Their business model focuses on getting and
          retaining clients, so their normal strategy is to urge clients to hire many different
          managers—diversifying the consultant’s “manager risk” but
          increasing costs to clients and adding complexity to manager management—firing
          laggards, hiring via “speed dating,” and, however unintentionally, coming
          between managers and clients rather than helping them build strong,
          “shared-understanding” working partnerships.Fund executives are certainly suspect. Disparagingly called “gatekeepers,”
          they are often understaffed and inexperienced with investments. Not empowered to make
          major decisions, they seem to serve only to facilitate hiring and firing decisions by
          powerful seniors on investment committees.Investment committees are obvious suspects. Most committee members are not experts on the
          intense challenges of contemporary investing. With the guidance of investment consultants,
          many investment committees misdefine their role as
          management—listening to presentations, hiring and firing managers,
          and so on—rather than concentrating on the important work of
            governance. Doing too much of the former and too little of the latter,
          they are unable to see that, ironically, their activities do more harm than good.Although all the suspects—active managers, consultants, fund
          executives, and investment committees—are contributing to the “crime” of
          institutional underperformance, the real fault is not with these performers but, rather,
          with the whole process of institutional investment management.The high costs—estimated at $10 billion to $20 billion a year—will continue
          until the process is changed. Until then, the process will be controlled by the agents
          whose incentives are not aligned with those of the principals.
Journal: Financial Analysts Journal
Pages: 13-19
Issue: 4
Volume: 68
Year: 2012
Month: 7
X-DOI: 10.2469/faj.v68.n4.2
File-URL: http://hdl.handle.net/10.2469/faj.v68.n4.2
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:68:y:2012:i:4:p:13-19




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# input file: UFAJ_A_12048109_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Andrew Ang
Author-X-Name-First: Andrew
Author-X-Name-Last: Ang
Author-Name: Marie Brière
Author-X-Name-First: Marie
Author-X-Name-Last: Brière
Author-Name: Ombretta Signori
Author-X-Name-First: Ombretta
Author-X-Name-Last: Signori
Title: Inflation and Individual Equities
Abstract: 
 Since 1990, stocks with strong inflation-hedging abilities have had higher average returns
     than stocks with low inflation betas and have tended to be drawn from the technology and
     oil/gas sectors. The authors found substantial time variation among stock inflation betas,
     which makes it difficult to construct portfolios from stocks that are strong out-of-sample
     inflation hedges. This finding holds for sector portfolios, portfolios constructed on
     past-inflation betas, and portfolios constructed from high-dividend-paying stocks. We studied whether portfolios of individual stocks can adequately hedge inflation risk.
     Although the poor inflation-hedging ability of the aggregate stock market has long been
     documented, the literature has focused on the behavior of aggregate stock market
      indices. But there is considerable heterogeneity in how individual stock
     returns covary with inflation. Different companies have different pricing power. Constructing
     portfolios on the basis of individual stocks has the potential to provide a much better
     inflation hedge than the aggregate market.To measure the inflation-hedging ability of individual stocks, we computed stock-level
     inflation betas. We grouped stocks into portfolios on the basis of inflation betas for the full
     sample, which allowed us to conduct both an ex post analysis of which
     companies provided the strongest realized covariation between stock returns and inflation and a
     tradable out-of-sample analysis in which the portfolios were constructed by using information
     available only at the beginning of each month.We found substantial variation in how individual stocks covary with inflation. Although the
     correlation of the aggregate market with inflation is negative (the average inflation beta of
     S&P 500 Index stocks was –0.52), there is a significant subset of stocks with high
     and significantly positive inflation betas over the sample. Since the 1990s, the top 20 stocks
     with the highest realized-inflation betas have had inflation betas exceeding 5. The quintile
     portfolio with the highest ex post inflation betas overweighted oil/gas, which
     benefits from rising commodity prices, and technology, a sector in which the products of many
     companies command premium prices owing to technological innovation. The remaining quintile
     portfolios had negative inflation betas. Thus, a non-negligible subset of stocks has covaried
     positively with inflation. Moreover, stocks that have been good inflation hedges have had, on
     average, high nominal and real returns.However, trying to forecast ex ante inflation betas at the individual stock
     level is not easy. The inflation betas exhibit pronounced time variation. Up to 20% of stocks,
     on average, exhibit sign changes in inflation betas from year to year. The large amount of time
     variation in inflation betas at the individual stock level makes it hard to construct
     portfolios of stocks that have good inflation-hedging ability on an ex ante
     basis. The cross-sectional dispersion of inflation betas also varies over time. During the
     recent financial crisis, the inflation betas for many stocks changed signs, going from negative
     before 2008 to positive over 2008–2009. The substantial variation in stock inflation
     betas makes it difficult to find stocks that are good out-of-sample inflation hedges. This is
     true not only for portfolios constructed on past-inflation betas but also for sector portfolios
     and portfolios constructed from high-dividend-paying stocks 
Journal: Financial Analysts Journal
Pages: 36-55
Issue: 4
Volume: 68
Year: 2012
Month: 7
X-DOI: 10.2469/faj.v68.n4.3
File-URL: http://hdl.handle.net/10.2469/faj.v68.n4.3
File-Format: text/html
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Author-Name: John D. Burger
Author-X-Name-First: John D.
Author-X-Name-Last: Burger
Author-Name: Francis E. Warnock
Author-X-Name-First: Francis E.
Author-X-Name-Last: Warnock
Author-Name: Veronica Cacdac Warnock
Author-X-Name-First: Veronica Cacdac
Author-X-Name-Last: Warnock
Title: Emerging Local Currency Bond Markets
Abstract: 
 In this article, the authors assess local currency bond markets in emerging market economies
     (EMEs). Supported by policies and laws that helped improve macroeconomic stability and creditor
     rights, local currency EME bond markets have grown substantially over the past decade and have
     provided USD-based investors with attractive returns. U.S. investors have responded by sharply
     increasing their holdings of EME local currency bonds, especially in EMEs with
     investor-friendly institutions and policies.In this article, we characterized the development of emerging market economy (EME) local
     currency bond markets, focusing on their size, fundamental factors that enable their growth,
     and the returns they have produced for USD-based investors. We showed that EME local currency
     bond markets have grown sharply over the past decade and, importantly, their growth has reduced
     EMEs’ reliance on foreign currency debt. Although growth in EME local bond markets has
     been relatively broad based, we found that EMEs with lower inflation volatility and stronger
     legal rights are better able to develop local currency bond markets. We also showed that this
     growing asset class has provided USD-based investors with attractive return characteristics
     over the past decade.U.S. investors have responded to these favorable developments. U.S. holdings of local
     currency bonds increased in almost every EME in our sample, with aggregate bond holdings in
     EMEs increasing from less than $2 billion in 2001 to more than $27 billion in 2008. Some EMEs
     received more investment than others; we found that U.S. bond portfolios are tilted toward
     markets that provide more potential diversification benefits (i.e., markets that have a lower
     correlation with U.S. bonds) and in which the expected mean and skewness of returns are more
     positive. We also found that countries with investor-friendly institutions and
     policies—specifically, fewer capital controls, greater market liquidity and efficiency,
     stronger regulatory quality and creditor rights, better market infrastructure, lower taxation,
     and a larger local institutional investor base—attract more U.S. investment.Our work suggests a handful of fundamental factors that investors should watch as they assess
     EME local currency bond markets. On the supply side, investors should track the evolution of
     legal rights for creditors. Creditor rights remain quite limited in many of the largest EMEs;
     improvement on this front will support additional expansion in EME bond markets, whereas any
     backsliding will decrease investor demand. Investors should also be mindful of the recent surge
     in inflation across EMEs, which could jeopardize the progress in local bond market development.
     On the one hand, if the recent increase in inflation is contained, it would support further
     growth in these markets and could signal a continuation of the decade-long attractive returns.
     On the other hand, if the hard-earned macroeconomic stability is lost and EMEs move into a more
     volatile, high-inflation environment, both local and global investors will shun these markets.
     Finally, cross-border investors should also keep an eye on the investability measures that we
     showed are linked to increased U.S. investor holdings of local currency bonds.
Journal: Financial Analysts Journal
Pages: 73-93
Issue: 4
Volume: 68
Year: 2012
Month: 7
X-DOI: 10.2469/faj.v68.n4.4
File-URL: http://hdl.handle.net/10.2469/faj.v68.n4.4
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Author-Name: Jerry H. Tempelman
Author-X-Name-First: Jerry H.
Author-X-Name-Last: Tempelman
Title: Against Quantitative Easing by the European Central Bank
Abstract: 
 The author discusses his views on an issue of interest to FAJ
          readers.Editor’s Note: Jerry H. Tempelman, CFA, is a former senior
            financial and economic analyst with the Federal Reserve Bank of New York. The views
            expressed in this essay are strictly his own.
Journal: Financial Analysts Journal
Pages: 4-6
Issue: 4
Volume: 68
Year: 2012
Month: 7
X-DOI: 10.2469/faj.v68.n4.5
File-URL: http://hdl.handle.net/10.2469/faj.v68.n4.5
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Author-Name: Ananth Madhavan
Author-X-Name-First: Ananth
Author-X-Name-Last: Madhavan
Title: Exchange-Traded Funds, Market Structure, and the Flash Crash
Abstract: 
 The author analyzes the relationship between market structure and the flash crash. The
     proliferation of trading venues has resulted in a market that is more fragmented than ever. The
     author constructs measures to capture fragmentation and shows that they are important in
     explaining extreme price movements. New market structure reforms should help mitigate such
     market disruptions in the future but have not eliminated the possibility of another flash
     crash, albeit with a different catalyst. The “flash crash” of 6 May 2010 saw some stocks and exchange-traded funds traded
     at pennies only to rapidly recover in price. There has been considerable effort to understand
     and isolate the “cause” of the flash crash with a focus on the precise chronology
     of events. This article instead focuses on the relationship between market structure and the
     flash crash without taking a view on its catalyst. My hypothesis is that equity market
     structure—specifically, the pattern of market fragmentation—is a key determinant of
     the risk of extreme price changes. Prices are more sensitive to liquidity shocks in fragmented
     markets because imperfect intermarket linkages effectively “thin out” each
     venue’s limit order book. Fragmentation is naturally measured by the actual pattern of
     volumes traded across different venues, but it can also be measured with respect to a
     venue’s quotation activity at the best bid or offer. Quote fragmentation captures the
     competition among traders for order flow and, thus, may be better a proxy for the dynamics of
     higher-frequency activity than a measure based on traded volumes.I began with a time-series perspective using intraday trade data from January 1994 to
     September 2011 for all U.S. equities and found that fragmentation now is at the highest level
     ever, reflecting the complexity of U.S. equity market structure today. Cross-sectionally, I
     related fragmentation positively to company size and the use of intermarket sweep orders, which
     are typically used in aggressive liquidity-demanding strategies by nonretail traders. I showed
     that ETPs are more concentrated than other equities and that fragmentation was much greater on
     the day of the flash crash.Regarding the relationship between market structure and the flash crash, I found strong
     evidence that securities that experienced greater fragmentation before the flash crash were
     disproportionately affected on 6 May 2010. This result is consistent with my hypothesis that
     market structure is important in understanding the propagation of a liquidity shock. Although
     quote fragmentation is related to volume fragmentation, the two measures are distinct and
     diverged on the day of the flash crash. Both volume and quote fragmentation measures are
     important risk factors in explaining the observed cross-sectional price movements during the
     flash crash.My analysis provides insight into why ETPs were differentially affected even though ETP
     trading is less fragmented than that of other equities. For ETPs whose components are traded
     contemporaneously, widespread distortion of the prices of underlying basket security prices can
     confound the arbitrage pricing mechanism for ETPs, thus delinking price from value.From the public policy viewpoint, the fact that fragmentation is now at its highest level
     ever may help explain why the flash crash did not occur earlier in response to other liquidity
     shocks; the rapid growth of high-frequency trading and the use of aggressive sweep orders in a
     highly fragmented market is a recent phenomenon. Current policy proposals will help mitigate
     future sharp drawdowns, but another flash crash, albeit with a different catalyst and in a
     different asset class, remains a possibility.
Journal: Financial Analysts Journal
Pages: 20-35
Issue: 4
Volume: 68
Year: 2012
Month: 7
X-DOI: 10.2469/faj.v68.n4.6
File-URL: http://hdl.handle.net/10.2469/faj.v68.n4.6
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “Adaptive Markets and the New World Order,” by Andrew W. Lo, in the March/April 2012 issue of the Financial Analysts Journal.
Journal: Financial Analysts Journal
Pages: 8-8
Issue: 4
Volume: 68
Year: 2012
Month: 7
X-DOI: 10.2469/faj.v68.n4.7
File-URL: http://hdl.handle.net/10.2469/faj.v68.n4.7
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 96-96
Issue: 4
Volume: 68
Year: 2012
Month: 7
X-DOI: 10.2469/faj.v68.n4.8
File-URL: http://hdl.handle.net/10.2469/faj.v68.n4.8
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Author-Name: Ann Marie Hibbert
Author-X-Name-First: Ann Marie
Author-X-Name-Last: Hibbert
Author-Name: Edward R. Lawrence
Author-X-Name-First: Edward R.
Author-X-Name-Last: Lawrence
Author-Name: Arun J. Prakash
Author-X-Name-First: Arun J.
Author-X-Name-Last: Prakash
Title: Do Finance Professors Invest Like Everyone Else?
Abstract: 
 Comparing the results of the Fed’s Survey of Consumer Finances with those of a survey
     of finance professors at U.S. universities, the authors found that finance professors are
     significantly more likely than others to invest in equities. They also found that finance
     professors are less prone to behavioral biases because their decision not to invest in equities
     is based on neither the outcome of their past investments nor their short-term expectations of
     the market.See comments and response on this article.Standard rational economic models predict that in the presence of a positive risk premium,
     all investors will hold some equity. However, there is evidence in the finance literature that
     a number of households in the United States hold no equity. Results from the Fed’s Survey
     of Consumer Finances (SCF) show that even within the top quintile of income distribution, a
     significant number of households do not invest in equities. In our study, we examined the
     investment pattern of finance professors to investigate whether they participate in the stock
     market to a greater extent than the general public.Finance theory suggests that in order to achieve optimal diversification, a portion of every
     portfolio should be invested in equities. Because finance professors are advocates of
     traditional finance theory on equity market participation, we would expect all finance
     professors to invest in equities. To test whether this group of experts practices what it
     preaches, we surveyed finance professors at universities across the United States. During the
     summer of 2007, using the University of Texas at Austin list of all regionally accredited
     universities, we manually collected the names and e-mail addresses of finance professors at
     these institutions. We used a questionnaire to collect data on actual portfolio holdings and
     demographics from each finance professor selected. We investigated whether finance professors,
     compared with households in the Fed’s 2007 SCF sample, are significantly more likely to
     invest in equities. Because our investigation focused on individuals who provided detailed
     information on their financial asset holdings, we included 4,160 respondents from the SCF
     sample and 1,368 respondents from the finance faculty sample.Unsurprisingly, we found that finance professors participate in the stock market to a greater
     extent than do members of the SCF sample. However, our counterintuitive finding is that a
     significant number of the finance professors do not participate in the stock market. Arguably,
     those finance professors who choose not to hold stocks are aware of the “rational”
     arguments for investing in stocks. Our findings thus raise the question of whether it is an
     oversimplification to suggest that not holding stocks is an investment “mistake.”
     Therefore, advising those less knowledgeable in finance always to hold stocks may not be
     beneficial.We also investigated whether some behavioral biases related to nonparticipation in the stock
     market are present in our sample of finance professors. Researchers have broadly characterized
     these biases as overconfidence and considering the past. An
     investor’s overconfidence in the future prospects of an investment can lead to an
     increased affinity for risk taking. With respect to the bias of considering the past, two
     alternative manifestations have been popularized: (1) Investors are willing to take on more
     risk after experiencing a gain because they believe they are using the house’s money, and
     (2) investors are willing to take on more risk after experiencing a loss because they are
     trying to recoup their prior losses (i.e., break even).We first examined whether finance professors are so confident in their own stock market
     predictions that they will invest in equities only if they expect a bull market in the short
     term. We then investigated whether our finance professors consider their past investment
     outcomes in deciding whether to hold equities and are thus prone to either the
      house-money effect or the break-even effect. Specifically,
     we tested whether members of this group decide whether to invest in equities on the basis of
     either their short-term market predictions or the outcomes of their past investments. We found
     no support for overconfidence (in predictions), the house-money effect, or the break-even
     effect. Taken together, these results suggest that our sample of finance professors is less
     prone to certain behavioral biases than the general public.
Journal: Financial Analysts Journal
Pages: 95-105
Issue: 5
Volume: 68
Year: 2012
Month: 9
X-DOI: 10.2469/faj.v68.n5.1
File-URL: http://hdl.handle.net/10.2469/faj.v68.n5.1
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Author-Name: Denis B. Chaves
Author-X-Name-First: Denis B.
Author-X-Name-Last: Chaves
Title: “Demographic Changes, Financial Markets, and the Economy”: Author Response
Abstract: 
 This material comments on “Demographic Changes, Financial Markets, and the Economy”.
Journal: Financial Analysts Journal
Pages: 14-16
Issue: 5
Volume: 68
Year: 2012
Month: 9
X-DOI: 10.2469/faj.v68.n5.10
File-URL: http://hdl.handle.net/10.2469/faj.v68.n5.10
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 112-112
Issue: 5
Volume: 68
Year: 2012
Month: 9
X-DOI: 10.2469/faj.v68.n5.11
File-URL: http://hdl.handle.net/10.2469/faj.v68.n5.11
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Author-Name: Charles D. Ellis
Author-X-Name-First: Charles D.
Author-X-Name-Last: Ellis
Title: “Demographic Changes, Financial Markets, and the Economy”: A Comment
Abstract: 
 This material comments on “Demographic Changes, Financial Markets, and the Economy”.
Journal: Financial Analysts Journal
Pages: 14-14
Issue: 5
Volume: 68
Year: 2012
Month: 9
X-DOI: 10.2469/faj.v68.n5.12
File-URL: http://hdl.handle.net/10.2469/faj.v68.n5.12
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Author-Name: Laurens Swinkels
Author-X-Name-First: Laurens
Author-X-Name-Last: Swinkels
Title: Emerging Market Inflation-Linked Bonds
Abstract: 
 Investigating the value added by inflation-linked bonds in investment portfolios in emerging
     markets, the author found that the inclusion of inflation-linked bonds improved the
     risk–return characteristics of investment portfolios in many of the emerging markets. He
     also found that inflation-linked bond returns correlate more positively with realized inflation
     than do nominal bonds, even in the short run. Thus, investors should consider adding emerging
     market inflation-linked bonds to their investment portfolios. I investigated the value added by inflation-linked bonds in an investment portfolio.
     Recently, several studies have questioned the value added by inflation-linked bonds on the
     basis of empirical analyses of developed markets only. The disadvantage of using those markets
     is that they have experienced low and stable inflation rates since the introduction of
     inflation-linked bonds. In times of low and stable inflation, the inflation protection embedded
     in inflation-linked bonds does not seem to be beneficial to investors. However, such empirical
     analyses do not imply that inflation-linked bonds are an unattractive asset class in general.
     Studying countries that have issued inflation-linked bonds in an environment of higher and more
     volatile inflation rates can provide useful insights for investors that worry about future
     inflation risk. Extending the cross section of countries with a set of nine emerging markets, I
     found that for many of these countries, the inclusion of inflation-linked bonds improves the
     risk–return characteristics of investment portfolios. This finding implies that investors
     in developed markets who take into account future scenarios with higher or more volatile
     inflation rates can also benefit from allocating to inflation-linked bonds. I also documented
     that inflation-linked bond returns correlate more with realized inflation than do those of
     nominal bonds, even in the short run. Thus, investors in nominal bonds and equities should also
     allocate a significant amount to inflation-linked bonds. Furthermore, my mean–variance
     spanning tests indicate that international investors who already invest in emerging market
     nominal bonds and equities can benefit from adding emerging market inflation-linked bonds to
     their investment portfolios.
Journal: Financial Analysts Journal
Pages: 38-56
Issue: 5
Volume: 68
Year: 2012
Month: 9
X-DOI: 10.2469/faj.v68.n5.2
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Author-Name: Jason S. Scott
Author-X-Name-First: Jason S.
Author-X-Name-Last: Scott
Title: Household Alpha and Social Security
Abstract: 
 The author discusses his views on an issue of interest to FAJ readers.Editor’s Note: The views expressed herein are those of the author and do not necessarily represent the views of Financial Engines, Inc.
Journal: Financial Analysts Journal
Pages: 6-10
Issue: 5
Volume: 68
Year: 2012
Month: 9
X-DOI: 10.2469/faj.v68.n5.3
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# input file: UFAJ_A_12048123_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Abe de Jong
Author-X-Name-First: Abe
Author-X-Name-Last: de Jong
Author-Name: Marie Dutordoir
Author-X-Name-First: Marie
Author-X-Name-Last: Dutordoir
Author-Name: Nathalie van Genuchten
Author-X-Name-First: Nathalie
Author-X-Name-Last: van Genuchten
Author-Name: Patrick Verwijmeren
Author-X-Name-First: Patrick
Author-X-Name-Last: Verwijmeren
Title: Convertible Arbitrage Price Pressure and Short-Sale Constraints
Abstract: 
 Using a sample of 4,148 convertibles issued over 1990–2009 by companies listed in 35
     countries, the authors exploited worldwide differences in short-sale constraints to examine
     whether short selling by convertible arbitrageurs creates downward pressure on convertible
     issuers’ stock prices. They found that short-sale constraints have a positive effect on
     issue-date abnormal stock returns, which suggests that a substantial part of the stock price
     effect of convertible issues is attributable to convertible arbitrageurs. Convertible bonds are securities that can be converted, at the option of the holder, into a
     fixed number of the issuer’s ordinary shares. Convertible arbitrage hedge funds have
     played an important role in the convertible bond market, especially since the beginning of the
     21st century. These hedge funds combine long positions in convertibles with short positions in
     the underlying stock.We exploited worldwide differences in short-sale constraints to examine whether convertible
     arbitrage short selling creates downward pressure on convertible issuers’ stock prices.
     Because arbitrage hedge funds are unable to execute their hedging strategy in markets that are
     short-sale constrained, we used the existence of short-sale constraints as a proxy for the
     presence of convertible arbitrage hedge funds in a market. We hypothesized that convertibles
     issued by companies listed in countries where short selling is legally restricted are
     associated with more favorable issue-date stock price effects than are convertibles issued in
     countries where short selling is allowed and practiced. We tested this hypothesis with a sample
     of 4,148 convertible bonds issued over 1990–2009 by companies listed in 35 countries. In
     line with our hypothesis, we found that short-sale constraints have a positive effect on
     issue-date abnormal stock returns. We further found that this effect is stronger in years with
     higher hedge fund involvement and for offerings expected to induce more arbitrage short
     selling.In addition, our study maps the global convertible bond market as completely as permitted by
     publicly available data sources and offers new insights into the determinants of the negative
     stock price reaction associated with convertible bond offerings. Previous papers have
     attributed this negative reaction to the signaling content of convertible bond issues. Our
     approach allowed us to estimate the magnitude of downward price pressure around convertible
     bond offerings that is attributable to the actions of convertible arbitrageurs rather than to
     the negative signal inferred from the convertible bond announcement. Our findings suggest that
     both academics and practitioners who analyze post-2000 convertible bond announcement effects
     are likely to overstate the negative announcement effects when they fail to control for the
     short-sale pressure of convertible bond arbitrageurs. On a more general level, our study
     suggests that stock price behavior around corporate financing events can be substantially
     affected by short-selling regulations.
Journal: Financial Analysts Journal
Pages: 70-88
Issue: 5
Volume: 68
Year: 2012
Month: 9
X-DOI: 10.2469/faj.v68.n5.4
File-URL: http://hdl.handle.net/10.2469/faj.v68.n5.4
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Author-Name: Mohamed A. El-Erian
Author-X-Name-First: Mohamed A.
Author-X-Name-Last: El-Erian
Author-Name: Michael Spence
Author-X-Name-First: Michael
Author-X-Name-Last: Spence
Title: Systemic Risk, Multiple Equilibriums, and Market Dynamics: What You Need to Know and Why
Abstract: 
 Using an array of real-life examples—including the current sovereign debt crisis in
          the eurozone—the authors analyze the underlying dynamics of the periodic bouts of
          systemic path dependence that affect not only financial markets (their functioning and
          stability, investment returns, and volatility) but also investment strategy itself. Their
          analysis explains how sudden shifts in expectations can morph into particularly disruptive
          multiple-equilibrium dynamics and points to possible implications for market outcomes,
          market equilibriums, and policy responses.With too many advanced economies confronting the twin dilemmas of too much debt and too
          little growth—and with systemically important emerging countries navigating the
          tricky middle-income developmental transition—today’s global economy poses
          unusual challenges for traditional concepts of policy responses, asset allocation, and
          risk management. It is also slowly changing the way investors think about correlations,
          volatility, guidelines, and benchmarks.These changes can be particularly pronounced in situations where markets transition from
          a mean-reverting paradigm to one of multiple equilibriums and path dependency. In
          today’s world, expectations play a major role in economic and market outcomes.On the negative side, we saw the phenomenon unfold dramatically in the 2008 financial
          crisis, and Europe has been experiencing it more recently. Moreover, it was central to
          many of the historic bubbles and bank runs that are still the subject of analysis and
          fascination. On the positive side, it has characterized the beneficial breakout phase in
          several emerging economies. We also saw it in the market reactions to circuit breakers
          imposed by decisive policy actions on the part of some advanced countries in 2009.In these circumstances, successful investors (as well as policymakers, researchers, and
          opinion leaders) must extend well beyond their conventional understanding of fundamentals,
          historic risk premiums, correlations, and relative value. They have no alternative but to
          try to understand the expectation formation process itself, including agent signaling and
          feedback loops incorporating economic outcomes and incentive structures. Without such
          understanding, continuous success in meeting objectives becomes even
          harder—especially in a world that will continue to delever and where policymakers
          are still in full experimentation mode.Both theory and the experience of the last few years suggest that investors must also
          enhance their analyses of policymakers’ reaction function. Indeed, this is an
          important input into assessments of correlations, volatility, returns, and risk.For policymakers, the need for a better design and use of ex ante and
            ex post circuit breakers is clear. The former prevent the evolution of
          structures that amplify feedback loops. The latter are better suited to break the serial
          contamination of expectations, the real economy, and market linkages, thereby interrupting
          the often disruptive dynamic that leads to a sequence of bad equilibriums.
Journal: Financial Analysts Journal
Pages: 18-24
Issue: 5
Volume: 68
Year: 2012
Month: 9
X-DOI: 10.2469/faj.v68.n5.5
File-URL: http://hdl.handle.net/10.2469/faj.v68.n5.5
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Author-Name: John Hull
Author-X-Name-First: John
Author-X-Name-Last: Hull
Author-Name: Alan White
Author-X-Name-First: Alan
Author-X-Name-Last: White
Title: CVA and Wrong-Way Risk
Abstract: 
 The authors propose a simple model for incorporating wrong-way and right-way risk into the
     Monte Carlo simulation that is used to calculate credit value adjustment (CVA). The model
     assumes a relationship between the hazard rate of a counterparty and variables whose values are
     generated, or can be generated, as part of the Monte Carlo simulation. The authors present
     numerical results for portfolios of 25 instruments dependent on five underlying market
     variables.Credit value adjustment, or CVA, is the reduction in the value of a dealer’s portfolio
     of derivative transactions with a counterparty to reflect the possibility that the counterparty
     will default. DVA (debit or debt value adjustment) is the increase in the value of the
     portfolio due to the possibility of a default by the dealer. In this article, we explain the
     way CVA and DVA calculations are carried out. For CVA calculations, it is necessary to divide
     the remaining life of the derivative portfolio into a number of time steps and to calculate (1)
     the probability of a counterparty default during each time step and (2) the expected exposure
     of the dealer to the counterparty at the midpoint of each time step. The probabilities of
     default are estimated from credit spreads. The expected exposure is calculated by carrying out
     a Monte Carlo simulation of the market variables on which the value of the portfolio
     depends.The simplest assumption in CVA calculations is that the probability of a counterparty default
     at a point in time is independent of the exposure at that time. Wrong-way risk arises from a
     positive correlation between probability of default and exposure, and right-way risk arises
     from a negative correlation between probability of default and exposure. Most approaches for
     taking account of wrong-way and right-way risk make adjustments to the expected exposure.
     Specifically, the expected exposure conditional on default is assumed to be different from the
     unconditional expected exposure.We use a different approach. We assume that the counterparty’s hazard rate at a
     particular time (which is a measure of its default probability) depends on the values of
     variables that are included, or could be included, in the Monte Carlo simulation of the
     underlying market variables. There are a number of alternative ways in which these variables
     can be chosen. For example, for a gold producer, it may make sense to relate the hazard rate to
     the price of gold. In other circumstances, the hazard rate could be related to a
     company’s stock price. Yet another possibility is to relate the hazard rate to the value
     of the dealer’s portfolio with the counterparty. The nature of the relationship between
     the hazard rate and the chosen variable (or variables) can be estimated subjectively or by
     using historical data. We explain how the relationship can be chosen so that it is consistent
     with the initial term structure of credit spreads.We present numerical results for the case in which the hazard rate is assumed to depend on
     the value of the dealer’s portfolio with the counterparty. We considered portfolios of 25
     instruments dependent on five underlying market variables and found that wrong-way risk and
     right-way risk have a significant effect on the variables used to calculate CVA as well as on
     CVA itself. We also found that the percentage effect depends on the collateral
     arrangements.
Journal: Financial Analysts Journal
Pages: 58-69
Issue: 5
Volume: 68
Year: 2012
Month: 9
X-DOI: 10.2469/faj.v68.n5.6
File-URL: http://hdl.handle.net/10.2469/faj.v68.n5.6
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Author-Name: Antti Ilmanen
Author-X-Name-First: Antti
Author-X-Name-Last: Ilmanen
Title: Do Financial Markets Reward Buying or Selling Insurance and Lottery Tickets?
Abstract: 
 Selling financial investments with insurance or lottery characteristics should earn
          positive long-run premiums if investors like positive skewness enough to overpay for these
          characteristics. The empirical evidence is unambiguous: Selling insurance and selling
          lottery tickets have delivered positive long-run rewards in a wide range of investment
          contexts. Conversely, buying financial catastrophe insurance and holding speculative
          lottery-like investments have delivered poor long-run rewards. Thus, bearing small risks
          is often well rewarded, bearing large risks not.See comments and response on this article.Financial markets are full of strategies that resemble insurance or lotteries. It seems
          worth asking whether investors maximize long-term expected returns by buying or selling
          financial investments that have insurance-like or lottery-like characteristics. This
          question is related to economists’ long-standing puzzle about consumers’
          simultaneous demand for insurance and lottery tickets, which appears to be inconsistent
          with rational behavior and standard risk preferences in a mean–variance world.The answer depends on the market pricing of skewness: how investors
          trade asymmetry against mean return. If most investors prefer positive skewness,
          investments with positively asymmetric payoffs tend to be highly priced and offer
          relatively low long-run returns. However, this outcome is not a foregone conclusion.
          Conceivably, for a given mean return, investors may prefer to suffer losses in one big hit
          instead of a slow trickle, implying a preference for negative skewness.Separately discussing these patterns on the left and right tails of the return
          distribution can enhance our intuition. Positive skewness may reflect a truncated/thinner
          left tail or a thicker/longer right tail—that is, a lesser likelihood of large
          losses or a greater possibility of outsized gains. Both characteristics can increase
          skewness and can be appealing, but their psychological drivers seem quite different. The
          left tail concerns demand for insurance, and the emphasis is on systematic risk and
          limiting the downside, especially in financial crises. The right tail concerns demand for
          lottery tickets, and the emphasis is on idiosyncratic opportunities to enhance the upside.
          Both types of demand for positive skewness can lead to “overpricing” and thus
          to long-run rewards for sellers of insurance and lottery tickets.This article surveys rational and behavioral theories on the pricing of asymmetric
          payoffs and presents wide-ranging empirical evidence in highly diverse contexts.
          Theoretical predictions differ on whether skewness is priced and, if so, with what sign.
          The empirical evidence is much more consistent. I found broadly similar patterns in
          diverse contexts.First, selling volatility on either the left tail (insurance) or the right tail (lottery
          tickets) earns profits in the long run. Conversely, buying option-based tail risk
          insurance against financial catastrophes and holding lottery-like high-volatility
          investments can result in poor long-run returns.Second, the evidence is not restricted to option trading. Carry-seeking and other
          strategies with asymmetric payoffs are close cousins of volatility selling; they are all
          variants of selling tail risk insurance and have earned positive long-run returns.
          Moreover, speculative, lottery-like investments have delivered lower risk-adjusted returns
          than their defensive peers within all major asset classes. In general, accepting small
          risks has been well rewarded, but taking further large risks has been poorly rewarded.
          Thus, levering up low-volatility opportunities appears to boost long-run returns.To interpret the long-run gains from selling financial catastrophe insurance as rational
          risk premiums seems natural. In contrast, the gains from lottery selling seem better
          explained by investor irrationality or by such nonstandard preferences as lottery seeking
          or leverage aversion.
Journal: Financial Analysts Journal
Pages: 26-36
Issue: 5
Volume: 68
Year: 2012
Month: 9
X-DOI: 10.2469/faj.v68.n5.7
File-URL: http://hdl.handle.net/10.2469/faj.v68.n5.7
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Author-Name: Bruce I. Jacobs
Author-X-Name-First: Bruce I.
Author-X-Name-Last: Jacobs
Author-Name: Kenneth N. Levy
Author-X-Name-First: Kenneth N.
Author-X-Name-Last: Levy
Title: Leverage Aversion and Portfolio Optimality
Abstract: 
 Portfolio volatility is the only source of risk in mean–variance optimality, but it
     fails to capture all the risks faced by leveraged portfolios. These risks include the
     possibility of margin calls and forced liquidations at adverse prices and losses beyond the
     capital invested. To recognize these risks, the authors incorporated leverage aversion into the
     optimization process and examined the effects of volatility and leverage aversion on optimal
     long–short portfolios.Mean–variance optimization considers only portfolio volatility; it fails to capture all
     the risks incurred by leveraged portfolios, including long–short portfolios. Leverage
     introduces such risks as the possibility of margin calls and forced liquidations at adverse
     prices, as well as potential losses beyond the capital invested. We believe that many investors
     are averse to these sources of risk, as well as to volatility. That is, risk aversion—or
     its inverse, risk tolerance—is multidimensional. An investor’s tolerance for
     leverage should play a role alongside the investor’s tolerance for volatility in
     selecting an optimal leveraged portfolio. It may restrain the investor’s appetite for
     leverage (and potential lenders’ willingness to underwrite it) and be able to explain the
     difference between the apparent optimality of leveraged portfolios from a conventional
     mean–variance perspective and their suboptimal nature from the investor’s
     perspective. We examine leverage aversion in the context of leveraged portfolios that contain short
     positions. An enhanced active equity (EAE) portfolio relaxes the long-only constraint to allow
     for short sales equal to some percentage of capital and for use of the short-sale proceeds to
     buy additional securities long while maintaining a 100% exposure to an underlying benchmark.
     For example, short sales equal to 30% of capital provide for a 30% expansion of long positions,
     giving rise to an enhanced active 130–30 long–short portfolio. We define a
     parameter that measures leverage tolerance and determine what amount of short selling as a
     percentage of capital (the enhancement) is optimal given various levels of investor leverage
     tolerance.We posit that an investor’s risk tolerance includes a component of leverage tolerance
     in addition to volatility tolerance and develop a leverage tolerance term that can be added to
     the conventional mean–variance utility function. Given estimates for securities’
     expected active returns and covariances for the stocks in the S&P 100 Index, we find EAE
     portfolios that maximize this augmented utility function for a range of volatility and leverage
     tolerances. We find that as volatility tolerance increases, the optimal level of enhancement increases,
     rapidly at first. As leverage tolerance increases, the optimal enhancement increases at a
     slower rate. The optimal enhancement levels off more slowly in the case of leverage tolerance
     than in the case of volatility tolerance. When leverage tolerance is added to the investor’s utility function, optimizations
     yield EAE portfolios that seem reasonable given the levels of leverage of actual EAE
     portfolios. For example, a leverage tolerance of 1 combined with a volatility tolerance of 1
     results in an optimal enhancement of about 25%. We found that the optimal level of enhancement
     is highly dependent upon the investor’s particular level of leverage tolerance. For a
     volatility tolerance of 1 and leverage tolerances between 0 and 2, the optimal level of
     enhancement ranges from less than 5% to more than 45%. Leverage introduces sources of risk that are not captured by traditional mean–variance
     optimization. We suggest the inclusion of leverage tolerance in investor utility functions. The
     explicit recognition of leverage aversion by investors might curtail some of the outsized
     levels of leverage and consequent market disruptions that have been experienced in recent
     years.
Journal: Financial Analysts Journal
Pages: 89-94
Issue: 5
Volume: 68
Year: 2012
Month: 9
X-DOI: 10.2469/faj.v68.n5.8
File-URL: http://hdl.handle.net/10.2469/faj.v68.n5.8
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “Regime Shifts: Implications
            for Dynamic Strategies,” by Mark Kritzman, CFA, Sébastien Page,
          CFA, and David Turkington, CFA, in the May/June 2012 issue of the Financial
            Analysts Journal.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 5
Volume: 68
Year: 2012
Month: 9
X-DOI: 10.2469/faj.v68.n5.9
File-URL: http://hdl.handle.net/10.2469/faj.v68.n5.9
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Author-Name: Eugene F. Fama
Author-X-Name-First: Eugene F.
Author-X-Name-Last: Fama
Author-Name: Robert Litterman
Author-X-Name-First: Robert
Author-X-Name-Last: Litterman
Title: An Experienced View on Markets and Investing
Abstract: 
 At the 65th CFA Institute Annual Conference in Chicago (held 6–9 May 2012),
                    Robert Litterman interviewed Eugene F. Fama to elicit his views on financial
                    markets and investing.At the 65th CFA Institute Annual Conference in Chicago (held 6–9 May 2012),
                    Robert Litterman, executive editor of the Financial Analysts
                        Journal, interviewed Eugene F. Fama to elicit his views on
                    financial markets and investing.
Journal: Financial Analysts Journal
Pages: 15-19
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.1
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Author-Name: Jeffrey E. Horvitz
Author-X-Name-First: Jeffrey E.
Author-X-Name-Last: Horvitz
Title: “Murder on the Orient Express: The Mystery of Underperformance”: Peter Drucker Redux
Abstract: 
 This material comments on “Murder on the Orient Express: The Mystery of Underperformance”.
Journal: Financial Analysts Journal
Pages: 11-11
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.10
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Author-Name: Charles Renwick
Author-X-Name-First: Charles
Author-X-Name-Last: Renwick
Title: “Does IFRS Stand for InFormation RiSk?”: A Comment
Abstract: 
 This material comments on “Does IFRS Stand for InFormation RiSk?”.
Journal: Financial Analysts Journal
Pages: 12-13
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.11
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Author-Name: Victor S. Sidhu
Author-X-Name-First: Victor S.
Author-X-Name-Last: Sidhu
Title: “Murder on the Orient Express: The Mystery of Underperformance”: A Comment
Abstract: 
 This material comments on “Murder on the Orient Express: The Mystery of Underperformance”.
Journal: Financial Analysts Journal
Pages: 11-12
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.12
File-URL: http://hdl.handle.net/10.2469/faj.v68.n6.12
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Author-Name: Ginny W. Frings
Author-X-Name-First: Ginny W.
Author-X-Name-Last: Frings
Author-Name: Michael C. Frings
Author-X-Name-First: Michael C.
Author-X-Name-Last: Frings
Author-Name: M. Christian Mastilak
Author-X-Name-First: M. Christian
Author-X-Name-Last: Mastilak
Title: “Does IFRS Stand for InFormation RiSk?”: Author Response
Abstract: 
 This material comments on “Does IFRS Stand for InFormation RiSk?”.
Journal: Financial Analysts Journal
Pages: 13-14
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.13
File-URL: http://hdl.handle.net/10.2469/faj.v68.n6.13
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Author-Name: Xi Li
Author-X-Name-First: Xi
Author-X-Name-Last: Li
Author-Name: Ying Becker
Author-X-Name-First: Ying
Author-X-Name-Last: Becker
Author-Name: Didier Rosenfeld
Author-X-Name-First: Didier
Author-X-Name-Last: Rosenfeld
Title: “Asset Growth and Future Stock Returns: International Evidence”: Author Response
Abstract: 
 This material comments on “Asset Growth and Future Stock Returns: International Evidence”.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.14
File-URL: http://hdl.handle.net/10.2469/faj.v68.n6.14
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “Jump on the Post–Earnings Announcement Drift,” by Haigang Zhou, CFA, and John Qi Zhu, in the May/June 2012 issue of the Financial Analysts Journal.
Journal: Financial Analysts Journal
Pages: 9-9
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.15
File-URL: http://hdl.handle.net/10.2469/faj.v68.n6.15
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# input file: UFAJ_A_12048137_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Laurence B. Siegel
Author-X-Name-First: Laurence B.
Author-X-Name-Last: Siegel
Title: Fewer, Richer, Greener: The End of the Population Explosion and the Future for Investors
Abstract: 
 The population explosion is almost over, with fertility below the replacement
                    rate in many advanced countries and rapidly declining in most developing
                    countries. In the next half century, economic growth will be robust, especially
                    in developing countries, and will increase world wealth dramatically. These
                    factors will make it easier, not harder, to preserve the natural environment and
                    avoid resource shortages. Investors should focus on natural resources and other
                    industries that will benefit from these trends.Despite a deep-seated bias toward pessimism that pervades much of intellectual
                    thought throughout history, the human condition—physical and
                    economic—has steadily improved for at least two centuries and will
                    continue to do so in the future. In contrast to the past 200 years, however,
                    future economic growth will be accompanied by population stabilization as
                    fertility rates decline in developing countries even more quickly than they
                    declined in developed countries in past decades. In other words, the population
                    explosion is almost over. A “greener” environment will be a
                    consequence of the leveling off of world population and increasing affluence as
                    more resources are devoted to conservation, pollution control, and environmental
                    remediation.As a population becomes richer, there is a change in the trade-off facing a
                    couple deciding how many children to have. Children become expensive and provide
                    fewer benefits (e.g., you cannot put them to work on the farm if you are not
                    engaged in farming). As a result, the fertility rate declines. A decline in
                    fertility rates was observed long ago in developed countries, but the decline
                    has become nearly universal today, with such countries as Brazil, Turkey, and
                    Iran approaching First World fertility rates. The UN Population
                    Division’s projections reflect these trends, with the world’s
                    population reaching 10 billion to 11 billion late in this century before
                    stabilizing or possibly declining. This population outlook is very favorable for
                    addressing such environmental concerns as natural-resource usage, overcrowding,
                    and pollution (including greenhouse gas emissions) and is consistent with
                    projections of continued rapid economic growth, especially in the developing
                    world.Everyone knows that the world is becoming dramatically richer, yet at the same
                    time, many people seem to believe that economic conditions are worse than in the
                    “good old days.” In the last five years, there has been some
                    deterioration, but economic setbacks have always occurred and have usually been
                    followed by rebounds to new heights of prosperity. The facts are that
                    developed-country per capita GDP has been rising at a remarkably steady annual
                    rate of 1.8% for two centuries and developing-country per capita GDP has been
                    rising even faster, though over a shorter period. “Peak inequality”
                    between developing and developed countries occurred around 1950, and the
                    developing world has been catching up ever since, while inequality in
                    developed-world economies has edged upward. The forecast is for more of the
                    same, with developing economies leading the way.Perhaps the most difficult forecast for readers to accept is that this richer
                    world of fewer people will also be greener, more environmentally sound. A
                    proposition called the environmental Kuznets curve (EKC) asserts that as an
                    economy begins to develop, the environment becomes “dirtier”
                    because of industrial pollution and higher population densities. As the society
                    becomes more affluent, however, people can afford a cleaner environment and can
                    attain it through a mix of private and public action. The argument is
                    essentially that environmental quality is a luxury good. The EKC theory is borne
                    out for most industrial pollutants but not for all environmental indicators; for
                    example, wild fisheries have continued to deteriorate in developed countries
                    even as air and water have become dramatically cleaner.A related question is whether the high cost of increasingly scarce natural
                    resources will limit economic growth. Economic history suggests strongly that it
                    will not, in part because the high price of a given resource causes substitutes
                    to be developed. However, some resources are in essentially fixed supply, and
                    one should be careful about extrapolating consumption growth rates in such
                    circumstances.A growing world economy should favor equities at the expense of fixed income.
                    Active managers hoping to profit from a greener world of fewer, richer people
                    should focus on food and agri-technology, water, traditional and alternative
                    energy, minerals and other natural resources, infrastructure, environmental
                    remediation, and human capital.
Journal: Financial Analysts Journal
Pages: 20-37
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.2
File-URL: http://hdl.handle.net/10.2469/faj.v68.n6.2
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# input file: UFAJ_A_12048138_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Thomas M. Idzorek
Author-X-Name-First: Thomas M.
Author-X-Name-Last: Idzorek
Author-Name: James X. Xiong
Author-X-Name-First: James X.
Author-X-Name-Last: Xiong
Author-Name: Roger G. Ibbotson
Author-X-Name-First: Roger G.
Author-X-Name-Last: Ibbotson
Title: The Liquidity Style of Mutual Funds
Abstract: 
 Recent literature indicates that a liquidity investment style—the process
                    of investing in less liquid stocks—has led to excess returns relative to
                    size and value. The authors examined whether this style, previously documented
                    at the security level, can be uncovered at the mutual fund level. Across a wide
                    range of mutual fund categories, they found that, on average, mutual funds that
                    held less liquid stocks significantly outperformed those that held more liquid
                    stocks.Recent literature indicates that the liquidity investment style—investing
                    in relatively less liquid stocks within the liquid universe of publicly traded
                    stocks—produces risk-adjusted returns that rival or exceed those of the
                    three best-known market anomalies: small minus large, value minus growth, and
                    high minus low momentum. We examined whether this style, previously documented
                    at the security level, can be found at the mutual fund level.Combining data from an individual stock database and a mutual fund holdings
                    database, we were able to build composites of mutual funds based on the
                    weighted-average liquidity of the individual stocks held by the mutual funds. We
                    then studied the performance of the composites.In aggregate and across a wide range of mutual fund categories, we found that, on
                    average, mutual funds that held less liquid stocks significantly outperformed
                    mutual funds that held more liquid stocks (by 2.65% per year over nearly the
                    last 15 years). Using monthly rebalanced mutual fund composites, we found that
                    for each of the 16 groupings in our U.S. equity universe, the lowest-liquidity
                    composite had a superior annual geometric return, annual arithmetic return,
                    standard deviation, Sharpe ratio, annualized alpha versus the category’s
                    composite average, and annualized alpha versus the three Fama–French
                    factors. Surprisingly, the outperformance of the mutual funds that hold less
                    liquid stocks was primarily due to superior performance in down markets. We
                    found similar results in four separate robustness tests based on permutations in
                    the construction of our liquidity-based composites.Overall, we found that the liquidity premium is sufficiently strong to show up in
                    portfolios of managers who are most likely not directly focusing on
                    liquidity.
Journal: Financial Analysts Journal
Pages: 38-53
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.3
File-URL: http://hdl.handle.net/10.2469/faj.v68.n6.3
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: Global Trade Imbalances Matter
Abstract: 
 The editor discusses his views on an issue of interest to FAJ readers.
Journal: Financial Analysts Journal
Pages: 4-6
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.4
File-URL: http://hdl.handle.net/10.2469/faj.v68.n6.4
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Author-Name: Ke Tang
Author-X-Name-First: Ke
Author-X-Name-Last: Tang
Author-Name: Wei Xiong
Author-X-Name-First: Wei
Author-X-Name-Last: Xiong
Title: Index Investment and the Financialization of Commodities
Abstract: 
 The authors found that, concurrent with the rapidly growing index investment in
                    commodity markets since the early 2000s, prices of non-energy commodity futures
                    in the United States have become increasingly correlated with oil prices; this
                    trend has been significantly more pronounced for commodities in two popular
                    commodity indices. This finding reflects the financialization of the commodity
                    markets and helps explain the large increase in the price volatility of
                    non-energy commodities around 2008.Since the early 2000s, commodity futures have emerged as a popular asset class
                    for many financial institutions. As a result, investment flows on the order of
                    hundreds of billions of dollars have entered the commodity markets. Various
                    observers and policymakers have expressed a strong concern that index investment
                    as a form of financial speculation might have caused unwarranted increases in
                    the cost of energy and food and induced excessive price volatility.What is the economic impact of the rapid growth of commodity index investment?
                    Prior to the early 2000s, despite the liquid futures contracts traded on many
                    commodities, academic researchers documented several characteristics indicating
                    that commodity markets were partly segmented from outside financial markets and
                    from each other: The commodity prices provided a risk premium for idiosyncratic
                    commodity price risk and had little comovement with stocks and with each other.
                    Recognition of the potential diversification benefits of investing in the
                    segmented commodity markets prompted the rapid growth of commodity index
                    investment after the early 2000s and precipitated a fundamental process of
                    financialization among commodity markets. In our study, we analyzed the effects
                    of this financialization process.Our analysis focused on a salient empirical pattern of greatly increased price
                    comovements between various commodities after 2004, when significant index
                    investment started to flow into commodity markets. Because index investors
                    typically focus on strategic portfolio allocation between the commodity class
                    and other asset classes, such as stocks and bonds, they tend to trade in and out
                    of all commodities in a given index at the same time. As a result, their
                    increasing presence should have a greater impact on commodities in the two most
                    popular commodity indices—the S&P GSCI and the Dow Jones-UBS Commodity
                    Index (DJ-UBSCI)—than on commodities off the indices. Consistent with this
                    hypothesis, we found that futures prices of non-energy commodities became
                    increasingly correlated with oil after 2004. In particular, this trend was
                    significantly more pronounced for indexed commodities than for off-index
                    commodities after controlling for a set of alternative arguments. Although this
                    trend intensified after the world financial crisis triggered by the bankruptcy
                    of Lehman Brothers in September 2008, its presence was already evident and
                    significant before the crisis.We also documented an increasing return correlation between commodities and the
                    MSCI Emerging Markets Index in recent years, which confirms the rising
                    importance of commodity demands from rapidly growing emerging economies in
                    determining commodity prices. However, comovements of commodity futures prices
                    in China remained stable over 2006–2008, in sharp contrast to the large
                    increases in the United States. This contrast suggests that the increases in
                    commodity price comovements were not caused solely by changes in the supply of
                    and demand for commodities driven by emerging economies.It is also important to note the sharp contrast between the high commodity return
                    correlations of the last few years and those of the 1970s and early 1980s, when
                    persistent oil supply shocks and stagflation hit the U.S. economy: The high
                    correlations in the recent period were not only larger in magnitude but also
                    different in nature. They emerged while inflation and inflation volatility
                    remained subdued throughout the past decade.We would expect the growing presence of commodity index investors to affect the
                    commodity markets in various ways. On the one hand, their presence can lead to a
                    more efficient sharing of commodity price risk; on the other hand, their
                    portfolio rebalancing can spill price volatility from outside markets on and
                    across commodity markets. Consistent with the volatility spillover effect, our
                    analysis shows that in 2008, indexed non-energy commodities had higher price
                    volatility than did off-index commodities, and this difference was partly
                    related to the greater return correlations of indexed commodities with oil.The changes induced by the index investment flows in commodity price correlation
                    and volatility have profound implications on a wide range of issues, from
                    commodity producers’ hedging strategies and speculators’ investment
                    strategies to many countries’ energy and food policies.
Journal: Financial Analysts Journal
Pages: 54-74
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.5
File-URL: http://hdl.handle.net/10.2469/faj.v68.n6.5
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Author-Name: Attilio Meucci
Author-X-Name-First: Attilio
Author-X-Name-Last: Meucci
Title: A Fully Integrated Liquidity and Market Risk Model
Abstract: 
 Going beyond the simple bid–ask spread overlay for a particular value at
                    risk, the author introduces an innovative framework that integrates liquidity
                    risk, funding risk, and market risk. He overlaid a whole distribution of
                    liquidity uncertainty on future market risk scenarios and allowed the liquidity
                    uncertainty to vary from one scenario to another, depending on the liquidation
                    or funding policy implemented. The result is one easy-to-interpret,
                    easy-to-implement formula for the total liquidity-plus-market-risk profit and
                    loss distribution.In this article, I introduce a new framework to integrate liquidity risk, funding
                    risk, and market risk. The main result is a novel liquidity-plus-market-risk
                    P&L distribution formula, which is easy to interpret and easy to implement.
                    My approach improves on the current approaches to jointly modeling market risk
                    and liquidity risk in seven ways:My liquidity model goes beyond a deterministic bid–ask spread
                            overlay to a pure market risk component. Indeed, it models the full
                            impact of any actual liquidation schedule, including impact uncertainty
                            and impact correlations, as well as the differential impact between
                            trading quickly and trading slowly.My liquidity model is state dependent: In those scenarios where the
                            market is down and volatile, the adverse impact of any liquidation
                            schedule is worse and, therefore, so is the liquidity of the
                            portfolio.My liquidity model addresses both exogenous liquidity risk (arising from
                            market conditions beyond our control) and funding risk (i.e., endogenous
                            liquidity risk): Using this framework, one can model more aggressive
                            liquidation schedules on capital-intensive securities specifically in
                            those market scenarios that give rise to very negative P&L, all
                            while no liquidation occurs in positive P&L scenarios.My liquidity model includes all the features of the market risk component
                            beyond mean and variance. In particular, it models the P&L of not
                            only nonsymmetrical tail events but also such nonlinear securities as
                            complex derivatives.My liquidity model explicitly addresses the issue of estimation error,
                            allowing for fast distributional stress testing via the fully flexible
                            probabilities methodology (discussed later in the article).My methodology allows for a novel decomposition of risk into a market
                            risk component and a liquidity risk component.My methodology also allows for a natural definition of the
                            portfolio’s liquidity score in monetary units.From a methodology perspective, my approach relies on three pillars: (1) the
                    literature on optimal execution—to model liquidity risk as a function of
                    the actual trading involved; (2) an analytical conditional convolution—to
                    blend market risk and liquidity/funding risk whereby different liquidation
                    decisions are made in different market scenarios; and (3) the fully flexible
                    probabilities approach—to model and stress test market risk even in highly
                    non-normal portfolios with complex derivatives.My approach can be implemented efficiently with portfolios of thousands of
                    securities, which can be accomplished by using the MATLAB code supporting the
                    case study in the article (www.symmys.com/node/350).
Journal: Financial Analysts Journal
Pages: 94-105
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.6
File-URL: http://hdl.handle.net/10.2469/faj.v68.n6.6
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# input file: UFAJ_A_12048142_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert M. Anderson
Author-X-Name-First: Robert M.
Author-X-Name-Last: Anderson
Author-Name: Stephen W. Bianchi
Author-X-Name-First: Stephen W.
Author-X-Name-Last: Bianchi
Author-Name: Lisa R. Goldberg
Author-X-Name-First: Lisa R.
Author-X-Name-Last: Goldberg
Title: Will My Risk Parity Strategy Outperform?
Abstract: 
 The authors gauged the return-generating potential of four investment strategies:
                    value weighted, 60/40 fixed mix, and unlevered and levered risk parity. They
                    report three main findings: (1) Even over periods lasting decades, the start and
                    end dates of a backtest can have a material effect on results; (2) transaction
                    costs can reverse ranking, especially if leverage is used; and (3) a
                    statistically significant return premium does not guarantee outperformance over
                    reasonable investment horizons. See comments and response on this article.We examined the historical performance of four familiar investment strategies
                    over an 85-year horizon. Our study included a market or value-weighted
                    portfolio, which is the optimal risky portfolio in the capital asset pricing
                    model, and a 60/40 mix, which is popular with pension funds and other
                    long-horizon investors. Our study also included two risk parity strategies: one
                    that is unlevered and another that is levered to match market volatility. Risk
                    parity has been popular since the 2008 financial crisis, as frustrated investors
                    have struggled to meet return targets by levering low-risk or low-beta assets or
                    portfolios.Our main findings are as follows.
                    Performance depends materially on the backtesting period. Our
                    results are consistent with the notion that the relative performance of risk
                    parity strategies is better in turbulent periods than in bull markets. This
                    finding is plausible because turbulence is often accompanied by a flight to
                    quality, when safer (low-risk) assets tend to increase in value. However, we do
                    not have sufficient data to support the finding statistically.
                    Market frictions negate the outperformance of an idealized
                        (frictionless) levered risk parity strategy. Our results are
                    consistent with the empirical literature on the low-beta/low-risk anomaly.
                    Specifically, in a frictionless setting, our low-risk strategy had higher
                    risk-adjusted returns than our high-risk strategies. We extend the empirical
                    literature by showing that this effect can persist after taking market frictions
                    into account. However, leverage exacerbates market frictions, which degrade both
                    return and risk-adjusted return. We further extend the literature by showing
                    that after accounting for market frictions, a risk parity strategy levered to
                    match market volatility underperforms the market on the basis of both return and
                    risk-adjusted return. Specifically, among the four strategies we examined,
                    unlevered risk parity had the highest Sharpe ratio and the lowest expected
                    return over the 85-year period of our study (1926–2010). When the
                    unlevered risk parity was levered to have the same volatility as the
                    value-weighted portfolio, transaction costs reduced its Sharpe ratio and its
                    cumulative return was less than the return of the 60/40 and value-weighted
                    strategies. In summary, at least for the simple risk parity strategy we
                    examined, market frictions fully explain the anomaly.
                    A statistically significant return premium is hard to come by, and in
                        any case, it is far from a guarantee of outperformance over reasonable
                        investment horizons. The confidence intervals on the returns of an
                    investment strategy are very wide, even with many decades of data. Thus, it is
                    rarely possible to demonstrate with conventional statistical significance that
                    one strategy dominates another. However, even if we were reasonably confident
                    that one strategy achieved higher expected returns than another without
                    incurring extra risk, it would be entirely possible for the weaker strategy to
                    outperform over periods of several decades, certainly beyond the investment
                    horizon of most individuals and even perhaps of such institutions as pension
                    funds and endowments.
Journal: Financial Analysts Journal
Pages: 75-93
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.7
File-URL: http://hdl.handle.net/10.2469/faj.v68.n6.7
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 112-112
Issue: 6
Volume: 68
Year: 2012
Month: 11
X-DOI: 10.2469/faj.v68.n6.8
File-URL: http://hdl.handle.net/10.2469/faj.v68.n6.8
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Author-Name: William R. Sodjahin
Author-X-Name-First: William R.
Author-X-Name-Last: Sodjahin
Title: Change in Cash-Holding Policies and Stock Return Predictability in the Cross Section
Abstract: 
 The author found that stocks with a positive change in company cash holdings have significantly
higher risk-adjusted returns than stocks with a negative change in cash holdings (CCH). Moreover,
the return predictive power of CCH is (1) distinct from the effect of cash holdings (CH), (2) absent
among cash-rich companies, (3) stronger among small-cap stocks, and (4) limited to non-January
months. The CCH anomaly appears to be more “contaminated” than the CH effect by
mispricing.A considerable amount of research has been published on the determinants of a company’s
cash holdings and the holdings’ time-series properties over time. Only recently, however, have
excess cash holdings been linked to stock returns and a precautionary savings policy to expected
returns. This study investigates the cross-sectional relation between a company’s changes in
cash holdings (CCH) and subsequent equity returns. Changes in cash holdings are, by definition,
different from the level of cash holdings or excess cash holdings in the sense that a company can
increase its cash holdings and still have a low cash-holding level or a company can decrease its
cash holdings and still maintain an excess cash-holding level. I found evidence that CCH, as a
signal for changes in future investment opportunities, predicts subsequent stock returns. The
abnormal returns associated with CCH remain significant in the presence of size, book-to-market,
momentum, asset growth, illiquidity, and idiosyncratic volatility. Specifically, stocks with
positive CCH significantly outperform stocks with negative CCH. The dispersion in risk premiums is
not explained by the capital asset pricing model, the Fama–French three-factor model, or the
Carhart four-factor model. Importantly, the Sharpe ratio of a CCH-based factor-mimicking portfolio
is higher than that of the market factor or the Fama–French SMB and HML factors and is very
close to that of the momentum factor. Moreover, the return predictive power of CCH is (1) distinct
from the effect of the level of cash holdings (CH)—that is, the abnormal returns associated
with CCH remain after controlling for CH, and vice versa—(2) absent among cash-rich companies,
(3) stronger among small-cap stocks, and (4) limited to non-January months. I explored the
implications of arbitrage risk for both the CCH and the CH effects and found that unlike accrual and
asset growth anomalies, both effects are pervasive across arbitrage risk groups (proxied by
idiosyncratic risk) but that the CCH anomaly appears to be more influenced than the CH effect by
mispricing. Finally, I found a surprisingly negative CCH effect for January months, which is,
however, driven entirely by mispricing.
Journal: Financial Analysts Journal
Pages: 53-70
Issue: 1
Volume: 69
Year: 2013
Month: 1
X-DOI: 10.2469/faj.v69.n1.1
File-URL: http://hdl.handle.net/10.2469/faj.v69.n1.1
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Author-Name: Robert Novy-Marx
Author-X-Name-First: Robert
Author-X-Name-Last: Novy-Marx
Title: Logical Implications of the GASB’s Methodology for Valuing Pension Liabilities
Abstract: 
 The marginal valuation of assets can be negative under the Governmental Accounting Standards
     Board’s methodology for valuing pension liabilities. In such cases, a plan can improve
     its GASB funding status by literally burning money. GASB accounting also gives different
     “valuations” for the same assets and liabilities when they are partitioned
     differently among plans. Finally, the methodology is exactly equivalent to fairly valuing plan
     liabilities but accounting for stocks at more than twice their traded prices.State and local governments employ one out of seven U.S. workers, and these workers generally
     participate in state-sponsored defined benefit (DB) pension plans. Governments value their
     pension liabilities, which run to trillions of dollars, using a methodology prescribed by the
     Governmental Accounting Standards Board (GASB). These valuations are used in planning and
     budgeting. Because they routinely provide the basis for multibillion dollar decisions, their
     accuracy has direct implications for government efficiency.Disagreement remains, however, regarding the validity of the GASB’s prescribed
     methodology and, in particular, the rate used to discount liabilities. The GASB discounts
     projected benefit payments at the expected return on plan assets because it believes this rate
     “reflects the employer’s projected sacrifice of resources.” Financial
     economists prefer a lower discount rate because accumulated pension promises are viewed as
     nearly default free and the basic tenets of financial economics require that cash flows be
     discounted at rates reflecting their risks. The difference in the aggregate liability posed by
     state and local DB pension plans calculated using the discount rates preferred by the GASB and
     financial economists is enormous—in excess of $2 trillion.It is well known that the GASB’s methodology of discounting liabilities at the expected
     return on plan assets implies that the GASB funding status of state and local government DB
     pension plans improves when the plans take on more investment risk. In this article, I document
     several lesser-known pathologies of the GASB methodology. In particular, I show that GASB
     accounting is susceptible to the “Yogi Berra fallacy,” in which a pizza is less
     filling when sliced into fewer pieces: The GASB gives different “valuations” for
     the exact same assets and liabilities when they are partitioned differently among plans.
     Moreover, the marginal valuation of assets can be negative under GASB rules. In such cases, a
     plan can improve its GASB funding status by literally burning money. Finally, I show that the
     GASB’s methodology is exactly equivalent to fairly valuing plan liabilities but
     accounting for stocks at more than twice their traded prices and further crediting a plan an
     additional dollar for each dollar of stock that it intends to buy in the
     future.
Journal: Financial Analysts Journal
Pages: 26-32
Issue: 1
Volume: 69
Year: 2013
Month: 1
X-DOI: 10.2469/faj.v69.n1.2
File-URL: http://hdl.handle.net/10.2469/faj.v69.n1.2
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Author-Name: Sébastien Page
Author-X-Name-First: Sébastien
Author-X-Name-Last: Page
Title: How to Combine Long and Short Return Histories Efficiently
Abstract: 
 A common challenge in portfolio risk analysis is that certain assets have shorter return
     histories than others. Unfortunately, many standard portfolio risk analysis
     techniques—including historical tail risk measurement, regime-dependent risk analysis,
     and bootstrapping simulations—require full return histories for all assets or risk
     factors. The author presents easy instructions on how to efficiently combine data for
     investments whose histories differ in length and offers a new model to better account for
     non-normal distributions. A common challenge in portfolio risk analysis is that certain assets have shorter return
     histories than others. Unfortunately, many standard portfolio risk analysis
     techniques—including historical tail risk measurement, regime-dependent risk analysis,
     and bootstrapping simulations—require full return histories for all assets or risk
     factors.To address this problem, analysts often discard potentially valuable data on assets with long
     histories. For example, the history of returns for bonds and equities in the United States is a
     rich one, going back to the 1920s. This data sample includes the Great Depression, wars,
     several business cycles, periods of hyperinflation and deflation, and various financial crises.
     Analysts often exclude most of this rich data sample because returns for the other assets in
     the portfolio are not available as far back in history. Consequently, their models may not
     capture important risk dynamics for both assets with long return histories and assets with
     short return histories.In this article, the author presents easy instructions on how to efficiently combine data for
     investments whose histories differ in length and suggests a new model to better account for
     non-normal distributions. The new model backfills the missing data for assets with short return
     histories. (Of course, the author does not claim to offer a model that magically transforms
     missing data into additional information. The model merely makes it easier to incorporate
     information from the long sample and to analyze more regimes than those included in the short
     sample.) Importantly, unlike conventional approaches that rely on the normal distribution,
      the model samples empirical residuals from the short sample to model uncertainty
      around the backfilled returns. Essentially, the model represents a hybrid between
     maximum likelihood estimation and bootstrapping. It provides an easy, simple, relatively
     assumption-free approach to account for fat tails—and other features of the
     distribution—in the return-backfilling process beyond means and covariances.
Journal: Financial Analysts Journal
Pages: 45-52
Issue: 1
Volume: 69
Year: 2013
Month: 1
X-DOI: 10.2469/faj.v69.n1.3
File-URL: http://hdl.handle.net/10.2469/faj.v69.n1.3
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Author-Name: Robert J. Shiller
Author-X-Name-First: Robert J.
Author-X-Name-Last: Shiller
Title: Capitalism and Financial Innovation
Abstract: 
 At the 2012 CFA Institute Financial Analysts Seminar, held 23–27 July in Chicago,
          Robert J. Shiller discussed his view that capitalism must be constantly updated through
          innovation in order to be successful in its purpose of achieving society’s goals.
          Three recent innovations—the benefit corporation, crowd funding, and the social
          impact bond—are good examples of how finance and financiers can contribute to
          attaining these goals.At the 2012 CFA Institute Financial Analysts Seminar, held 23–27 July in Chicago,
          Robert J. Shiller discussed his view that capitalism must be constantly updated through
          innovation in order to be successful in its purpose of achieving society’s goals. Three recent innovations—the benefit corporation, crowd funding, and the social
          impact bond—are good examples of how finance and financiers can contribute to
          attaining these goals. A benefit corporation is a class of corporation required by law to
          create a general benefit for society as well as for its shareholders through profit
          maximization. Crowd funding is the funding of a company by selling small amounts of equity
          to many investors. It allows the small investor to be, in effect, a venture capitalist,
          and it essentially democratizes finance. A social impact bond operates over a fixed period
          of time but does not offer a fixed rate of return. Repayment to investors is contingent on
          the achievement of specified social outcomes. The idea is to let the free enterprise
          system solve a social or even an environmental problem. The bond proceeds are used to
          create a financial market that will encourage and incentivize private vendors to find
          practical solutions for social concerns.The author also proposes an investment vehicle called “trills” that could be
          a useful innovation. A trill is a promise to pay an investor a share of a nation’s
          GDP. A government would sell shares of its GDP to the public and make the shares
          marketable. The price of a trill would fluctuate in the market on the basis of the
          anticipated GDP of the issuing country. The concept is similar to a country issuing equity
          instead of debt, and trill issuance would be a type of risk management for the country.
          The author suggests that the U.S. government could begin to solve the budget crisis today
          by refinancing maturing debt into trills.
Journal: Financial Analysts Journal
Pages: 21-25
Issue: 1
Volume: 69
Year: 2013
Month: 1
X-DOI: 10.2469/faj.v69.n1.4
File-URL: http://hdl.handle.net/10.2469/faj.v69.n1.4
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: 2012 Report to Readers
Journal: Financial Analysts Journal
Pages: 12-13
Issue: 1
Volume: 69
Year: 2013
Month: 1
X-DOI: 10.2469/faj.v69.n1.5
File-URL: http://hdl.handle.net/10.2469/faj.v69.n1.5
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Author-Name: Roger Edelen
Author-X-Name-First: Roger
Author-X-Name-Last: Edelen
Author-Name: Richard Evans
Author-X-Name-First: Richard
Author-X-Name-Last: Evans
Author-Name: Gregory Kadlec
Author-X-Name-First: Gregory
Author-X-Name-Last: Kadlec
Title: Shedding Light on “Invisible” Costs: Trading Costs and Mutual Fund Performance
Abstract: 
 Industry observers have long warned of the “invisible” costs of fund trading, yet
evidence that these costs matter is mixed because many studies do not account for the largest
trading-cost component—price impact. Using portfolio holdings and transaction data, the
authors found that funds’ annual trading costs are, on average, higher than their expense
ratio and negatively affect performance. They also developed an accurate but computationally simple
trading-cost proxy—position-adjusted turnover.The expense ratio is one of the few reliable predictors of mutual fund return performance, and
the increasing market share of low-cost index and exchange-traded funds suggests that investors use
this information when making investment decisions. However, as noted by John Bogle and other
prominent industry observers, the expense ratio captures only the “visible” (i.e.,
reported) costs of mutual funds. Funds incur a host of “invisible” costs that are less
transparent to investors—most notably, the transaction costs associated with implementing
changes in portfolio positions. In our study, we estimated funds’ annual expenditures on
trading costs and examined the impact of those costs on fund return performance.We developed a detailed position-by-position measure of funds’ annual expenditures on
trading costs by using fund portfolio holdings data, transaction-level securities data, and U.S. SEC
filings. First, we used quarterly portfolio holdings data to determine each fund’s position
changes on a stock-by-stock basis. Second, for each position change, we applied an estimate of the
cost (brokerage commission, bid–ask spread, and price impact) of trading that amount of that
stock in that quarter. Third, we computed each fund’s annual expenditure on trading costs by
aggregating the costs of all trades for that fund over the year. We applied this approach to our
sample of 1,758 domestic equity funds over 1995–2006.We found that funds’ annual expenditures on trading costs (i.e., aggregate trading cost)
were comparable in magnitude to the expense ratio (1.44% a year versus 1.19%, respectively).
Moreover, there was considerably more variation in fund trading costs than in expense ratios. For
example, the difference in average expense ratio for small-cap growth and large-cap value funds was
0.32 percentage points (1.39% versus 1.07%), whereas the difference in average aggregate trading
costs for the same funds was 2.33 percentage points (3.17% versus 0.84%). The more important question concerns how funds’ expenditures on trading costs relate to
return performance. We found a strong negative relation between aggregate trading cost and fund
return performance. Sorting funds by expenses, fund total net assets, or turnover (the most common
trading-cost proxy) yielded no consistent, monotonic pattern of returns. In stark contrast, sorting
funds on the basis of their aggregate trading-cost estimate yielded a clear monotonic pattern of
decreasing risk-adjusted performance as fund trading costs increase. The difference in average
annual return for funds in the highest and lowest quintiles of aggregate trading cost was
–1.78 percentage points.Given the power of aggregate trading cost in predicting fund performance, it would be a useful
tool for investment decision makers. Unfortunately, these direct estimates of fund trading costs are
difficult to come by for reasons of both data availability and computational complexity. The most
readily available metric to proxy for trading costs, used by both academics and practitioners, is
fund turnover. However, the empirical evidence on the relation between fund turnover and return
performance is ambiguous. We conjectured that this ambiguity is due to the fact that turnover does
not account for the differential cost of fund trades—which depends on fund size (i.e., trade
size) and stock liquidity (i.e., small cap versus large cap). For example, a $500 million small-cap
fund with 50% turnover will have much higher trading costs than a $100 million large-cap fund with
100% turnover, despite the former’s lower turnover.To address this underlying deficiency, we propose a simple adjustment to turnover. In particular,
we compute “position-adjusted turnover” by multiplying each fund’s turnover by its
relative position size. A fund’s relative position size is equal to its average position size
(total net assets divided by number of holdings) divided by the average position size of all funds
in its market-cap category. Relative position size captures the price impact of the fund’s
trades—the greatest component of a fund’s trading costs. We found that this simplified
proxy has power similar to that of our more fastidious measure. The difference in average annual
return for funds in the highest and lowest quintiles of position-adjusted turnover was –1.92
percentage points. Overall, our results suggest that trading costs are an important determinant of
fund performance, and we offer a simple proxy for trading costs that can be used by investors and
researchers alike.
Journal: Financial Analysts Journal
Pages: 33-44
Issue: 1
Volume: 69
Year: 2013
Month: 1
X-DOI: 10.2469/faj.v69.n1.6
File-URL: http://hdl.handle.net/10.2469/faj.v69.n1.6
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: Rebalancing Global Trade: No Quick Fix
Abstract: 
 The editor discusses his views on an issue of interest to FAJ readers.
Journal: Financial Analysts Journal
Pages: 6-9
Issue: 1
Volume: 69
Year: 2013
Month: 1
X-DOI: 10.2469/faj.v69.n1.7
File-URL: http://hdl.handle.net/10.2469/faj.v69.n1.7
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Author-Name: Murad J. Antia
Author-X-Name-First: Murad J.
Author-X-Name-Last: Antia
Author-Name: Richard L. Meyer
Author-X-Name-First: Richard L.
Author-X-Name-Last: Meyer
Title: Should the SEC Outsource Research to Academia?
Abstract: 
 This material comments on “Governance: Travel and Destinations”. (July/August 2009).
Journal: Financial Analysts Journal
Issue: 1
Volume: 69
Year: 2013
Month: 1
X-DOI: 10.2469/faj.v69.n1.8
File-URL: http://hdl.handle.net/10.2469/faj.v69.n1.8
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Issue: 1
Volume: 69
Year: 2013
Month: 1
X-DOI: 10.2469/faj.v69.n1.9
File-URL: http://hdl.handle.net/10.2469/faj.v69.n1.9
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Author-Name: Messod D. Beneish
Author-X-Name-First: Messod D.
Author-X-Name-Last: Beneish
Author-Name: Charles M.C. Lee
Author-X-Name-First: Charles M.C.
Author-X-Name-Last: Lee
Author-Name: D. Craig Nichols
Author-X-Name-First: D. Craig
Author-X-Name-Last: Nichols
Title: Earnings Manipulation and Expected Returns
Abstract: 
 An accounting-based earnings manipulation detection model has strong
                    out-of-sample power to predict cross-sectional returns. Companies with a higher
                    probability of manipulation (M-score) earn lower returns on
                    every decile portfolio sorted by size, book-to-market, momentum, accruals, and
                    short interest. The predictive power of M-score stems from its
                    ability to forecast changes in accruals and is most pronounced among low-accrual
                    (ostensibly “high-earnings-quality”) stocks. These findings support
                    the investment value of careful fundamental and forensic analyses of public
                    companies.In our study, we investigated the investment value of a particular form of
                    financial analysis associated with the detection of earnings manipulation. The
                    statistical model we examined (the Beneish model) represents a systematic
                    distillation of forensic accounting principles described in the practitioner
                    literature. Specifically, we investigated a potential link between the
                    probability of manipulation (M-score) generated by the Beneish
                    model and subsequent returns.Although relatively few companies are indicted for accounting fraud, the
                    incidence of earnings manipulation among public companies is likely much higher.
                    We posited that the M-score is informative about a
                    company’s expected returns because the “typical earnings
                    manipulator” is a company that is growing quickly, experiencing
                    deteriorating fundamentals, and adopting aggressive accounting practices.Our main hypothesis was that companies that share traits with past earnings
                    manipulators (i.e., those that “look like manipulators”) represent a
                    particularly vulnerable type of growth stock. Although the accounting games they
                    engage in might not be serious enough to warrant regulatory action, we posited
                    that their earnings trajectory is more likely to disappoint investors (i.e.,
                    they have lower “earnings quality”). To the extent that the pricing
                    implications of these accounting-based indicators are not fully transparent to
                    investors, companies that “look like” past earnings manipulators
                    will also earn lower future returns.We found that companies with a higher probability of manipulation
                        (M-score) earn lower returns in every decile portfolio
                    sorted by size, book-to-market, momentum, accruals, and short-interest ratio.
                    These returns are economically significant (averaging just below 1% a month on a
                    risk-adjusted basis) and survive a host of risk controls. We further found that
                    a large proportion of the abnormal return is earned in the short three-day
                    windows centered on the next four quarterly earnings releases, suggesting that
                    our results are due to a delayed reaction to earnings-related news rather than
                    risk-based factors. The robustness of these results, even among highly liquid
                    companies, implies that they are unlikely to be fully explained by transaction
                    costs.We performed three sets of analyses to better understand the nature of the
                    information conveyed by M-score. First, we conducted detailed
                    tests on the joint ability of accruals and M-score to predict
                    returns. We found that the dominance of M-score over accruals
                    is evident in both independent sorts and nested sorts. When companies are sorted
                    on these two variables independently, M-score is particularly
                    effective in predicting returns among low-accrual companies (i.e., companies
                    that have “high earnings quality” according to their accruals
                    ranking). For example, in the lowest-accrual quintile—companies typically
                    viewed as “buys”—the spread in size-adjusted returns between
                    high- M-score companies and low- M-score
                    companies is –19.8% over the next 12 months.Second, we used a difference-in-difference test to examine which individual
                    components of the model contributed the most to its incremental predictive
                    power. Our results show that variables related to a predisposition to
                        commit fraud (sales growth, asset quality index, and leverage) are
                    more important than variables associated with the level of
                    aggressive accounting (accruals, days in receivables, and depreciation
                    expense).Third, we found that the Beneish model’s efficacy is associated with its
                    ability to predict the directional change in current-year
                    accruals (i.e., whether the accruals component of current-year earnings will
                    continue into next year or disappear). Specifically, we found that high-
                        M-score companies have income-increasing (-decreasing)
                    accruals that are more likely to disappear (persist) next year; we observed the
                    exact opposite among low- M-score companies. In other words,
                        M-score provides useful information about the future
                        persistence of current-year accruals.Our study adds to the literature on the effective use of financial information by
                    documenting the usefulness of earnings manipulation detection techniques for
                    earnings quality assessment and return prediction. Our evidence on how and why
                    such techniques work suggests new directions for earnings quality analysis and
                    should enhance future efforts to identify potential over- and undervaluations.
                    Overall, our analyses provide substantial support for the use of forensic
                    accounting in equity investing.
Journal: Financial Analysts Journal
Pages: 57-82
Issue: 2
Volume: 69
Year: 2013
Month: 3
X-DOI: 10.2469/faj.v69.n2.1
File-URL: http://hdl.handle.net/10.2469/faj.v69.n2.1
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Author-Name: John E. Merseburg
Author-X-Name-First: John E.
Author-X-Name-Last: Merseburg
Title: “Do Finance Professors Invest Like Everyone Else?”: A Comment
Abstract: 
 This material comments on “Do Finance Professors Invest Like Everyone Else?”. (September/October 2012).
Journal: Financial Analysts Journal
Issue: 2
Volume: 69
Year: 2013
Month: 3
X-DOI: 10.2469/faj.v69.n2.10
File-URL: http://hdl.handle.net/10.2469/faj.v69.n2.10
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Author-Name: Ann Marie Hibbert
Author-X-Name-First: Ann Marie
Author-X-Name-Last: Hibbert
Author-Name: Edward R. Lawrence
Author-X-Name-First: Edward R.
Author-X-Name-Last: Lawrence
Author-Name: Arun J. Prakash
Author-X-Name-First: Arun J.
Author-X-Name-Last: Prakash
Title: “Do Finance Professors Invest Like Everyone Else?”: Author Response
Abstract: 
 This material comments on “‘Do Finance Professors Invest Like Everyone Else?’: A Comment” (March/April 2013).
Journal: Financial Analysts Journal
Issue: 2
Volume: 69
Year: 2013
Month: 3
X-DOI: 10.2469/faj.v69.n2.11
File-URL: http://hdl.handle.net/10.2469/faj.v69.n2.11
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Author-Name: Nassim N. Taleb
Author-X-Name-First: Nassim N.
Author-X-Name-Last: Taleb
Title: “Do Financial Markets Reward Buying or Selling Insurance and Lottery Tickets?”: A Comment
Abstract: 
 This material comments on “‘Do Financial Markets Reward Buying or Selling Insurance and Lottery Tickets?’: A Comment” (March/April 2013).
Journal: Financial Analysts Journal
Issue: 2
Volume: 69
Year: 2013
Month: 3
X-DOI: 10.2469/faj.v69.n2.12
File-URL: http://hdl.handle.net/10.2469/faj.v69.n2.12
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Author-Name: Antti Ilmanen
Author-X-Name-First: Antti
Author-X-Name-Last: Ilmanen
Title: “Do Financial Markets Reward Buying or Selling Insurance and Lottery Tickets?”: Author Response
Abstract: 
 This material comments on “‘Do Financial Markets Reward Buying or Selling Insurance and Lottery Tickets?’: A Comment” (March/April 2013).
Journal: Financial Analysts Journal
Issue: 2
Volume: 69
Year: 2013
Month: 3
X-DOI: 10.2469/faj.v69.n2.13
File-URL: http://hdl.handle.net/10.2469/faj.v69.n2.13
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Author-Name: William F. Sharpe
Author-X-Name-First: William F.
Author-X-Name-Last: Sharpe
Title: The Arithmetic of Investment Expenses
Abstract: 
 Recent regulatory changes have brought a renewed focus on the impact of
                    investment expenses on investors’ financial well-being. The author offers
                    methods for calculating relative terminal wealth levels for those investing in
                    funds with different expense ratios. Under plausible conditions, a person saving
                    for retirement who chooses low-cost investments could have a standard of living
                    throughout retirement more than 20% higher than that of a comparable investor in
                    high-cost investments. Recent regulatory changes have brought a renewed focus on the impact of
                    investment expenses on investors’ financial well-being. Moreover, in a
                    recent issue of this publication, Charles Ellis argued eloquently that the
                    impact of such fees is much larger than many think.In this article, the author provides methods for calculating relative terminal
                    wealth levels for those investing in funds with different expense ratios. For
                    cases in which a lump-sum investment is made and held for many years and both
                    low-cost and high-cost funds have the same gross returns, the terminal wealth
                    ratio is a simple function of the expense ratios and the number of years the
                    investments are held. For cases in which returns are subject to risks and/or
                    recurring investments are made, the calculations are more complex and may
                    require Monte Carlo simulation. The author shows how to analyze such cases and
                    provides quantitative results.Whether one is investing a lump-sum amount or a series of periodic amounts, the
                    arithmetic of investment expenses is compelling. Under plausible conditions, a
                    person saving for retirement who chooses low-cost investments could have a
                    standard of living throughout retirement more than 20% higher than that of a
                    comparable investor in high-cost investments. Although a long-term investor may
                    be able to find one or more high-cost managers who can beat an appropriate
                    benchmark by an amount sufficient to more than offset the added costs, the
                    negative impact on an investor’s wealth can be very large. Managers with
                    extraordinary skills may exist, but another exercise in arithmetic indicates
                    that such managers are in the minority. And as Ellis has reminded us, they are
                    very hard indeed to identify in advance. Caveat emptor.
Journal: Financial Analysts Journal
Pages: 34-41
Issue: 2
Volume: 69
Year: 2013
Month: 3
X-DOI: 10.2469/faj.v69.n2.2
File-URL: http://hdl.handle.net/10.2469/faj.v69.n2.2
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:69:y:2013:i:2:p:34-41




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# input file: UFAJ_A_12048162_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Frank Leclerc
Author-X-Name-First: Frank
Author-X-Name-Last: Leclerc
Author-Name: Jean-François L’Her
Author-X-Name-First: Jean-François
Author-X-Name-Last: L’Her
Author-Name: Tammam Mouakhar
Author-X-Name-First: Tammam
Author-X-Name-Last: Mouakhar
Author-Name: Patrick Savaria
Author-X-Name-First: Patrick
Author-X-Name-Last: Savaria
Title: Industry-Based Alternative Equity Indices
Abstract: 
 The authors examined five alternative equity indices (AEIs) in the United States
                    using industries instead of individual stocks as building blocks to form
                    portfolios and compared their performance with that of the
                    capitalization-weighted equity benchmark for the period 1964–2011. The
                    five AEIs had, ex post, lower risk and better returns than the
                    cap-weighted benchmark. Net risk-adjusted returns of three AEIs were
                    significantly positive when controlling for four risk factors.The authors examined five U.S. alternative equity indices (AEIs) using industries
                    instead of individual stocks as building blocks to form portfolios and compared
                    their performance with that of a cap-weighted equity benchmark. They chose
                    industries instead of stocks for three reasons. First, industries are natural
                    candidates to cluster stock constituents and to overcome the “curse of
                    dimensionality” and the “error maximization” problem. Reducing
                    the size of the covariance matrix mitigates these problems. Second, industries
                    are important economic drivers that explain a significant part of the
                    cross-sectional dispersion in active returns. The authors found that for the
                    S&P 500 Index, the average cross-sectional dispersion in gross active
                    returns from industry bets represents half of the dispersion in active returns
                    from security bets. Third, although some stock constituent–based AEIs may
                    outperform industry-based AEIs before any transaction costs, the latter make
                    more sense in terms of capacity, liquidity, transparency, simplicity, and
                    resultant transaction costs. Consequently, the outperformance of most
                    constituent-based AEIs is largely driven by exposure to the small-cap factor.
                    Using industries (capitalization-weighting scheme within the industry) instead
                    of individual stocks as building blocks for portfolio formation allowed the
                    authors to overcome this drawback.The five AEIs use alternative industry-based weighting schemes designed to
                    improve on capitalization weightings by reducing risk without sacrificing
                    return: (1) equally weighted (EW), (2) equally weighted among low-beta
                    industries (EWLB), (3) equally weighted risk contribution (EWR), (4) minimum
                    variance (MV), and (5) maximum diversification (MD). The authors used the U.S.
                    industry total returns from Fama and French (Standard Industrial Classification,
                    or SIC, and the broad universe of stocks) and focused on the period
                    1964–2011. The other contribution of this article is the detailed
                    examination of the comparative performance of the five AEIs using the same
                    dataset (the U.S. stock market from 1964 to 2011) and the same methodologies
                    (shrinkage estimator for risk assessment and four risk factors for performance
                    analysis). The authors also examined the robustness of these AEIs when using
                    more granular building blocks, analyzing an out-of-sample period from 1931 to
                    1964, and considering different stock universes (the broad market versus the
                    S&P 500) and different industry classifications (SIC versus the Global
                    Industry Classification Standard, or GICS). Few papers have included this
                    variety of in-depth comparative analyses and robustness tests.Our study yielded five main conclusions. First, each of the five alternative
                    weighting schemes, compared with the cap-weighted scheme, had a lower risk
                        ex post. This result is not surprising because all the AEIs
                    are designed to, ex ante, reduce concentration, reduce
                    systematic risk exposure, offer a better balance of portfolio risk contribution,
                    reduce the absolute risk, or improve diversification. Each AEI except MV ranked
                    first ex post against the performance metric derived from its
                    respective stated objective. Interestingly, even though all five alternative
                    weighting schemes had lower risk, they also had better returns. There is no
                    theory that predicts, ex ante, that any of the AEIs will be
                    more efficient than other portfolios. Second, the authors found that
                    industry-based AEIs, like constituent-based AEIs, have a significant value tilt.
                    However, unlike constituent-based AEIs, industry-based AEIs have a significant
                    tilt toward large size and are consequently more scalable. Third, the equally
                    weighted, equally weighted among low-beta industries, and equally weighted risk
                    contribution AEIs displayed a statistically significant risk-adjusted
                    outperformance (alphas from the Fama–French three-factor pricing model
                    augmented by the Carhart momentum risk factor) net of costs. Fourth, these
                    results are robust; they are not sensitive to the industrial granularity used
                    (30 industries versus 10), the period examined (1931–1964 versus
                    1964–2011), the industry classification (SIC versus GICS), or the universe
                    of stocks used (the S&P 500 versus the broad universe of stocks). Finally,
                    the authors constrained the active risk of the five AEIs to mitigate any
                    important deviation from cap weights, notably during industry bubbles, and they
                    levered them up to match, ex ante, the risk of the cap-weighted
                    benchmark. All five risk-constrained, levered AEIs significantly outperformed
                    the cap-weighted benchmark, and except for MV, their risk-adjusted returns were
                    significant and positive even after rebalancing costs.
Journal: Financial Analysts Journal
Pages: 42-56
Issue: 2
Volume: 69
Year: 2013
Month: 3
X-DOI: 10.2469/faj.v69.n2.3
File-URL: http://hdl.handle.net/10.2469/faj.v69.n2.3
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Handle: RePEc:taf:ufajxx:v:69:y:2013:i:2:p:42-56




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# input file: UFAJ_A_12048163_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Xi Li
Author-X-Name-First: Xi
Author-X-Name-Last: Li
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Author-Name: Danielle Xu
Author-X-Name-First: Danielle
Author-X-Name-Last: Xu
Author-Name: Guodong Gao
Author-X-Name-First: Guodong
Author-X-Name-Last: Gao
Title: Sell-Side Analysts and Gender: A Comparison of Performance, Behavior, and Career Outcomes
Abstract: 
 Using a comprehensive sample of investment recommendations, the authors
                    investigated differences in the performance, behavior, and career outcomes of
                    male and female sell-side analysts. They found that the recommendations of
                    female analysts, compared with those of their male counterparts, produce similar
                    abnormal returns but with lower idiosyncratic risks. Further, gender does not
                    seem to negatively affect female analysts’ career outcomes as defined by
                    their “star” rankings and job mobility among brokerage firms.Sell-side analysts are important and prominent figures in the portfolio
                    management community. Identifying those analysts with superior earnings forecast
                    and investment recommendation abilities consumes significant investor
                    resources.Using a large sample of investment recommendations from January 1994 through
                    December 2005, we examined whether female sell-side analysts perform and behave
                    differently from their male counterparts. Controlling for analyst performance
                    and behavior, we further examined evidence related to whether career outcomes of
                    female analysts differ from those of male analysts.Specifically, we compared male and female analysts in terms of their (1)
                    performance, as measured by the excess return (alpha) of investment
                    recommendations, (2) risk taking, measured as the portfolio residual risk
                    implied by investment recommendations, (3) bias, measured as the percentage of
                    sell recommendations, and (4) career outcomes, measured as the probability of
                    moving among brokerage firms of different sizes and by the probability of their
                    being an Institutional Investor or Wall Street
                        Journal star.We found that the investment recommendations of female analysts as compared with
                    those of their male counterparts produce similar abnormal returns but with lower
                    idiosyncratic risks. These results imply that the recommendations of female
                    analysts may generate slightly higher information ratios than those of their
                    male counterparts. Our results further suggest that female analysts underperform
                    with respect to their upgrade recommendations and have little or no
                    outperformance with their downgrades. This finding may be consistent with our
                    finding that female analysts tend to take less risk in their recommendations
                    than do their male counterparts.Finally, our examination of the relation between gender and career outcomes with
                    respect to job mobility among brokerage firms and star status based on
                        Institutional Investor and Wall Street
                        Journal rankings showed no evidence of discrimination against
                    female analysts. In fact, female analysts seem to have a better chance than male
                    analysts of being recognized as stars in both the Institutional
                        Investor and the Wall Street Journal analyst
                    rankings.
                        Editor’s Note: Rodney N. Sullivan, CFA, is editor of
                        the Financial Analysts Journal. He was recused from the
                        referee and acceptance processes and took no part in the scheduling and
                        placement of this article. See the FAJ policies section of
                        cfapubs.org for more information. 
Journal: Financial Analysts Journal
Pages: 83-94
Issue: 2
Volume: 69
Year: 2013
Month: 3
X-DOI: 10.2469/faj.v69.n2.4
File-URL: http://hdl.handle.net/10.2469/faj.v69.n2.4
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# input file: UFAJ_A_12048164_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert C. Merton
Author-X-Name-First: Robert C.
Author-X-Name-Last: Merton
Author-Name: Monica Billio
Author-X-Name-First: Monica
Author-X-Name-Last: Billio
Author-Name: Mila Getmansky
Author-X-Name-First: Mila
Author-X-Name-Last: Getmansky
Author-Name: Dale Gray
Author-X-Name-First: Dale
Author-X-Name-Last: Gray
Author-Name: Andrew W. Lo
Author-X-Name-First: Andrew W.
Author-X-Name-Last: Lo
Author-Name: Loriana Pelizzon
Author-X-Name-First: Loriana
Author-X-Name-Last: Pelizzon
Title: On a New Approach for Analyzing and Managing Macrofinancial Risks (corrected)
Abstract: 
 At the fifth annual CFA Institute European Investment Conference on 19 October
                    2012 in Prague, Robert C. Merton gave a presentation on analyzing and managing
                    macrofinancial risk. This article is based on his talk and on research he
                    carried out with his coauthors. A framework for measuring and analyzing macrofinancial risk, particularly
                    financial system credit risk and sovereign credit risk, is described, along with
                    how one might go about monitoring the connections. The data suggest that the
                    degree of connectedness across different types of financial institutions and
                    sovereigns changes considerably over time.Current financial system models used by economists and central banks to assess
                    and manage economies are generally not capable of accurately analyzing and
                    managing the macrofinancial risks because they do not incorporate the
                    fundamental nonlinear structures of credit risks. As a result, they cannot
                    measure the changing degree of connectedness among financial institutions and
                    sovereigns. A new approach for analyzing and managing macrofinancial risks is
                    needed, particularly one that integrates monetary, fiscal, and financial
                    stability policies and accounts for interconnectedness and risk transmission. At the fifth annual CFA Institute European Investment Conference on 19 October
                    2012 in Prague, Robert C. Merton gave a presentation on analyzing and managing
                    macrofinancial risk. This article is based on his talk and on research he
                    carried out with his coauthors. 
                        Editor’s Note: Much of the research discussed herein
                        is from the paper “Sovereign, Bank, and Insurance Credit
                        Spreads: Connectedness and System Networks,” by M. Billio, M.
                        Getmansky, D. Gray, A. Lo, R.C. Merton, and L. Pelizzon, MIT working paper
                        (forthcoming 2013). 
                        Authors’ Note: This article was accepted before 3
                        February 2013.
Journal: Financial Analysts Journal
Pages: 22-33
Issue: 2
Volume: 69
Year: 2013
Month: 3
X-DOI: 10.2469/faj.v69.n2.5
File-URL: http://hdl.handle.net/10.2469/faj.v69.n2.5
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Author-Name: Larry Harris
Author-X-Name-First: Larry
Author-X-Name-Last: Harris
Title: What to Do about High-Frequency Trading
Abstract: 
 The author discusses his views on an issue of interest to FAJ readers.
Journal: Financial Analysts Journal
Pages: 6-9
Issue: 2
Volume: 69
Year: 2013
Month: 3
X-DOI: 10.2469/faj.v69.n2.6
File-URL: http://hdl.handle.net/10.2469/faj.v69.n2.6
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# input file: UFAJ_A_12048166_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Issue: 2
Volume: 69
Year: 2013
Month: 3
X-DOI: 10.2469/faj.v69.n2.7
File-URL: http://hdl.handle.net/10.2469/faj.v69.n2.7
File-Format: text/html
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# input file: UFAJ_A_12048167_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Clifford Asness
Author-X-Name-First: Clifford
Author-X-Name-Last: Asness
Author-Name: Andrea Frazzini
Author-X-Name-First: Andrea
Author-X-Name-Last: Frazzini
Author-Name: Lasse H. Pedersen
Author-X-Name-First: Lasse H.
Author-X-Name-Last: Pedersen
Title: “Will My Risk Parity Strategy Outperform?”: A Comment
Abstract: 
 This material comments on “Will My Risk Parity Strategy Outperform?”. (November/December 2012).
Journal: Financial Analysts Journal
Issue: 2
Volume: 69
Year: 2013
Month: 3
X-DOI: 10.2469/faj.v69.n2.8
File-URL: http://hdl.handle.net/10.2469/faj.v69.n2.8
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# input file: UFAJ_A_12048168_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert M. Anderson
Author-X-Name-First: Robert M.
Author-X-Name-Last: Anderson
Author-Name: Stephen W. Bianchi
Author-X-Name-First: Stephen W.
Author-X-Name-Last: Bianchi
Author-Name: Lisa R. Goldberg
Author-X-Name-First: Lisa R.
Author-X-Name-Last: Goldberg
Title: “Will My Risk Parity Strategy Outperform?”: Author Response
Abstract: 
 This material comments on “‘Will My Risk Parity Strategy Outperform?’: A Comment” (March/April 2013).
Journal: Financial Analysts Journal
Pages: 15-16
Issue: 2
Volume: 69
Year: 2013
Month: 3
X-DOI: 10.2469/faj.v69.n2.9
File-URL: http://hdl.handle.net/10.2469/faj.v69.n2.9
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# input file: UFAJ_A_12048170_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Gideon Ozik
Author-X-Name-First: Gideon
Author-X-Name-Last: Ozik
Author-Name: Ronnie Sadka
Author-X-Name-First: Ronnie
Author-X-Name-Last: Sadka
Title: Media Coverage and Hedge Fund Returns
Abstract: 
 The authors classified news items about equity hedge funds over 1999–2008 into
          three source groups—general newspapers, specialized magazines, and corporate
          communications—and found that corporate-covered funds outperformed general-covered
          funds by about 11 percentage points annually. Investor fund flows, however, were not
          related to information sources, which suggests that the return spread is not fully
          understood by investors. The magnitude of this return spread reflects the extensive costs
          of processing information to generate alpha.Our primary research interest was whether media coverage contains information about
          future fund performance. We ask the following questions: Do different media sources
          systematically differ in the manner in which they cover hedge funds? Are they overly
          negative or too lenient? Do media contain information about future fund performance? And
          to the extent that we found such a relationship, do investors understand this information
          and act on it? We found supporting evidence that media coverage contains information about
          fund performance; however, this information does not seem to affect investor fund flows.
          The results suggest that managers of alternative portfolios should incorporate media-based
          information in the investment management process to generate abnormal returns.We accessed various media sources and devised a measure of the information they report.
          We collected news articles on a sample of U.S. long–short equity hedge funds over
          1999–2008. The sample includes about 3,600 unique media sources, which we separated
          into three categories: general, which typically includes daily newspapers, such as the
            New York Times and the Washington Post; specialized,
          which includes such industry venues as Pensions & Investments,
            BusinessWeek, and other investment magazines; and corporate
          communications, which includes press releases and wire services, such as PR Newswire and
          Business Wire. We then applied a textual analysis to the title of each news item to gauge
          a measure of news item sentiment. Essentially, this procedure classifies each word as
          positive, negative, or undefined, according to the Harvard IV-4 psychosocial dictionary.
          We then measured the (positive) sentiment of a news item title as the ratio of its
          positive words to the sum of its positive and negative words.The main result of the article is that corporate-covered funds outperformed and
          general-covered funds underperformed, with a performance difference of about 11 pps
          annually. Such a result may be consistent with sentiment-related biases, such as the
          reporting style bias and editorial selection bias. To control for such biases, we computed
          sentiment-adjusted returns. We found that the outperformance of corporate-covered funds
          and the underperformance of general-covered funds remained unchanged when we used
          sentiment-adjusted returns. In fact, unreported results show that sentiment alone does not
          predict fund performance. Therefore, sentiment-related biases do not explain the
          inter-source return spread. We further investigated whether investors respond to the
          return information embedded in media coverage. Despite the economically significant
          inter-source return spread documented in this article, we found that investors do not seem
          to differentially respond to the media coverage of hedge funds by different sources. That
          is, although hedge fund investor flows generally respond to media coverage (e.g., Ozik and
          Sadka 2010b), regressing hedge fund flows on the different media sources results in no
          differential response across the different type of media sources. Therefore, investors do
          not seem to fully distinguish between the different sources.The fact that media coverage predicts sentiment-adjusted returns suggests that although
          investors may understand biases stemming from differences in sentiment, they may not fully
          understand inter-source biases. The power of our tests stems from comparing the media
          coverage of almost 1,000 funds from thousands of different media sources. In addition, our
          findings mainly pertain to funds exclusively covered by one of the source groups.
          Therefore, to gauge whether a fund is, for example, exclusively covered by general media
          requires one to verify not only that the fund is covered by at least one source classified
          as general but also that the fund is not covered by any source classified as corporate or
          specialized. The extensive gathering and processing of such information is fairly costly.
          Thus, although media coverage is public information, investors may not be able to process
          it, and therefore, the return spread can be interpreted as a pure alpha, reflecting the
          costs of obtaining information.
Journal: Financial Analysts Journal
Pages: 57-75
Issue: 3
Volume: 69
Year: 2013
Month: 5
X-DOI: 10.2469/faj.v69.n3.1
File-URL: http://hdl.handle.net/10.2469/faj.v69.n3.1
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Author-Name: Keith Ambachtsheer
Author-X-Name-First: Keith
Author-X-Name-Last: Ambachtsheer
Title: Fixing the “Loser’s Game”: What It Will Take
Abstract: 
 The author discusses his views on an issue of interest to FAJ readers.
Journal: Financial Analysts Journal
Pages: 6-12
Issue: 3
Volume: 69
Year: 2013
Month: 5
X-DOI: 10.2469/faj.v69.n3.2
File-URL: http://hdl.handle.net/10.2469/faj.v69.n3.2
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Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: Mandatory Retirement Savings
Abstract: 
 Nudges toward voluntary defined-contribution retirement savings have transformed many
          nonsavers into savers but have left many behind. The author argues that it is time to
          switch from libertarian-paternalistic nudges to fully paternalistic shoves. He advocates a
          retirement savings solution centered on a paternalistic second layer of
            mandatory private defined-contribution savings accounts in a retirement
          savings pyramid, above the paternalistic first layer of Social Security and below the
          libertarian third layer of voluntary savings.Nudges toward voluntary defined-contribution retirement savings have transformed many
          nonsavers into savers but have left many behind. It is time to switch from
          libertarian-paternalistic nudges to fully paternalistic shoves. I draw on evidence from
          the United States and other countries to advocate a retirement savings solution centered
          on a paternalistic second layer of mandatory private defined-contribution
          savings accounts in a retirement savings pyramid, above the paternalistic first layer of
          Social Security and below the libertarian third layer of voluntary savings.  Mandatory defined-contribution retirement savings plans exist in Australia, the United
          Kingdom, Israel, and other countries. Minimum mandatory contributions are set to increase
          to 12% of employee earnings in Australia, 8% of earnings in the United Kingdom, and more
          than 18% of earnings in Israel. Indeed, mandatory defined-contribution retirement plans
          are in effect at many U.S. universities, even if they are not described as such.
          Universities contribute an average of 10% of employee salaries as “core”
          contributions, regardless of employee contributions. Additional employee contributions are
          voluntary at some universities and mandatory at others. Existing mandatory defined-contribution retirement savings plans offer lessons about
          features worth adopting and features worth avoiding. Features worth adopting include the
          following:Combined mandatory contributions by employers and employees amounting to a minimum of
              12% of earnings.A central agency to administer plans for employees whose employers do not provide
              defined-contribution retirement savings plans. Default offerings of well-diversified target-date funds set in one-year intervals.
            Fees not exceeding 30 bps. No borrowing from retirement savings accounts and no cashing out of accounts before
              retirement age. Enhanced financial literacy without hampering the retirement income of people lacking
              financial literacy.
Journal: Financial Analysts Journal
Pages: 14-18
Issue: 3
Volume: 69
Year: 2013
Month: 5
X-DOI: 10.2469/faj.v69.n3.3
File-URL: http://hdl.handle.net/10.2469/faj.v69.n3.3
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Author-Name: Roger G. Ibbotson
Author-X-Name-First: Roger G.
Author-X-Name-Last: Ibbotson
Author-Name: Zhiwu Chen
Author-X-Name-First: Zhiwu
Author-X-Name-Last: Chen
Author-Name: Daniel Y.-J. Kim
Author-X-Name-First: Daniel Y.-J.
Author-X-Name-Last: Kim
Author-Name: Wendy Y. Hu
Author-X-Name-First: Wendy Y.
Author-X-Name-Last: Hu
Title: Liquidity as an Investment Style
Abstract: 
 Liquidity should be given equal standing with size, value/growth, and momentum as an
          investment style. As measured by stock turnover, liquidity is an economically significant
          indicator of long-run returns. The returns of liquidity are sufficiently different from
          those of the other styles that it is not merely a substitute. Finally, a stock’s
          liquidity is relatively stable over time, with changes in liquidity associated with
          changes in valuation.In 1992, William F. Sharpe defined four criteria that characterize a benchmark investment
          style: (1) “identifiable before the fact,” (2) “not easily
          beaten,” (3) “a viable alternative,” and (4) “low in cost.”
          We propose that equity liquidity meets these criteria and should be given equal standing
          with the currently accepted styles of size, value/growth, and momentum.Extensive academic literature has confirmed that less liquid stocks outperform more
          liquid stocks under various measures of liquidity. Despite this significant and
          multifaceted body of evidence, liquidity has rarely been treated as a control in
          cross-sectional studies of stock returns.In our study, we used stock turnover, which is a well-established measure of liquidity
          that is negatively correlated with long-term returns in the U.S. equity market. We
          examined stock-level liquidity in a top 3,500 market-capitalization universe of U.S.
          equities over 1971–2011 and subjected it to the four style tests of Sharpe. Our
          empirical findings, which extend and amplify the existing literature, are that liquidity
          clearly meets all four criteria.First, the previous year’s stock turnover is “identifiable before the
          fact.” Other liquidity measures could have met that criteria as well, but we chose
          turnover because it is simple and easy to measure and has a significant impact on
          returns.Using each investment style, we constructed top quartile portfolios, all of which
          outperformed the equally weighted market portfolio. The returns of the low-liquidity
          quartile portfolio were comparable to those of the other styles, beating size and momentum
          but trailing value. We consider all four styles to be “not easily beaten.”We constructed double-sorted independent portfolios, comparing liquidity with size,
          value, and momentum in four-by-four matrices. The impact of liquidity was additive to each
          of the other styles. Thus, we determined that liquidity is a distinct and “viable
          alternative” to size, value, and momentum.We also constructed a liquidity factor by subtracting the Quartile 4 high-liquidity
          return series from the Quartile 1 low-liquidity return series. This factor added
          significant alpha to all the Fama–French factors when expressed either as a factor
          or as a low-liquidity long portfolio. The existence of the significant positive alpha is
          further evidence that investors ought to include liquidity with the other styles to form
          efficient portfolios.Finally, we demonstrated that less liquid portfolios could be formed “at low
          cost.” Our portfolios were formed only once a year, and 63% of the stocks stayed in
          the same quartile in consecutive years. Some 77% of the stocks in the high-performing
          low-liquidity quartile stayed in that quartile. Thus, the liquidity portfolios themselves
          exhibit low turnover, which can keep their costs low.Liquidity has perhaps the most straightforward explanation as to why it deserves to be a
          style. Investors clearly want more liquidity and are willing to pay for it in all asset
          classes, including stocks. Less liquidity comes with costs: It takes longer to trade less
          liquid stocks, and the transaction costs tend to be higher. In equilibrium, these costs
          must be compensated by less liquid stocks earning higher gross returns. The liquidity
          style rewards the investor who has longer horizons and is willing to trade less
          frequently.However, less liquid does not necessarily mean higher risk. In all cases in our study,
          the less liquid portfolios were substantially less volatile than the more liquid
          portfolios.
Journal: Financial Analysts Journal
Pages: 30-44
Issue: 3
Volume: 69
Year: 2013
Month: 5
X-DOI: 10.2469/faj.v69.n3.4
File-URL: http://hdl.handle.net/10.2469/faj.v69.n3.4
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Author-Name: Darrin DeCosta
Author-X-Name-First: Darrin
Author-X-Name-Last: DeCosta
Author-Name: Fei Leng
Author-X-Name-First: Fei
Author-X-Name-Last: Leng
Author-Name: Gregory Noronha
Author-X-Name-First: Gregory
Author-X-Name-Last: Noronha
Title: Minimum Maturity Rules: The Cost of Selling Bonds before Their Time
Abstract: 
 The authors found that the performance of traditional fixed-income index funds is
          negatively affected by minimum maturity rules of the indices that the funds seek to
          replicate. Bonds removed from indices for violating minimum maturity rules underperformed
          a matched sample in an extended period surrounding their removal, resulting in a 3.5 bp
          loss in annualized return to the ETF from which the bonds were removed. The authors
          demonstrate that relaxing the minimum maturity rules could result in improved performance
          for a popular fixed-income index ETF.The authors examined the effects of a common rule of fixed-income index
          construction—the minimum maturity rule—and found that it imposes significant
          additional costs on investors. These costs could be avoided by holding the bonds until
          they mature.The indices that fixed-income index mutual funds and ETFs seek to replicate are typically
          governed by a series of rules that determine changes in the composition of the indices
          over time. These rules cover bond credit quality, minimum par amount outstanding, minimum
          maturity, and rebalancing frequency. The purpose of these index rules is to define the
          investable universe of securities and to allow for the creation of low-cost, passive
          portfolios. The authors found that the implementation of the most basic of index rules,
          minimum time to maturity, in an index-based portfolio can increase costs borne by the
          portfolio and thus negatively affect its performance. A simple and obvious change to the
          index rules to allow fixed-income securities to be held to maturity would alleviate the
          problem and result in improved investment outcomes for investors.The authors examined the impact of the minimum maturity rule on the performance of a
          fund—the iShares iBoxx $ Investment Grade Corporate Bond Fund—that tracks a
          bond index, the iShares iBoxx $ Liquid Investment Grade Index. They compared the returns
          of bonds deleted from the fund (because of deletion from the index) with those of bonds
          with similar risk characteristics and found that the deleted bonds significantly
          underperformed the matching bonds in an extended period around the index deletion event,
          with the dollar volume of the deleted bonds sold directly related to the underperformance.
          Their findings suggest the existence of selling pressure, which they estimate to result in
          an annual underperformance of around 3.5 bps for the fund that tracks the iBoxx index.
          They posit that selling pressure and the transaction costs of trading bonds in the OTC
          market can be avoided by relaxing the minimum maturity rule and holding bonds to
          maturity.
Journal: Financial Analysts Journal
Pages: 45-56
Issue: 3
Volume: 69
Year: 2013
Month: 5
X-DOI: 10.2469/faj.v69.n3.5
File-URL: http://hdl.handle.net/10.2469/faj.v69.n3.5
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# input file: UFAJ_A_12048175_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 88-88
Issue: 3
Volume: 69
Year: 2013
Month: 5
X-DOI: 10.2469/faj.v69.n3.6
File-URL: http://hdl.handle.net/10.2469/faj.v69.n3.6
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Author-Name: Thomas M. Idzorek
Author-X-Name-First: Thomas M.
Author-X-Name-Last: Idzorek
Author-Name: Maciej Kowara
Author-X-Name-First: Maciej
Author-X-Name-Last: Kowara
Title: Factor-Based Asset Allocation vs. Asset-Class-Based Asset Allocation
Abstract: 
 This article addresses the issue of the alleged superiority of risk-factor-based asset
     allocations over the more traditional asset-class-based asset allocation. The authors used both
     an idealized model, capable of precise mathematical treatment, and optimizations based on
     different periods of historical data to show that neither approach is inherently superior to
     the other. Although the authors appreciate the role of risk models in portfolio management,
     they urge caution with respect to unwarranted claims of their dominance.The article addresses the issue of the alleged relative superiority of risk-factor-based
     asset allocations versus the more traditional, asset-class-based asset allocations. The topic
     has been the subject of several recent articles that implicitly or explicitly claim such
     superiority. After a brief synopsis of the history of risk factors as such, the authors examine
     the logic of these claims and find it generally defective: In most cases, the alleged
     superiority is simply a result of mis-specified “apples to oranges” comparisons,
     where a robustly diversified set of risk factors is held up as a winner against a very basic
     asset allocation model that consists of just stocks and bonds. The authors then introduce a
     model in which there is a one-to-one mapping between asset classes and risk factors and show
     that in such an idealized setting, one can mathematically prove that neither approach is
     superior; the same mean–variance-optimal portfolio is returned by both approaches. (This
     finding is not new—it goes by the name “rotational indeterminacy of the
     factors”—but it seems that theoretically minded investors or researchers may have
     lost sight of it.) Finally, the authors use real-world historical data from different time
     periods to perform optimizations. It turns out that which approach would have yielded a
     dominant portfolio depends on the time period and the risk level selected. The authors, who
     appreciate the role of risk-factor models in portfolio management—asset classes are,
     after all, an example of risk factors themselves—conclude by urging caution against
     hasty, uncritical acceptance of these new claims of inherent superiority. The real advantage in
     portfolio management results from an ability to better model risk and reward assumptions,
     whether of asset classes or risk factors, rather than from simply rearranging the format of the
     inputs.
Journal: Financial Analysts Journal
Pages: 19-29
Issue: 3
Volume: 69
Year: 2013
Month: 5
X-DOI: 10.2469/faj.v69.n3.7
File-URL: http://hdl.handle.net/10.2469/faj.v69.n3.7
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# input file: UFAJ_A_12048178_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Claude B. Erb
Author-X-Name-First: Claude B.
Author-X-Name-Last: Erb
Author-Name: Campbell R. Harvey
Author-X-Name-First: Campbell R.
Author-X-Name-Last: Harvey
Title: The Golden Dilemma
Abstract: 
 Although gold has been around for thousands of years, its role in diversified portfolios
          is not well understood. The authors critically examined such popular stories as
          “gold is an inflation hedge.” Investors face the following dilemma: The real
          price of gold is historically very high and may revert to the mean, but if prominent
          emerging markets increase their gold holdings, the real price of gold may rise even
          further from today’s elevated levels.Gold is an important asset, with a market capitalization of $9 trillion—roughly 10%
          of the combined capitalization of world stock and bond markets. Yet, gold’s role in
          diversified portfolios is not well understood.Our goal was to better understand the role of gold in asset allocation. We started by
          critically examining many stories about gold: Gold is an inflation hedge, a currency
          hedge, an attractive asset when there are low real returns, a safe haven, desirable
          because we are returning to a de facto world gold standard, and
          underrepresented in most investors’ portfolios. We show that gold may be a good
          inflation hedge over many centuries but a poor inflation hedge for horizons up to 20 years
          (the relevant horizon for most investors). We argue that gold is also an unreliable
          currency hedge. Even in periods of hyperinflation, gold may not keep its real value. We
          also argue that gold should not be counted on as a safe haven in times of extreme stress,
          such as war.There are widely divergent views on the value of gold, even among expert investors. For
          example, Warren Buffett believes gold is overvalued and compares the current value of gold
          to three famous bubbles: the tulip bubble, the dot-com bubble, and the recent housing
          bust. In contrast, Ray Dalio argues that there will be an ugly contest to depreciate the
          three main currencies by printing money and investors own a dangerously small amount of
          gold.Our analysis examines the price of gold over the past 2,000 years, but most of our
          analysis focuses on the post-1974 period, when it was legal to own gold in the United
          States. Over the recent period or even over the extended historical period, the current
          real price of gold is high. In the past, when the real price of gold was high, subsequent
          returns were low, reflecting a mean reversion, and the mean is $780 over the recent
          period.There is, however, a plausible scenario for the other side of the argument. What if the
          BRIC countries increase their gold holdings to a level that reflects the U.S. gold/GDP
          ratio? Our analysis shows that the BRIC gold holdings would have to triple, leading to an
          accumulation of an extra 4,000 metric tons in reserves. The entire annual world production
          of gold is less than 3,000 metric tons. Even the most aggressive buyer of gold, China, has
          managed to increase its holdings by only about 50 metric tons a year over the past 11
          years. The demand for an extra 4,000 metric tons would likely lead to higher prices.In the end, investors are faced with a golden dilemma. Will history repeat itself and the
          real price of gold revert to its long-term mean? Or have we entered a new era with new
          emerging markets, where it is dangerous to extrapolate from history? Those are the
          uncertain outcomes that gold investors have to grapple with.Editor’s Note: A short piece called “Chinese CFOs Think China
              Should Triple Gold Holdings” and a Chinese translation of it are available as
              Supplemental Information at www.cfapubs.org/toc/faj/2013/69/4.Authors’ Note: Campbell R. Harvey is associated with the Man Group, plc,
              as its investment strategy adviser. Some of the Man Group’s investment funds
              trade gold as part of diversified commodity portfolios. Professor Harvey does not
              offer to the Man Group any advice on gold investment, and the Man Group was not
              involved in providing financial or other support for this independent research. Claude
              B. Erb is unaffiliated and also has no conflict of interest.
Journal: Financial Analysts Journal
Pages: 10-42
Issue: 4
Volume: 69
Year: 2013
Month: 7
X-DOI: 10.2469/faj.v69.n4.1
File-URL: http://hdl.handle.net/10.2469/faj.v69.n4.1
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Author-Name: Xuanjuan Chen
Author-X-Name-First: Xuanjuan
Author-X-Name-Last: Chen
Author-Name: Tong Yu
Author-X-Name-First: Tong
Author-X-Name-Last: Yu
Author-Name: Ting Zhang
Author-X-Name-First: Ting
Author-X-Name-Last: Zhang
Title: What Drives Corporate Pension Plan Contributions: Moral Hazard or Tax Benefits?
Abstract: 
 In testing moral hazard and tax benefit hypotheses regarding defined benefit plan funding and
     contribution incentives by incorporating sponsors’ bankruptcy risk, the authors proposed
     that high-bankruptcy-risk sponsors have a strong moral hazard incentive because the put value
     of the U.S. Pension Benefit Guaranty Corporation guarantee is high. For low-bankruptcy-risk
     sponsors, the put value is low; maximizing tax benefits associated with pension contributions
     becomes a powerful incentive. Results based on sponsors’ voluntary contributions support
     both hypotheses. Underfunding of corporate defined benefit (DB) pension plans has become a prevalent issue
     among U.S. companies amid the recent financial crisis. A key question that has attracted
     considerable research interest is what determines a DB plan sponsor’s decisions on
     pension funding and contributions. Within one unified framework, the authors tested two
     hypotheses—one on the moral hazard incentive and the other on the tax benefit
     incentive—with respect to decisions on DB pension funding and contributions by
     incorporating sponsors’ expected bankruptcy risk, as measured by Moody’s EDF
     (expected default frequency). The incorporation of expected bankruptcy risk is critical in
     better understanding a sponsor’s incentives because it relates directly to the put option
     value derived from U.S. Pension Benefit Guaranty Corporation (PBGC) insurance. The authors
     hypothesized that sponsors with high expected bankruptcy risk are dominated by the moral hazard
     incentive because the put option on the PBGC guarantee has the greatest value. In contrast, for
     sponsors with low expected bankruptcy risk, the PBGC put option value is low; maximizing tax
     benefits associated with pension contributions becomes a dictating incentive.Unlike earlier researchers who used total pension contributions, the authors decomposed total
     pension contributions into mandatory and voluntary contributions. They used voluntary
     contributions as a major measure for sponsors’ incentives regarding pension funding and
     contributions. Using IRS Form 5500 data for 1990–2010, they calculated sponsors’
     voluntary pension contributions on the basis of applicable pension laws and regulations. The
     results based on sponsors’ voluntary contributions are consistent with the two hypotheses
     after controlling for potential endogeneity. In particular, sponsors with high expected
     bankruptcy risk make low voluntary contributions; for those with low bankruptcy risk, voluntary
     contributions increase with the marginal tax rate. Using the recent financial crisis as a
     natural experiment on the effects of sponsors’ expected bankruptcy risk, the authors
     found that both moral hazard and tax benefits have intensified since the crisis.Suggesting that the existing pension regulations do not successfully reduce sponsors’
     moral hazard incentive, the authors discuss three important policy implications: (1) The PBGC
     premium structure should fully reflect the bankruptcy risk that a plan sponsor poses to PBGC,
     (2) the PBGC claims on unfunded pension liabilities during corporate bankruptcy proceedings
     should be more strictly enforced, and (3) policymakers should address sponsors’ moral
     hazard incentive as a critical issue when designing pension regulations to ensure the soundness
     of the U.S. private pension system.
Journal: Financial Analysts Journal
Pages: 58-72
Issue: 4
Volume: 69
Year: 2013
Month: 7
X-DOI: 10.2469/faj.v69.n4.2
File-URL: http://hdl.handle.net/10.2469/faj.v69.n4.2
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Author-Name: Terry Marsh
Author-X-Name-First: Terry
Author-X-Name-Last: Marsh
Author-Name: Paul Pfleiderer
Author-X-Name-First: Paul
Author-X-Name-Last: Pfleiderer
Title: Flight to Quality and Asset Allocation in a Financial Crisis
Abstract: 
 With respect to the recent financial crisis, the authors argue that the appropriate
          adjustments to portfolio allocations in response to the market dislocation are determined
          by equilibrium considerations (supply must equal demand) and depend on individual
          investors’ characteristics relative to societal averages. Using a simple model that
          captures the magnitude of the recent crisis, the authors show that the optimal tactical
          adjustments for most portfolios require a turnover of less than 10%.In the recent financial crisis, investors suffered losses on their portfolios on the
          order of 20%–30%. In addition, they faced a market in which the volatility of most
          asset classes and the correlations among those asset classes surged, all of which served
          to greatly increase the risk of their portfolio positions. The challenging issue facing
          investors was the appropriate tactical adjustment they should make to their portfolio
          allocations in response to this market dislocation. In this article, the authors argue
          that the appropriate adjustment for any given investor is determined by equilibrium
          considerations (supply must equal demand) and depends on that investor’s
          characteristics relative to societal averages. Although this point should be obvious, it
          seems to have been ignored by many investors and their advisers. In a simple model
          calibrated to capture the magnitude of the 2007–09 crisis, the authors show that the
          optimal tactical portfolio adjustments for most investors are not large, requiring
          turnover of less than 10%, and that this finding is quite robust to changes in their
          assumptions.
Journal: Financial Analysts Journal
Pages: 43-57
Issue: 4
Volume: 69
Year: 2013
Month: 7
X-DOI: 10.2469/faj.v69.n4.3
File-URL: http://hdl.handle.net/10.2469/faj.v69.n4.3
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# input file: UFAJ_A_12048181_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Sandro C. Andrade
Author-X-Name-First: Sandro C.
Author-X-Name-Last: Andrade
Author-Name: Vidhi Chhaochharia
Author-X-Name-First: Vidhi
Author-X-Name-Last: Chhaochharia
Author-Name: Michael E. Fuerst
Author-X-Name-First: Michael E.
Author-X-Name-Last: Fuerst
Title: “Sell in May and Go Away” Just Won’t Go Away
Abstract: 
 The authors performed an out-of-sample test of the sell-in-May effect documented in
          previous research. Reducing equity exposure starting in May and levering it up starting in
          November persists as a profitable market-timing strategy. On average, stock returns are
          about 10 percentage points higher for November–April half-year periods than for
          May–October half-year periods. The authors also found that the sell-in-May effect is
          pervasive in financial markets.In this study, we performed a comprehensive out-of-sample analysis of a calendar anomaly
          studied by previous researchers and identified by the adage “Sell in May and go
          away.” We found that the adage remains good advice: Reducing equity exposure
          beginning in May and levering it up beginning in November persists as a profitable
          market-timing strategy.We found that the sell-in-May effect not only persists but also maintains the same
          economic magnitude as in the sample of previous researchers. On average across 37
          countries, stock returns are roughly 10 percentage points higher for November–April
          half-year periods than for May–October half-year periods. This out-of-sample
          persistence indicates that the effect is enduring and not a statistical fluke.We also showed how the sell-in-May effect could have been profitably exploited through
          low-cost trading strategies using extremely liquid securities. Simple market-timing
          strategies based on the effect deliver high Sharpe and information ratios. For example, a
          trading strategy with 0% in stocks in May–October half-year periods and 200% in
          stocks (spot plus futures) in November–April half-year periods would have a Sharpe
          ratio 40% larger than that of a buy-and-hold strategy. The annualized information ratio
          would equal 0.34, placing the sell-in-May market timer in the top quartile of the
          distribution of active equity mutual fund managers in the United States.We also presented novel evidence consistent with widespread seasonal variation in
          aggregate risk aversion as the cause of the sell-in-May effect. In addition to its
          presence in the equity risk premium, as documented by previous researchers, we found an
          economically large and statistically significant sell-in-May effect in strategies that
          exploit the size, value, foreign exchange carry trade, equity volatility risk, and credit
          risk premiums. Because these other trading strategies are outside the realm of typical
          retail investors, our results indicate that risk aversion seasonality may affect not only
          retail investors but also professional market participants. Therefore, widespread
          seasonality in financial markets’ aggregate risk aversion is likely the proximate
          cause of the sell-in-May effect. To the extent that this seasonality is ultimately
          irrational, our results suggest that markets may be slower to arbitrage away
          inefficiencies than previously thought.
Journal: Financial Analysts Journal
Pages: 94-105
Issue: 4
Volume: 69
Year: 2013
Month: 7
X-DOI: 10.2469/faj.v69.n4.4
File-URL: http://hdl.handle.net/10.2469/faj.v69.n4.4
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Author-Name: Charles D. Ellis
Author-X-Name-First: Charles D.
Author-X-Name-Last: Ellis
Title: Lessons on Grand Strategy
Abstract: 
 The author discusses his views on an issue of interest to FAJ
          readers.
Journal: Financial Analysts Journal
Pages: 6-9
Issue: 4
Volume: 69
Year: 2013
Month: 7
X-DOI: 10.2469/faj.v69.n4.5
File-URL: http://hdl.handle.net/10.2469/faj.v69.n4.5
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# input file: UFAJ_A_12048183_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 112-112
Issue: 4
Volume: 69
Year: 2013
Month: 7
X-DOI: 10.2469/faj.v69.n4.6
File-URL: http://hdl.handle.net/10.2469/faj.v69.n4.6
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# input file: UFAJ_A_12048184_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Antti Petajisto
Author-X-Name-First: Antti
Author-X-Name-Last: Petajisto
Title: Active Share and Mutual Fund Performance
Abstract: 
 Using Active Share and tracking error, the author sorted all-equity mutual funds into
          various categories of active management. The most active stock pickers outperformed their
          benchmark indices even after fees, whereas closet indexers underperformed. These patterns
          held during the 2008–09 financial crisis and within market-cap styles. Closet
          indexing has increased in both volatile and bear markets since 2007. Cross-sectional
          dispersion in stock returns positively predicts performance by stock pickers.Should a mutual fund investor pay for active fund management? Generally, the answer is
          no. A number of studies have all concluded that the average actively managed fund loses to
          a low-cost index fund, net of all fees and expenses. However, active managers are not all
          equal: They differ in how active they are and what type of active management they
          practice. These distinctions allow us to distinguish different types of active managers,
          which turns out to matter a great deal for investment performance.I divided active managers into several categories on the basis of both Active Share,
          which measures mostly stock selection, and tracking error, which measures mostly exposure
          to systematic risk. Active stock pickers take large but diversified positions away from
          the index. Funds that focus on factor bets generate large volatility with respect to the
          index even with relatively small active positions. Concentrated funds combine very active
          stock selection with exposure to systematic risk. Closet indexers do not engage much in
          any type of active management. A large number of funds in the middle are moderately active
          without a clearly distinctive style.Focusing on closet indexing, I started by looking at examples of different types of funds
          and then examined two famous funds in detail. I also investigated general trends in closet
          indexing over time and the reasons behind them. I then turned to fund performance, testing
          the performance of each category of funds through December 2009. I separately explored
          fund performance in the financial crisis of January 2008–December 2009 to see
          whether historical patterns held up during this highly unusual period. Finally, I tried to
          identify when market conditions are generally most favorable to active stock pickers.I found that closet indexing has been increasing in popularity since 2007, currently
          accounting for about one-third of all mutual fund assets. Over time, the average level of
          active management is low when volatility is high, particularly in the cross-section of
          stocks, and also when recent market returns have been low, which also explains the
          previous peak in closet indexing in 1999–2002.The average actively managed fund has had weak performance, losing to its benchmark by
          –0.41%. The performance of closet indexers is predictably poor. They largely just
          match their benchmark index returns before fees, and so after fees, they lag behind their
          benchmarks by approximately the amount of their fees. Funds that focus on factor bets have
          also lost money for their investors. However, one group has added value for investors: the
          most active stock pickers, who have beaten their benchmarks by 1.26% a year after fees and
          expenses. Before fees, their stock picks have even beaten the benchmarks by 2.61%,
          displaying a nontrivial amount of skill. High Active Share is most strongly related to
          future returns among small-cap funds, but its predictive power within large-cap funds is
          also both economically and statistically significant.The financial crisis hit active funds severely in 2008, leading to broad underperformance
          in 2008 and a strong recovery in 2009. The general patterns were similar to historical
          averages. The active stock pickers beat their indices over the crisis period by about 1%,
          whereas the closet indexers continued to underperform.Cross-sectional dispersion in stock returns positively predicts benchmark-adjusted
          returns on the most active stock pickers, suggesting that stock-level dispersion can be
          used to identify market conditions favorable to stock pickers. Other related measures,
          such as the average correlation with the market index, do not predict returns equally
          well.Author’s Note: This article was written when the author was a finance
              professor at the NYU Stern School of Business.
Journal: Financial Analysts Journal
Pages: 73-93
Issue: 4
Volume: 69
Year: 2013
Month: 7
X-DOI: 10.2469/faj.v69.n4.7
File-URL: http://hdl.handle.net/10.2469/faj.v69.n4.7
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Author-Name: William J. Bernstein
Author-X-Name-First: William J.
Author-X-Name-Last: Bernstein
Title: The Paradox of Wealth
Abstract: 
 A recent FAJ article by Laurence Siegel painted a sunny picture of the
          world’s economic and environmental future. Although the author agrees with
          Siegel’s analysis, his optimism does not extend to security returns; both theory and
          long-run empirical data support the notion that economic growth lowers
          security returns by reducing impatience for consumption and altering the
          supply–demand dynamics of capital—the price of living in an increasingly
          prosperous, safe, healthy, and intellectually gratifying world.In a recent issue of this publication, Laurence Siegel presented a compelling case for
          optimism about continued growth of the world economy, for improvement in the global
          environment, and for higher security returns. The author shares his optimism about the
          first two items but is more pessimistic about the last one.Over the past several decades, it has become obvious that although national
          economies—and thus corporate aggregate profits—frequently experience sustained
          growth, such growth often does not translate into similar growth of per
            share profits. This slippage occurs mainly as a result of share dilution, with
          the most rapidly growing economies, particularly in Asia, issuing the largest proportion
          of new shares. This dilution negatively affects per share growth of earnings and dividends
          and, ultimately, security returns.More importantly, as societies become wealthier, they become less “impatient”
          (in Irving Fisher’s memorable wording) for consumption because of improved housing,
          food supply, and life span. Nor is that all. Subsistence societies, by their very nature,
          exhibit an extreme imbalance between the supply of investment capital, which is tiny by
          definition, and the need for it; as societies become wealthier, this imbalance improves,
          which also reduces the return on/cost of capital. Over the past 5,000 years, this rate has
          been falling slowly, and I propose an approximate, simple inverse relationship between per
          capita total energy consumption and the cost of capital.This fall is a noisy one. In the past century alone, extreme swings in the return on/cost
          of capital have occurred, creating pockets of opportunity for the observant, disciplined,
          and historically aware. It seems likely, however, that these opportunities will be less
          frequent and more fleeting than in the past.
Journal: Financial Analysts Journal
Pages: 18-25
Issue: 5
Volume: 69
Year: 2013
Month: 9
X-DOI: 10.2469/faj.v69.n5.1
File-URL: http://hdl.handle.net/10.2469/faj.v69.n5.1
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Author-Name: Meir Statman
Author-X-Name-First: Meir
Author-X-Name-Last: Statman
Title: “Mandatory Retirement Savings”: Author Response
Abstract: 
 This material comments on “‘Mandatory Retirement Savings’: A Comment” (September/October 2013).
Journal: Financial Analysts Journal
Pages: 10-12
Issue: 5
Volume: 69
Year: 2013
Month: 9
X-DOI: 10.2469/faj.v69.n5.10
File-URL: http://hdl.handle.net/10.2469/faj.v69.n5.10
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Author-Name: Jason S. Scott
Author-X-Name-First: Jason S.
Author-X-Name-Last: Scott
Author-Name: John G. Watson
Author-X-Name-First: John G.
Author-X-Name-Last: Watson
Title: The Floor-Leverage Rule for Retirement
Abstract: 
 The floor-leverage rule is a spending and investment strategy designed for retirees who can
     tolerate investment risk but insist on sustainable spending. The rule calls for purchasing a
     spending guarantee with 85% of wealth and investing the remaining 15% in equities with 3×
     leverage. Surprisingly, this leverage is a tool for managing risk. The authors compare the rule
     with some popular strategies, illustrate it for a variety of retiree preferences, and evaluate
     its historical performance.The floor-leverage rule is a spending and investment strategy designed for retirees who can
     tolerate investment risk but insist on sustainable spending. The rule calls for purchasing a
     spending guarantee, or floor, with 85% of wealth and investing the remaining 15% in an
     exchange-traded fund (ETF) or mutual fund that maintains a daily 3× leveraged exposure to
     equities. The equity or surplus account is reviewed annually, and if it exceeds 15% of total
     wealth, additional floor spending is purchased with the excess.Although the strategy uses a leveraged surplus account, the total portfolio is not leveraged;
     leverage is used as a tool to manage risk. Similar to the dynamics of constant proportion
     portfolio insurance, this strategy sells equities and reduces risk when markets decline. The
     authors found that using leveraged ETFs or mutual funds is a cost-effective, limited-liability
     approach to implementing this dynamic strategy.Floor investments and spending rates depend on a retiree’s preferences. A retiree with
     a preference for sustainable real spending should invest in Treasury Inflation-Protected
     Securities and expect an initial withdrawal rate near 3%. A retiree with a preference for
     sustainable nominal spending should invest in government bonds and initially withdraw about 4%.
     But if this retiree will consider purchasing a late-life annuity with some of her assets, a 5%
     withdrawal rate is feasible.The authors compared the floor-leverage rule with some popular strategies found in the
     literature on financial planning, private wealth management, and economics. They found that
     most of these rules are either quantitatively vague or unduly complex. But the floor-leverage
     rule, which approximates an optimal investment and spending strategy from the economics
     literature, strikes a balance between precision and simplicity. Although not optimal, the
     floor-leverage rule is a very good approximation to the optimal solution; it has at least a 98%
     efficiency compared with the theoretical optimal solution.Finally, the authors analyzed the floor-leverage rule by using historical equity returns.
     They found that although spending was always sustained, spending upside varied widely with
     equity returns. In fact, after 20 years of retirement, spending for retirees when equities
     performed well was nearly three times higher than when equities performed poorly. Spending
     tends to ratchet upward nicely until a traumatic market event. Although spending is preserved
     after the event, there is a lengthy stagnation in the spending rate. For example, the 1970
     retiree took a substantial hit to the portfolio during the 1973–74 bear market and then
     had to wait until 1981 for a spending increase.
Journal: Financial Analysts Journal
Pages: 45-60
Issue: 5
Volume: 69
Year: 2013
Month: 9
X-DOI: 10.2469/faj.v69.n5.2
File-URL: http://hdl.handle.net/10.2469/faj.v69.n5.2
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Author-Name: David L. Stowe
Author-X-Name-First: David L.
Author-X-Name-Last: Stowe
Author-Name: Andy Fodor
Author-X-Name-First: Andy
Author-X-Name-Last: Fodor
Author-Name: John D. Stowe
Author-X-Name-First: John D.
Author-X-Name-Last: Stowe
Title: The Value and Use of the IRA Recharacterization Option
Abstract: 
 The recharacterization option allows IRA owners who convert a traditional IRA into a Roth
          IRA to choose the better of Roth or traditional treatment (for tax purposes)
            after returns are known. The authors used option-pricing models to
          estimate the value of this option and examined strategies to maximize its value. Using a
          simulation that applies a simple recharacterization strategy over a long time horizon, the
          authors show its potential value in private wealth management.The recharacterization option is a right given to a U.S. IRA owner who converts a
          traditional IRA into a Roth IRA. The owner may choose to have the IRA treated as a Roth
          IRA (for tax purposes) if the portfolio increases sufficiently in value before taxes are
          paid in the next tax year or to have the IRA “recharacterized” back to a
          traditional IRA otherwise. This asymmetric tax treatment can create tax savings for the
          IRA owner. This article applies option-pricing models to establish the value of the
          recharacterization option and discusses strategies to maximize the value of this option.
          The multiple-year and multiple-portfolio approaches to using the recharacterization option
          can create considerable value for an IRA owner. We simulated the results for an IRA owner
          using a simple recharacterization strategy over a long time horizon. The
          recharacterization option promises to be an important tool in private wealth
          management.The aggregate amount of traditional-to-Roth conversions should increase in future years,
          in part owing to the elimination of the income limit on potential converters. The
          recharacterization option provides substantial additional economic motivation for these
          conversions. A one-time use of the conversion/recharacterization option is worth the IRA
          owner’s tax rate times the value of the option. Pursuing the
          conversion/recharacterization process for multiple periods adds substantially to the
          expected gain. And using a multiportfolio approach, especially if the portfolios are
          shifted into riskier assets, would add even more value. Of course, the owner could do
          both. When using a multiperiod strategy, the IRA owner could divide a large IRA into
          several smaller IRAs and then pursue the conversion/recharacterization strategy for each
          IRA. The owner would recharacterize only those IRAs whose returns did not exceed their
          hurdle rates. Of course, valuation models express only the expected gain in wealth, not a
          particular outcome. For example, if the owner tries the conversion/recharacterization
          process three times and the market declines each time, the owner will have no gain. But if
          the owner converts a portfolio and asset values appreciate substantially, the
          owner’s gain is considerable.This article provides simulation results for a multiperiod strategy that leads to
          enhancements of IRA terminal values averaging about 16% (with a 90% confidence interval
          from 9% to 26%). If the taxes on the Roth conversions are paid from taxable investments,
          the terminal value is further increased to an average of about 19% (with a 90% confidence
          interval from 7% to 33%). These results are situation specific. The gains could be greater
          if the volatility of the portfolio increases, the length of the horizon (and number of
          possible recharacterizations) increases, future tax rates are higher, the owner uses
          multiple portfolios, and the owner pursues an optimal strategy. Of course, the gains are
          reduced by opposing circumstances.Conceptually, there is little downside risk associated with using the recharacterization
          option unless the owner forgets to recharacterize when he should. Absent such errors, the
          recharacterization option is a free option (except for paperwork) that has considerable
          value. Individuals in the United States have several trillion dollars saved in traditional
          IRAs, 401(k)s, and other such vehicles. The recharacterization option promises to be a
          valuable wealth management tool for many individual investors, materially enhancing their
          retirement wealth.
Journal: Financial Analysts Journal
Pages: 61-75
Issue: 5
Volume: 69
Year: 2013
Month: 9
X-DOI: 10.2469/faj.v69.n5.3
File-URL: http://hdl.handle.net/10.2469/faj.v69.n5.3
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Author-Name: Brad M. Barber
Author-X-Name-First: Brad M.
Author-X-Name-Last: Barber
Author-Name: Guojun Wang
Author-X-Name-First: Guojun
Author-X-Name-Last: Wang
Title: Do (Some) University Endowments Earn Alpha?
Abstract: 
 The authors analyzed the returns earned by U.S. educational endowments using style
          attribution models. For the average endowment, models with only public stock and bond
          benchmarks explain virtually all the time-series variation in returns, yield no alpha, and
          generate sensible factor loadings. Elite institutions perform better than public stock and
          bond benchmarks because of large allocations to alternative investments. The authors found
          no evidence that manager selection, market timing, and tactical asset allocation generate
          alpha.Do educational endowments earn superior returns? This question is interesting, given the
          strong returns earned by some legendary endowments (e.g., Yale University under the
          management of David Swensen), which have led to the widespread adoption of the so-called
          endowment model of investing. Using NACUBO/Commonfund data from 1991 to 2011, we analyzed
          the returns earned by U.S. educational endowments using simple style attribution
          models.We first documented the returns on the average endowment match the returns of a 60% U.S.
          stock (S&P 500 Index) and 40% U.S. bond portfolio (Barclays Capital U.S. Aggregate
          Bond Index). When we restrict the attribution model to public stock (U.S. and
          international stock) and bond (U.S. bond) benchmarks, the average endowment earns an alpha
          close to zero, the public stock/bond benchmarks explain 99% of the time-series variation
          in the return of the average endowment, and the attribution model yields sensible
          estimates of the typical stock and bond allocations (roughly 60% stock and 40% bonds).We then focused on the returns earned by elite institutions (Ivy League and top-SAT
          schools) and top-performing endowments (top decile of prior-year performance). These
          groups earn reliably positive alphas relative to simple public stock/bond benchmarks of
          2%–4% per year. However, when we add indices for hedge funds and private equity to
          our attribution model, the style-adjusted returns for elite institutions and
          top-performing endowments are indistinguishable from zero, with point estimates ranging
          from –0.99% to 0.46% per year. These results indicate that the strategic asset
          allocation decisions of elite institutions and top-performing funds were the most
          important determinant of their superior returns over the past two decades. We found no
          positive evidence that manager selection, market timing, or tactical asset allocation are
          able to generate alpha for educational endowments.Editor’s Note: The online appendix for this article is available
            at www.cfapubs.org/toc/faj/2013/69/5.
Journal: Financial Analysts Journal
Pages: 26-44
Issue: 5
Volume: 69
Year: 2013
Month: 9
X-DOI: 10.2469/faj.v69.n5.4
File-URL: http://hdl.handle.net/10.2469/faj.v69.n5.4
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Author-Name: John R. Boatright
Author-X-Name-First: John R.
Author-X-Name-Last: Boatright
Title: Confronting Ethical Dilemmas in the Workplace
Abstract: 
 The author discusses his views on an issue of interest to FAJ readers.
Journal: Financial Analysts Journal
Pages: 6-9
Issue: 5
Volume: 69
Year: 2013
Month: 9
X-DOI: 10.2469/faj.v69.n5.5
File-URL: http://hdl.handle.net/10.2469/faj.v69.n5.5
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 80-80
Issue: 5
Volume: 69
Year: 2013
Month: 9
X-DOI: 10.2469/faj.v69.n5.6
File-URL: http://hdl.handle.net/10.2469/faj.v69.n5.6
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Author-Name: Andrew S. Pike
Author-X-Name-First: Andrew S.
Author-X-Name-Last: Pike
Title: “Earnings Manipulation and Expected Returns”: A Comment
Abstract: 
 This material comments on “Earnings Manipulation and Expected Returns”. (March/April 2013).
Journal: Financial Analysts Journal
Pages: 14-14
Issue: 5
Volume: 69
Year: 2013
Month: 9
X-DOI: 10.2469/faj.v69.n5.7
File-URL: http://hdl.handle.net/10.2469/faj.v69.n5.7
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Author-Name: Stephen Mauzy
Author-X-Name-First: Stephen
Author-X-Name-Last: Mauzy
Title: “Mandatory Retirement Savings”: A Comment
Abstract: 
 This material comments on “Mandatory Retirement Savings”. (May/June 2013).
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 5
Volume: 69
Year: 2013
Month: 9
X-DOI: 10.2469/faj.v69.n5.9
File-URL: http://hdl.handle.net/10.2469/faj.v69.n5.9
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Author-Name: William Poole
Author-X-Name-First: William
Author-X-Name-Last: Poole
Title: Prospects for and Ramifications of the Great Central Banking Unwind
Abstract: 
 At the CFA Institute Global Investment Risk Symposium held in Washington, DC, on
          7–8 March 2013, William Poole gave a presentation on what he calls the “great
          central banking unwind.” Total assets on the balance sheets of the U.S. Federal
          Reserve and European Central Bank have exploded since 2008. The challenges and pressure
          faced by these and other central banks will probably have serious consequences for the
          global economy.As the U.S. Federal Reserve System and European Central Bank (ECB) have struggled to deal
          with the aftermath of the 2008 global financial crisis, total assets on these banks’
          balance sheets have exploded. The Fed’s expansionary monetary policy has been
          motivated primarily by a concern over unemployment; the ECB’s policy has been
          motivated by an effort to support the sovereign debt of fiscally weak governments. Because of concern over slow employment growth, the uncertainty of economic forecasts,
          and political pressure—among other things—the Fed has been slow to address the
          issue of its buildup of assets. Although it may appear that the Fed has to unwind its
          position, the Fed, in fact, has the option to hold its portfolio indefinitely. It can do
          so by raising the interest rate it pays on bank reserves as required to prevent an
          explosion of money and bank credit growth.The ECB has acquired a substantial amount of the sovereign debt of the fiscally weak
          southern European countries and has been lending to banks that have purchased the debt of
          those countries. The ECB will not be able to unwind its position until Spain, Italy,
          Portugal, and Greece resolve their fiscal problems. I believe the fundamental fiscal
          weakness in Europe will end in a crisis.Because the monetary policies since the crisis are unprecedented, there is no standard
          for what to do now. So far, inflationary pressures remain subdued, but the ability and
          willingness of the Fed and the ECB to react quickly to control inflation fears are in
          jeopardy, largely because of political forces. 
Journal: Financial Analysts Journal
Pages: 33-39
Issue: 6
Volume: 69
Year: 2013
Month: 11
X-DOI: 10.2469/faj.v69.n6.1
File-URL: http://hdl.handle.net/10.2469/faj.v69.n6.1
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Author-Name: Hendrik Bessembinder
Author-X-Name-First: Hendrik
Author-X-Name-Last: Bessembinder
Author-Name: William F. Maxwell
Author-X-Name-First: William F.
Author-X-Name-Last: Maxwell
Author-Name: Kumar Venkataraman
Author-X-Name-First: Kumar
Author-X-Name-Last: Venkataraman
Title: Trading Activity and Transaction Costs in Structured Credit Products
Abstract: 
 After conducting the first study of secondary trading in structured credit products, the
          authors report that the majority of products did not trade even once during the 21-month
          sample. Execution costs averaged 24 bps when trades occurred and were considerably higher
          for products with a greater proportion of retail-size trades. The authors estimate that
          the introduction of public trade reporting would decrease trading costs in retail-oriented
          products by 5–7 bps.Structured credit products (SCPs), including asset-backed securities (ABSs) and
          mortgage-backed securities (MBSs), compose one of the largest (comparable in size to the
          US Treasury security market) but least studied segments of the financial services
          industry. SCPs are complex instruments that include the payment obligations of numerous
          borrowers, contain multiple tranches that differ in terms of payment priority in case of
          default, and have sizes that can change randomly as underlying loans are repaid.
          Uncertainty regarding SCP valuation played a role in the recent financial crisis, owing in
          part to the fact that secondary trades for SCPs occurred in an opaque dealer market
          without public quotes or trade reports.Since May 2011, FINRA has required broker/dealers to report transaction prices and
          quantities for SCP trades to the TRACE (Trade Reporting and Compliance Engine) system.
          However, FINRA does not yet disseminate data for most SCP transactions to the public.
          Effective 5 November 2012, the U.S. SEC approved the public dissemination of transaction
          prices in a subset of SCPs (specifically, in “to-be-announced” securities).
          FINRA has recently proposed that trade prices of SCPs, including MBSs and ABSs, be
          disseminated to the public.For investors as well as regulators, the key difficulty in an opaque market lies in
          establishing the prevailing market price. Investors cannot compare their own execution
          prices with those observed for other transactions. Even institutional investors have to
          invest significant time and effort to obtain market information, either via
          ‘‘indicative’’ quotes obtained through messaging systems or by
          telephone calls to dealers. Increased transparency has the potential to reduce dealer
          markups, provide information on the fair price of securities, and improve the ability to
          control and evaluate trade execution costs.In this study, we examined the accumulated FINRA data to provide what we believe is the
          first comprehensive description of this important but little-studied market. The data
          include all secondary market transactions for the universe of US SCPs from 16 May 2011 to
          31 January 2013. We report on trading activity by subtypes of SCPs, the determinants of
          secondary market trading, and estimates of transaction costs in each type of SCP. Finally,
          focusing on segments of the corporate bond market that are comparable to segments of the
          SCP markets in terms of key characteristics, we present estimates of the potential effects
          of implementing transaction dissemination in these markets.Notably, less than 20% of the SCP universe traded at all during the 21-month sample
          period. One-way trade execution costs for SCPs averaged about 24 bps. However, trade
          execution costs varied substantially across SCP categories, from 92 bps for CBOs to just 1
          bp for TBA securities. We show that trading costs depend in particular on what we term the
          product’s “customer profile,” which depends on issue size and the
          proportion of retail to institutional-size trades. Subproducts with an institutional
          profile tend to have lower costs. The highest average trading costs are observed for
          agency CMOs (74 bps) and CBOs (92 bps), each of which has a low (22% or less) proportion
          of large trades. The lowest average trading cost estimates are observed for TBA securities
          (1 bp), CMBSs (12 bps), and ABSs secured by auto loans and equipment (7 bps), each of
          which has a substantial (54% or greater) percentage of large trades.By matching SCP subtypes with corporate bonds that are comparable in terms of customer
          profile, we present rough estimates of the potential impact of introducing price
          transparency for the SCP markets. Our analysis indicates that price transparency is likely
          to be associated with substantial decreases of 5–7 bps in one-way trading costs for
          MBSs, agency CMOs, and CBO securities, as well as securities in the subgroups TRAN and
          WHLN. We anticipate smaller trading cost reductions of about 2 bps for private label CMOs.
          In contrast, we anticipate little or no change in trading costs for CMBSs and SBA
          securities, as well as ABSY issues and CDOs. Broadly speaking, this analysis indicates
          that trading cost reductions are most likely to be observed for SCPs with a retail
          clientele, whereas transaction dissemination is less likely to be relevant for those
          products with an institutional clientele, which already carry lower trading costs.
Journal: Financial Analysts Journal
Pages: 55-67
Issue: 6
Volume: 69
Year: 2013
Month: 11
X-DOI: 10.2469/faj.v69.n6.2
File-URL: http://hdl.handle.net/10.2469/faj.v69.n6.2
File-Format: text/html
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Handle: RePEc:taf:ufajxx:v:69:y:2013:i:6:p:55-67




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Author-Name: Yaniv Konchitchki
Author-X-Name-First: Yaniv
Author-X-Name-Last: Konchitchki
Title: Accounting and the Macroeconomy: The Case of Aggregate Price-Level Effects on Individual Stocks
Abstract: 
 The author used financial statement analysis to examine systematic stock-valuation
          effects of aggregate price-level changes on individual companies, focusing on the
          implications for researchers and investment practitioners. Among other insights, he showed
          that (1) inflation-based investment strategies conditioned on available information
          resulted in significant risk-adjusted returns and (2) investing using the inflation effect
          on companies’ net monetary holdings resulted in insignificant abnormal hedge returns
          whereas investing using the inflation effect on companies’ nonmonetary holdings
          consistently yielded economically and statistically significant abnormal hedge returns.
          Taken together, the study sheds new light on the cross-sectional effects of inflation,
          with substantial implications for valuation.This study sheds new light on the cross-sectional effects of inflation, which have
          substantial implications for stock valuation. I used financial statement analysis to
          examine systematic stock-valuation effects of aggregate price-level changes on individual
          companies, focusing on the implications for both researchers and investment practitioners.
          I developed inflation-adjustment procedures that are straightforward for investors to
          implement in real time for extracting the inflation effect on individual companies. I
          found that inflation-based investment strategies conditioned on information available to
          investors as of the initial investment and rebalancing dates result in significant
          risk-adjusted returns. I also investigated the sources of abnormal returns to
          inflation-based investment strategies. Specifically, I estimated two separate components
          of the inflation effect on individual companies, one based on only monetary holdings
          (using the net position of monetary holdings) and the other based on only nonmonetary
          holdings. Investigating the stock-valuation implications of extracting the
          components-based inflation effect revealed striking evidence. In particular, investing
          based on the inflation effect on companies’ net monetary holdings results in
          insignificant abnormal hedge returns. In contrast, investing based on the inflation effect
          on companies’ nonmonetary holdings consistently yields economically and
          statistically significant abnormal hedge returns. These findings indicate that
          inflation-based abnormal hedge returns are driven not by the exposure of companies’
          net monetary holdings to inflation but, rather, by the exposure of their nonmonetary
          holdings to inflation. These results are consistent with the fact that companies’
          nonmonetary holdings are usually held for several years and thus accumulate inflationary
          effects over time whereas their monetary holdings are, on average, naturally hedged
          because the exposure of monetary assets cancels the exposure of monetary liabilities for
          the average company. In addition, I examined the direction of the stock returns to
          real-time investment strategies. 
Journal: Financial Analysts Journal
Pages: 40-54
Issue: 6
Volume: 69
Year: 2013
Month: 11
X-DOI: 10.2469/faj.v69.n6.3
File-URL: http://hdl.handle.net/10.2469/faj.v69.n6.3
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Author-Name: Stephen C. Sexauer
Author-X-Name-First: Stephen C.
Author-X-Name-Last: Sexauer
Author-Name: Laurence B. Siegel
Author-X-Name-First: Laurence B.
Author-X-Name-Last: Siegel
Title: A Pension Promise to Oneself
Abstract: 
 Saving for retirement is not hopeless. Well-run DB pension plans provided retirement
          income for generations. When plans failed, it is because they broke the rules. The same
          applies to individuals. By understanding a set of rules on how much to save and how to
          invest and then sticking to those rules—that is, by making a pension promise to
          oneself—retirement income goals can be met. Fulfilling this promise requires more
          saving than most people are accustomed to. With defined benefit (DB) pension plans on the ropes, defined contribution (DC) savings
          plans are the principal means by which Americans now accumulate assets for retirement.
          However, most DC plan participants do not save enough to retire. We show how they can.We note that if the economic resources that enable a DB plan to make its lifelong payouts
          are instead given to a DC plan, the latter should have enough resources to make the same
          payouts. The trick is getting money into a DC plan when contributions are voluntary. By
          showing workers that they can retire on DB-like levels of income if they save a large
          percentage of their incomes, invest conservatively, and use longevity pooling, we can
          motivate them to make and keep a pension promise to themselves.By assuming that investors can earn only the real riskless rate, which is currently zero,
          we can put an upper bound on the required savings level. We develop illustrations for
          three worker prototypes: a Columbus, Ohio, teacher, representing middle-income earners; a
          San Diego sanitation worker, representing lower-middle earners; and an Austin, Texas,
          software developer who later becomes an executive, representing upper-middle earners. We
          assume that in retirement, each worker needs 70% of final pay, inflating with the US
          Consumer Price Index.We begin by subtracting each worker’s expected Social Security benefit from the 70%
          replacement income target. We multiply the resulting income requirement by a retirement
          multiple (RM), currently 21.47, to arrive at the savings target. We derive the RM as
          follows: At the current real riskless rate of return, which is zero, the desired
          consumption level from age 65 to age 85 is guaranteed by saving 20 years’
          postretirement income (net of Social Security); consumption after age 85 is provided by a
          deferred income annuity (DIA). At age 65, the annuity is priced at 1.47 years’
          income. The RM is the sum of the two numbers 20 and 1.47.Because DIAs for which we were able to obtain price quotes provide a nominal, not real,
          benefit, inflation after age 85 is not hedged. If we could have found a real DIA, we would
          have “bought” it, increasing the RM slightly. A work-around is to buy a little
          more than the required amount of the DIA and if one lives beyond age 85, save some of the
          income benefit for future rather than present consumption.We assume that the three workers start their 40-year careers at age 25 and save 10%, 14%,
          and 15% of income, respectively. We estimate their real salary growth using published data
          for the teacher and sanitation worker and our own estimates for the software developer.
          The teacher needs to save 28.4% of income in his 20th year of work and 32% in his 40th and
          final year of work. The sanitation worker needs to save 21.2% in the 20th year and 27.3%
          in the 40th year; the developer needs to save 21.2% in the 20th year and 19% in the 40th
          year.Such high savings rates are completely consistent with the size of required DB plan
          contributions using realistic market return assumptions. To get employees up to such high
          rates, the Save More Tomorrow (a registered trademark of Shlomo Benartzi and Richard
          Thaler) program is a template. Saving 52%, 54%, and 25% of future real pay raises,
          respectively, achieves the desired overall savings. The savings rates needed to achieve an
          adequate payout are reached today in peak earnings years for the middle- and upper-income
          cohorts.At higher (2% real) rates of return, the required savings rates are substantially lower
          but not trivial and still require much more saving than most DC plan participants are
          accustomed to.Although not everyone will achieve these savings rates, almost everyone will retire. They
          will mostly do so by engaging in personal fiscal adjustments, adjustments to either
          production or consumption. One can work harder (e.g., by getting a second job), work
          smarter (by getting additional education or training), consume less before retirement, or
          consume less after retirement (e.g. by moving in with relatives). Pushing these levers is
          more effective than trying to increase one’s investment return because the latter
          often backfires and makes the investor worse off.
Journal: Financial Analysts Journal
Pages: 13-32
Issue: 6
Volume: 69
Year: 2013
Month: 11
X-DOI: 10.2469/faj.v69.n6.4
File-URL: http://hdl.handle.net/10.2469/faj.v69.n6.4
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Author-Name: Emanuel Derman
Author-X-Name-First: Emanuel
Author-X-Name-Last: Derman
Title: Knowing the World
Abstract: 
 The author discusses his views on an issue of interest to FAJ
          readers.
Journal: Financial Analysts Journal
Pages: 5-6
Issue: 6
Volume: 69
Year: 2013
Month: 11
X-DOI: 10.2469/faj.v69.n6.5
File-URL: http://hdl.handle.net/10.2469/faj.v69.n6.5
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 72-72
Issue: 6
Volume: 69
Year: 2013
Month: 11
X-DOI: 10.2469/faj.v69.n6.6
File-URL: http://hdl.handle.net/10.2469/faj.v69.n6.6
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “On a New Approach for Analyzing and Managing Macrofinancial Risks,” by Robert C. Merton, Monica Billio, Mila Getmansky, Dale Gray, Andrew W. Lo, and Loriana Pelizzon, in the March/April 2013 issue of the Financial Analysts Journal.
Journal: Financial Analysts Journal
Pages: 8-9
Issue: 6
Volume: 69
Year: 2013
Month: 11
X-DOI: 10.2469/faj.v69.n6.7
File-URL: http://hdl.handle.net/10.2469/faj.v69.n6.7
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Author-Name: John C. Bogle
Author-X-Name-First: John C.
Author-X-Name-Last: Bogle
Title: The Arithmetic of “All-In” Investment Expenses
Abstract: 
 This article represents a rare (if not unique) attempt to estimate the drag on mutual
          fund returns engendered by “all-in” investment expenses, including not only
          expense ratios (until now, the conventional measure of fund costs) but also fund
          transaction costs, sales loads, and cash drag. Compared with costly actively managed
          funds, over time, low-cost index funds create extra wealth of 65% for retirement plan
          investors.In “The Arithmetic of Investment Expenses” (Financial Analysts
            Journal, March/April 2013), William Sharpe reinforced the maxim that low
          investment costs are a critical component of investment success. He found that, by reason
          of its substantially lower expense ratio, a passive index fund, compared with more costly
          actively managed funds, could enhance an investor’s retirement savings by more than
          20%. This article extends Dr. Sharpe’s analysis by considering “all-in”
          investment expenses, including not only expense ratios but also fund transaction costs,
          cash drag, and sales loads. The conclusion is that index fund investors would enjoy an
          enhancement in wealth of 65% over four decades.This comprehensive approach to the consideration of mutual fund costs has, to the
          author’s knowledge, not previously been attempted. The reason for this vacuum seems
          to be that although mutual fund expense ratios can be calculated with precision, the other
          data are inevitably imprecise. For example, commissions paid to brokers by mutual funds on
          their portfolio transactions are disclosed in prospectuses, but bid–ask spreads and
          market impact costs are ignored and must be estimated.Sales loads paid to brokers and recurring fees paid to their account executives and to
          registered investment advisers are other major drags on fund returns. Most individual
          investors in actively managed funds rely on these distribution-related services to select
          their fund investments. But because the costs are paid directly by investors rather than
          by the funds themselves, they are ignored in the published performance data. Changing
          distribution patterns in the fund industry make it challenging to estimate these amounts
          with precision, but they must be part of all-in cost measurement.In his recent FAJ article, Sharpe compared the 0.06% annual expense
          ratio of an existing total stock market index fund with an average ratio of 1.12% for
          actively managed large-cap mutual funds—an annual cost advantage of 1.06 percentage
          points (pps) for the index fund. But the all-in costs raise the cost for actively managed
          equity funds to an estimated 2.27%, more than doubling that gap to 2.21 pps. The result is
          that, assuming a 7% annual stock market return, a hypothetical tax-deferred retirement
          plan investor in actively managed funds could accumulate a nest egg of $561,000 over 40
          years, compared with an accumulation of $927,000 in the index fund.Next, the impact of the extra costs of actively managed funds on taxable
          investors is considered. Given the fact that passive index funds are generally
          significantly more tax efficient (realizing fewer capital gains), the index advantage
          rises from 2.21 pps annually to an estimated 2.66 pps. Using a straightforward compound
          interest table based on the results of an initial investment of $10,000 (again using an
          assumed nominal stock market annual return of 7%), the index fund
          investment grows to $131,000 over 40 years, compared with $48,000 for the actively managed
          fund. The author also shows the returns in real dollars (assuming a 2%
          annual inflation rate) and describes the resultant gap in accumulations as scary and
          almost unbelievable.Finally, the author discusses another, more subtle, drag on the returns of active
          funds—the tendency of fund investors to move their investments out of funds with
          lagging performance and into funds with better records. Investor (asset-weighted) returns
          lag, with some consistency, fund (asset-weighted) returns, representing yet another source
          of diminished returns for investors in actively managed funds.The author argues that Sharpe was correct in his analysis of mutual fund expense ratios
          and the damaging impact they have on the long-term returns earned by investors. The author
          takes the analysis one step further by estimating the other significant costs incurred by
          actively managed funds and their investors, which, although much more challenging to
          quantify than expense ratios, add to the damage done to investors’ returns. The
          author’s advice to investors is (1) to take into account all the
          costs of fund investing, (2) to invest for a lifetime, and (3) do not allow the tyranny of
          compounding costs to overwhelm the magic of compounding returns.
Journal: Financial Analysts Journal
Pages: 13-21
Issue: 1
Volume: 70
Year: 2014
Month: 1
X-DOI: 10.2469/faj.v70.n1.1
File-URL: http://hdl.handle.net/10.2469/faj.v70.n1.1
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Author-Name: Clifford S. Asness
Author-X-Name-First: Clifford S.
Author-X-Name-Last: Asness
Title: My Top 10 Peeves
Abstract: 
 The author discusses a list of peeves that share three characteristics: (1) They are
          about investing or finance in general, (2) they are about beliefs that are very commonly
          held and often repeated, and (3) they are wrong or misleading and they hurt investors.
        In this article, I discuss a list of peeves that share three characteristics: (1) They
          are about investing or finance in general, (2) they are beliefs that are commonly held and
          often repeated, and (3) they are wrong or misleading and they hurt investors. The first peeve is that there are many who say that such “quant” measures as
          volatility are flawed and that the real definition of risk is the chance of losing money
          that you won’t get back (a permanent loss of capital). The second peeve is the
          overuse of the word “bubble.” Third, not only are insufficient data often
          driving our decisions, but the data we have are often used with the wrong sign; the three-
          to five-year periods most common in evaluating asset class, strategy, and manager
          selection decisions are a good example. The fourth peeve has two parts. First, the idea that we will ever find, or should find,
          one real culprit for the recent financial crisis is wrong. Second, the typical narratives
          and debates about the crisis conflate two events—a real estate/credit bubble in
          prices and a massive financial crisis. The question of who should shoulder the blame for
          the real estate bubble and who should shoulder the blame for the financial crisis do not
          necessarily lead to the same answer. The fifth peeve, admittedly more in the true spirit of a “peeve,” deals with
          things that people should stop saying. “It’s a stock picker’s
          market” is one of them because it doesn’t really make much sense. The overuse
          of the word “arbitrage” has led to a loss of the word’s meaning.
          “There is a lot of cash on the sidelines” is a fallacy that must be debunked;
          there are no sidelines in investing.Sixth, if you deviate markedly from capitalization weights, you are, by definition, an
          active manager making bets, but many incorrectly fight this label; they call their
          deviations from market capitalization—among other labels—smart beta,
          scientific investing, fundamental indexing, or risk parity. Seventh, much of the
          discussion of hedge fund returns is just not cogent. Eighth, the brouhaha over
          high-frequency trading is massively overwrought; HFT is mostly a good thing, not an evil
          conspiracy to crush Main Street. The ninth peeve is the fact that companies with
          executives who execute stock options still carry out buybacks to “prevent
          dilution,” which is nonsensical. The final peeve is that the ability to hold a bond
          to maturity and “get your money back” versus a bond fund that doesn’t
          have this ability seems to be greatly valued by many even though it is, in reality,
          valueless.
Journal: Financial Analysts Journal
Pages: 22-30
Issue: 1
Volume: 70
Year: 2014
Month: 1
X-DOI: 10.2469/faj.v70.n1.2
File-URL: http://hdl.handle.net/10.2469/faj.v70.n1.2
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Author-Name: Xi Li
Author-X-Name-First: Xi
Author-X-Name-Last: Li
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Author-Name: Luis Garcia-Feijóo
Author-X-Name-First: Luis
Author-X-Name-Last: Garcia-Feijóo
Title: The Limits to Arbitrage and the Low-Volatility Anomaly
Abstract: 
 The authors found that over 1963–2010, the existence and trading efficacy of the
          low-volatility stock anomaly were more limited than widely believed. For example, they
          found no anomalous returns for equal-weighted long–short (low-risk minus high-risk)
          portfolios and that alpha is largely eliminated when omitting low-priced stocks from
          value-weighted long–short portfolios. Furthermore, performance of long–short
          portfolios was significantly reduced by high transaction costs, reflecting the finding
          that the abnormal returns were concentrated among low-liquidity and smaller stocks.
          Amplifying liquidity needs, the anomalous excess returns quickly reversed, requiring
          frequent rebalancing. The authors’ findings have meaningful implications for
          implementing low-risk equity portfolio strategies.We found that over a long study period (1963–2010), the existence and trading
          efficacy of the well-known low-volatility stock anomaly are more limited than widely
          believed. For example, we found no anomalous returns to equal-weighted long–short
          (low-risk minus high-risk) portfolios. In value-weighted portfolios, alpha is largely
          eliminated when low-priced (less than $5) stocks are excluded. Furthermore, extracting any
          excess returns to a long–short portfolio is meaningfully hampered by high
          transaction costs, reflecting the finding that the abnormal returns are concentrated among
          low-liquidity and smaller stocks. Adding to the challenge, the anomalous excess returns
          quickly reverse, requiring traders to rebalance frequently in attempting to extract
          profits, thus amplifying liquidity needs. Our findings have meaningful implications for
          those attempting to implement low-risk equity portfolio strategies.Editor’s Note: Rodney N. Sullivan, CFA, is editor of the
            Financial Analysts Journal. He was recused from the referee and acceptance
              processes and took no part in the scheduling and placement of this article. See
              the FAJ policies section of cfapubs.org for more
              information.
Journal: Financial Analysts Journal
Pages: 52-63
Issue: 1
Volume: 70
Year: 2014
Month: 1
X-DOI: 10.2469/faj.v70.n1.3
File-URL: http://hdl.handle.net/10.2469/faj.v70.n1.3
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 72-72
Issue: 1
Volume: 70
Year: 2014
Month: 1
X-DOI: 10.2469/faj.v70.n1.4
File-URL: http://hdl.handle.net/10.2469/faj.v70.n1.4
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Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Author-Name: Anthony Bova
Author-X-Name-First: Anthony
Author-X-Name-Last: Bova
Author-Name: Stanley Kogelman
Author-X-Name-First: Stanley
Author-X-Name-Last: Kogelman
Title: Long-Term Bond Returns under Duration Targeting
Abstract: 
 Although most bond portfolios maintain a relatively stable duration over time and are thus
     implicitly or explicitly “duration targeted,” the distinctive nature of duration
     targeting (DT) is underappreciated. The authors’ theoretical DT model demonstrates that
     over multi-year horizons, annualized DT returns converge back to the starting yield, regardless
     of the rate path. For example, for almost all six-year holding periods since 1985, Barclays
     bond index returns have converged to within 1% of the starting yield.The standard analyses of bond behavior (and common intuitions about it) are based on either
     short-term returns or some form of a hold-to-maturity model. However, the vast majority of bond
     portfolios actually follow a process known as duration targeting (DT), which
     maintains a relatively stable duration over time. A DT approach is central to the rebalancing
     procedures of most active and passive institutional bond funds, bond mutual funds, and the
     fixed-income components of multi-asset funds. Even laddered bond portfolios with illiquid
     holdings implicitly function in a DT mode.Despite this widespread presence of DT, there remains an underappreciation of the very
     distinctive and rather surprising nature of long-term DT returns. This situation is
     particularly striking given the persistence of historically low interest rates and
     corresponding concerns about rising rates. In fact, most of the existing literature on DT
     investing has focused on either short-term price sensitivity or longer-term liability
     management through immunization or liability-driven investments.In our study, in order to gain deeper insight into the DT process, we began with a simplified
     model of a flat yield curve, no default risk, annual rebalancing, and an investment in a
     zero-coupon bond. We also tested our results against 25–30 years of bond index return
     data. In our simplified model, the duration target is equal to the bond maturity (i.e., the
     Macaulay duration) and the year-end price factor is equal to the initial duration reduced by
     one year. This year-end effect stands in contrast to the instantaneous price sensitivity, which
     is measured by the modified duration.We found that along a trendline path from the initial yield to the terminal yield, the
     average return depends on only the annual yield change and the duration target. At the outset,
     annual price losses dominate the incremental accruals. However, because the annual price losses
     remain constant along the trendline whereas the annual accrual rate rises with each
     year’s higher level of yields, the cumulative accruals ultimately are sufficiently above
     the starting yield to fully offset the cumulative price loss. The incremental return is then
     reduced to zero, and the annualized return just equals the starting yield for an investment
     horizon that is one year less than twice the duration target.For the more general case of random rate paths, we partitioned the total return volatility
     into two distinct, independent components: trendline-based volatility and tracking error
     relative to trendline paths. In contrast to trendline volatility, tracking error increases
     gradually with the investment horizon and tends to stabilize within three years of the
     “convergence horizon.” For a typical DT fund with a five-year duration, the total
     return volatility declines over time until flattening out at around 1% by the sixth year. These
     findings suggest that a DT fund with a five-year target should have returns that converge, by
     the sixth year, to within 1% of the starting yield—regardless of the intervening rate
     paths!We first tested the theoretical DT models by using the 1977–2011 history of
     constant-maturity US Treasury yields to simulate returns for both point and ladder portfolios
     with five-year duration targets. We also used a more market-related test based on several bond
     indices that have had relatively stable durations over a recent span of years and, in effect,
     have functioned as DT funds. For example, the Barclays U.S. Aggregate Government/Credit Index
     has maintained a duration of 5.4 years since 1985, and the Barclays U.S. Credit Index duration
     has remained close to 6.1 years since 1981. In all cases, these tests confirmed that the
     starting yield does indeed estimate the six-year returns, with standard deviations close to the
     theoretical level of 1%.
Journal: Financial Analysts Journal
Pages: 31-51
Issue: 1
Volume: 70
Year: 2014
Month: 1
X-DOI: 10.2469/faj.v70.n1.5
File-URL: http://hdl.handle.net/10.2469/faj.v70.n1.5
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Author-Name: Larry Harris
Author-X-Name-First: Larry
Author-X-Name-Last: Harris
Author-Name: Jay Ritter
Author-X-Name-First: Jay
Author-X-Name-Last: Ritter
Author-Name: Stephen Schaefer
Author-X-Name-First: Stephen
Author-X-Name-Last: Schaefer
Title: Statement of the Financial Economists Roundtable, October 2013: Financial Transaction Taxes
Abstract: 
 The Financial Economists Roundtable, a group of distinguished senior financial
          economists, discusses the proposal to tax financial transactions. They highlight the
          benefits of financial transactions and the potential costs and issues of taxing them.Authors’ Note: This statement is the outcome of the Financial Economists
              Roundtable’s discussion at its annual meeting on 20–22 July 2013 in Napa,
              California. It reflects a consensus of more than two-thirds of the attending
              members.
Journal: Financial Analysts Journal
Pages: 5-8
Issue: 1
Volume: 70
Year: 2014
Month: 1
X-DOI: 10.2469/faj.v70.n1.6
File-URL: http://hdl.handle.net/10.2469/faj.v70.n1.6
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: 2013 Report to Readers
Journal: Financial Analysts Journal
Pages: 10-11
Issue: 1
Volume: 70
Year: 2014
Month: 1
X-DOI: 10.2469/faj.v70.n1.7
File-URL: http://hdl.handle.net/10.2469/faj.v70.n1.7
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Author-Name: Ronald Doeswijk
Author-X-Name-First: Ronald
Author-X-Name-Last: Doeswijk
Author-Name: Trevin Lam
Author-X-Name-First: Trevin
Author-X-Name-Last: Lam
Author-Name: Laurens Swinkels
Author-X-Name-First: Laurens
Author-X-Name-Last: Swinkels
Title: The Global Multi-Asset Market Portfolio, 1959–2012
Abstract: 
 The market portfolio contains important information for purposes of strategic asset
          allocation. One could consider it a natural benchmark for investors. The authors composed
          the invested global multi-asset market portfolio for 1990–2012 by estimating the
          market capitalization for equities, private equity, real estate, high-yield bonds,
          emerging-market debt, investment-grade credits, government bonds, and inflation-linked
          bonds. They also used an expanded period (1959–2012) for the main asset categories:
          equities, real estate, nongovernment bonds, and government bonds.The invested global multi-asset market portfolio is the aggregate portfolio of all
          investors, in which portfolio weights indicate the constitution of the average portfolio.
          The invested global multi-asset market portfolio contains important information for
          purposes of strategic asset allocation. First, it shows the relative value of all asset
          classes according to the global financial investment community, which one could consider a
          natural benchmark for financial investors. Second, this portfolio may also serve as a
          starting point for investors who use a particular framework or follow adaptive asset
          allocation policies.In our study, we focused on the invested global multi-asset market portfolio, which is
          relevant to financial investors. We composed the invested global market portfolio for
          1990–2012 by estimating the market capitalizations of eight asset classes: equities,
          private equity, real estate, high-yield bonds, emerging-market debt, investment-grade
          credits, government bonds, and inflation-linked bonds.At the end of 2012, we estimated the total market capitalization of the invested global
          multi-asset market portfolio at $90.6 trillion. Equities (36.3%) represent the largest
          asset class, followed by government bonds (29.5%). Investment-grade credits (18.5%) are
          also a major asset class. The total market capitalization of the five other asset
          categories (15.6%) is relatively small. But the total weight of the relatively small asset
          classes increased from 6.2% to 15.6% over 1990–2012.For the four main asset categories—equities, real estate, nongovernment bonds
          (investment-grade credits and high-yield bonds), and government bonds (broadly defined and
          including inflation-linked bonds and emerging-market debt)—we compiled data series
          for 1959–2012; we did not take private equity into account. At the end of 2012, the
          market portfolio weights for these four main categories are 37.7%, 5.3%, 20.9%, and 36.1%,
          respectively, and the 54-year averages are 52.0%, 3.2%, 15.1%, and 29.6%. The weight of
          equities in 2012 is close to the record low of 37.1% in 2011. In 2011, for the first time
          in our sample period, equities no longer outweigh government bonds.We showed that pension funds’ allocation to equities is a little above the market
          portfolio’s allocation. The sovereign wealth funds in our sample tend to allocate
          more to equities and the endowments allocate more to alternative assets than is warranted
          by their weights in the market portfolio; their allocation to bonds falls short of the
          market portfolio’s weight of bonds.Our development of this new historical database on the global multi-asset market
          portfolio has important applications for the strategic asset allocations of practitioners.
          Moreover, our study might serve as a fruitful resource for future research in this field.
          We hope that this article will spark new applications, both theoretical and empirical.
Journal: Financial Analysts Journal
Pages: 26-41
Issue: 2
Volume: 70
Year: 2014
Month: 3
X-DOI: 10.2469/faj.v70.n2.1
File-URL: http://hdl.handle.net/10.2469/faj.v70.n2.1
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Author-Name: Malcolm Baker
Author-X-Name-First: Malcolm
Author-X-Name-Last: Baker
Author-Name: Brendan Bradley
Author-X-Name-First: Brendan
Author-X-Name-Last: Bradley
Author-Name: Ryan Taliaferro
Author-X-Name-First: Ryan
Author-X-Name-Last: Taliaferro
Title: The Low-Risk Anomaly: A Decomposition into Micro and Macro Effects
Abstract: 
 Low-risk stocks have offered a combination of relatively low risk and high returns. We
          decomposed the low-risk anomaly into micro and macro components. The micro component comes
          from the selection of low-beta stocks. The macro component comes from the selection of
          low-beta countries or industries. Both parts contribute to the anomaly, with important
          implications for the construction of managed-volatility portfolios.On a risk-adjusted basis, low-beta stocks have outperformed high-beta stocks in the
          United States and around the world. We decomposed this very basic market inefficiency into
          two components—a “micro” component and a “macro” component.
          The micro component arises from the selection of lower-risk stocks, holding country and
          industry risk constant. The macro component arises from the selection of lower-risk
          industries and countries, holding stock-level risk constant.For our industry decomposition, we used data from the Center for Research in Securities
          Prices (CRSP) for all US shares for the period January 1963 through December 2012. For our
          country decomposition, we used data from the S&P Developed Broad Market Index (BMI) of
          stocks for the period July 1989 through December 2012.The pattern of realizing low risk but earning high returns, the so-called low-risk
          anomaly, can in principle come from either the macro selection of lower-risk countries and
          industries or the micro selection of low-risk stocks within those countries and
          industries. We separated the two effects by forming long–short portfolios of stocks
          and held constant ex ante country- or industry-level risk to examine
          stock selection. Next, we held constant ex ante stock-level risk and
          examined country and industry selection. We found that both micro and macro selection
          contribute to the low-risk anomaly, but for two surprisingly different reasons.Whereas stock selection, within industries and countries, leads to higher CAPM (capital
          asset pricing model) alpha through a combination of significant risk reduction and modest
          return improvements, country selection leads to higher CAPM alpha through a combination of
          significant return improvements and modest risk reduction. In comparison to the stock
          selection effect and the country selection effect, the industry selection effect is
          relatively modest, and its associated CAPM alpha cannot be statistically distinguished
          from zero.These results suggest that when holding constant country- or industry-level risk, there
          is ample opportunity to form lower-risk portfolios through stock selection and that these
          lower-risk portfolios do not suffer lower returns. High-risk stocks can be distinctly
          identified within the utility industry or in Japan, for example, but they have similar raw
          returns on average when compared with low-risk stocks in the same industry or country
          grouping. This evidence supports the notion of limits to micro arbitrage in low-risk
          stocks that come from limits to leverage and traditional, long-only, fixed-benchmark
          mandates. The macro selection of countries in particular leads to increases in return,
          with only modest differences in risk. Countries that we identified as high risk ex
            ante were only modestly higher risk going forward, but they had distinctly
          lower returns. This evidence supports the limits to macro arbitrage across countries and
          industries.Our results on the decomposition of the low-risk anomaly into micro and macro effects
          have investment implications for plan sponsors and individuals alike. For individuals,
          they suggest that trying to exploit mispricing through industry, sector, or
          exchange-traded funds will capture only a portion of the anomaly. Although such a strategy
          can gain exposure to the macro effects, it cannot exploit the considerable risk reduction
          available in micro stock selection. For institutional investors and plan sponsors, our
          results suggest that perfunctory approaches to risk modeling and overly constrained
          mandates will not fully appreciate the benefits of the macro effects. Broad mandates with
          less stringent constraints and thoughtful techniques to modeling risk will do the most to
          exploit the low-risk anomaly.Authors’ note: The views expressed herein are those of the
            authors and do not necessarily reflect the views of the National Bureau of Economic
            Research or Acadian Asset Management. The views should not be considered investment
            advice and do not constitute or form part of any offer to issue or sell, or any
            solicitation of any offer to subscribe or to purchase, shares, units or other interests
            in any particular investments.
Journal: Financial Analysts Journal
Pages: 43-58
Issue: 2
Volume: 70
Year: 2014
Month: 3
X-DOI: 10.2469/faj.v70.n2.2
File-URL: http://hdl.handle.net/10.2469/faj.v70.n2.2
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Author-Name: Sascha Wilkens
Author-X-Name-First: Sascha
Author-X-Name-Last: Wilkens
Author-Name: Nastja Bethke
Author-X-Name-First: Nastja
Author-X-Name-Last: Bethke
Title: Contingent Convertible (CoCo) Bonds: A First Empirical Assessment of Selected Pricing Models
Abstract: 
 This study is the first to assess selected pricing models for contingent convertible (CoCo)
     bonds empirically. Substantial amounts of these instruments have recently been issued by a
     number of banks. The authors’ analysis shows that although all tested approaches—a
     structural model, an equity derivatives model, and a credit derivatives model—largely fit
     market prices, they exhibit biases in derived hedge ratios. The equity derivatives model is the
     most practical for the pricing and risk management of CoCo bonds.With several banks issuing substantial amounts of contingent convertible (CoCo) bonds since
     2009, this article is the first to analyze empirically the suitability of selected pricing
     models proposed for this kind of instrument. To the best of our knowledge, no comprehensive
     empirical analysis of the pricing of CoCo bonds has been conducted until now. Neither a
     “market standard” nor a preferred practitioner approach for the pricing and hedging
     of CoCo bonds exists at this point. This article aims to close this research gap by comparing
     the performance of three types of pricing models—a structural model, an equity
     derivatives model, and a credit derivatives model—with respect to reconciling and
     explaining market prices and their changes over time for the major CoCo bond issues by Lloyds
     Banking Group and Credit Suisse (some of the earliest examples).The “classic” CoCo bond is a debt instrument that converts into common equity
     when the issuing financial institution’s capital ratio falls below a predetermined
     critical level. It is therefore not surprising that we found the underlying share price of the
     company to be one of the major price drivers of the analyzed CoCo bonds, whereas the role of
     other parameters, such as CDS spreads and interest rates (which are usually price drivers of
     vanilla bonds), in the price-building mechanism is less pronounced. Our analysis shows that all
     tested approaches are largely able to fit observed CoCo bond prices. Regarding the derivation
     of hedge ratios, however, all models are found to exhibit biases. Although the structural
     model’s strength lies in the explicit modeling of the bank’s balance sheet
     structure—reflecting all parameters required for CoCo bond pricing, such as the capital
     ratio trigger—this explicit modeling of the bank’s assets and liabilities also
     introduces significant parameter uncertainty. Essentially none of the model parameters are
     directly observable in the market on a daily basis, the most critical being asset value, and so
     approximations are necessary, which negatively affect model performance. Although the overall
     model specification is conceptually sound for the equity and credit derivatives models, the
     “reduced-form” parameterization does not capture the capital ratio trigger
     explicitly, which is a limitation. Nevertheless, on balance, our results point to the equity
     derivatives model, with its straightforward parameterization and interpretation, as the most
     promising approach for the practical pricing and risk management of CoCo bonds. Given that
     share price has been identified as one of the few clear drivers of CoCo bond prices, explicit
     pricing based on this parameter and the associated easy interpretation and implementation of
     hedging strategies are advantages from a practitioner’s viewpoint. With the limited set
     of bonds and time series available for our analysis, more empirical research into this young
     market is needed.Authors’ Note: The views expressed in this article are those of the
      authors and do not necessarily reflect the views and policies of BNP Paribas.
Journal: Financial Analysts Journal
Pages: 59-77
Issue: 2
Volume: 70
Year: 2014
Month: 3
X-DOI: 10.2469/faj.v70.n2.3
File-URL: http://hdl.handle.net/10.2469/faj.v70.n2.3
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Author-Name: Charles D. Ellis
Author-X-Name-First: Charles D.
Author-X-Name-Last: Ellis
Title: Hard Choices: Where We Are
Abstract: 
 The author discusses his views on an issue of interest to FAJ readers.
Journal: Financial Analysts Journal
Pages: 6-10
Issue: 2
Volume: 70
Year: 2014
Month: 3
X-DOI: 10.2469/faj.v70.n2.4
File-URL: http://hdl.handle.net/10.2469/faj.v70.n2.4
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Author-Name: Laurence B. Siegel
Author-X-Name-First: Laurence B.
Author-X-Name-Last: Siegel
Title: “Knowing the World”: A Comment
Abstract: 
 This material comments on “Knowing the World”. (November/December 2013).
Journal: Financial Analysts Journal
Pages: 11-11
Issue: 2
Volume: 70
Year: 2014
Month: 3
X-DOI: 10.2469/faj.v70.n2.5
File-URL: http://hdl.handle.net/10.2469/faj.v70.n2.5
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Author-Name: Thomas J. Sargent
Author-X-Name-First: Thomas J.
Author-X-Name-Last: Sargent
Title: Rational Expectations and Ambiguity (corrected)
Abstract: 
 On 20 May 2013 at the 66th CFA Institute Annual Conference in Singapore, Thomas J. Sargent
     discussed his research on rational expectations and macroeconomics. He examined the probability
     distribution function of potential future outcomes in terms of ambiguity aversion and discussed
     market equilibrium under ambiguity aversion. He also considered whether swings in the market
     represent changes in the degree of ambiguity and, if so, whether those states can be
     predicted.On 20 May 2013 at the 66th CFA Institute Annual Conference in Singapore, Thomas J. Sargent
     discussed his research on rational expectations and macroeconomics. He examined the probability
     distribution function over potential future outcomes in terms of ambiguity aversion and
     consequences for equilibrium returns. He also considered whether swings in the market represent
     changes in the degree of ambiguity and whether those states can be predicted. 
Journal: Financial Analysts Journal
Pages: 14-19
Issue: 2
Volume: 70
Year: 2014
Month: 3
X-DOI: 10.2469/faj.v70.n2.6
File-URL: http://hdl.handle.net/10.2469/faj.v70.n2.6
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles.
Journal: Financial Analysts Journal
Pages: 88-88
Issue: 2
Volume: 70
Year: 2014
Month: 3
X-DOI: 10.2469/faj.v70.n2.7
File-URL: http://hdl.handle.net/10.2469/faj.v70.n2.7
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Author-Name: Elroy Dimson
Author-X-Name-First: Elroy
Author-X-Name-Last: Dimson
Author-Name: Christophe Spaenjers
Author-X-Name-First: Christophe
Author-X-Name-Last: Spaenjers
Title: Investing in Emotional Assets
Abstract: 
 The authors reviewed the long-term investment performance of collectibles and found that
          these so-called emotional assets have outperformed government bonds, Treasury bills, and
          gold over the long run. However, the costs of trading in these markets are high and an
          investor faces many dangers and pitfalls. Emotional assets are particularly attractive to
          some high-net-worth investors. The need for vigilance makes it hard to justify the
          inclusion of emotional assets in the portfolios of most institutional investors.The authors reviewed the long-term investment performance of three important categories
          of emotional assets—stamps, art, and musical instruments. The long-run returns on
          these collectibles have been superior to the total return from government bonds and
          Treasury bills (and gold), at least before taking into account differences in transaction
          costs and other expenses. However, the price volatility of emotional assets is larger than
          is suggested by the standard deviations of price indices. The investment risk is further
          elevated by collectibles’ exposure to fluctuating tastes and fads and by their
          vulnerability to frauds. Finally, indirect investment in emotional asset markets comes
          with its own set of problems. The available evidence thus indicates that an investment in
          collectibles should not be undertaken lightly. However, even if collectible emotional
          assets are dominated by financial assets with respect to risk–return
          characteristics, they can still be rational purchases for those who derive pleasure from
          owning them.
Journal: Financial Analysts Journal
Pages: 20-25
Issue: 2
Volume: 70
Year: 2014
Month: 3
X-DOI: 10.2469/faj.v70.n2.8
File-URL: http://hdl.handle.net/10.2469/faj.v70.n2.8
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Author-Name: John Rogers
Author-X-Name-First: John
Author-X-Name-Last: Rogers
Title: A New Era of Fiduciary Capitalism? Let’s Hope So
Abstract: 
 The author discusses his views on an issue of interest to FAJ readers.
Journal: Financial Analysts Journal
Pages: 6-12
Issue: 3
Volume: 70
Year: 2014
Month: 5
X-DOI: 10.2469/faj.v70.n3.1
File-URL: http://hdl.handle.net/10.2469/faj.v70.n3.1
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Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Xiaoyi Xu
Author-X-Name-First: Xiaoyi
Author-X-Name-Last: Xu
Title: Duration Targeting: No Magic for High-Yield Investors
Abstract: 
 Over time, the annualized return of a duration-targeting, investment-grade corporate bond
          portfolio will nearly match its initial yield. A high-yield bond portfolio’s
          performance is not similarly predictable. Furthermore, the difference between the
          high-yield universe’s initial yield and annualized return has a sharply negative
          bias. The absence of benefits from duration targeting has a bearing on valuation of the
          high-yield asset class and helps explain the instability in its investor base.A duration-targeting portfolio maintains an approximately constant duration by selling
          bonds as they approach maturity and replacing them with longer-dated issues. Over a
          determinable period, a duration-targeting investment-grade bond portfolio will reliably
          produce an annualized return very close to its initial yield. If interest rates rise, the
          portfolio’s market value falls and thus its total return declines. As these events
          occur, however, the reinvestment rate increases. Given sufficient time, reinvesting at the
          higher-than-initial rate offsets the loss in market value, leaving a net return equal to
          the initial yield. Conversely, if interest rates fall, the resulting gain in market value
          is eventually offset by a lower reinvestment rate. The convergence of initial yield and
          total return represents a valuable benefit in the form of predictability.Martin L. Leibowitz, Anthony Bova, and Stanley Kogelman mathematically demonstrated that
          initial yield and total return converge after the number of years that equals twice the
          duration minus 1 (2d – 1). They referred to this point in time as
          the bond’s effective maturity. The authors confirmed that
          convergence occurred in practice by examining historical returns on the Barclays US
          Aggregate Government/Credit Index.In our study, a similar analysis using The BofA Merrill Lynch US High Yield Index did not
          reveal a convergence of any practical value to investors. On the basis of historical
          experience, a portfolio manager who, on 31 December 2012, held a portfolio similar to the
          US High Yield Index with a yield-to-worst of 6.11% and monthly rebalancing might realize
          an annualized return of anywhere from –2.31% to 6.68% over the succeeding five
          years.The explanation of high yield’s less pronounced return convergence lies in its
          greater price volatility. During our study’s observation period, prices on the
          investment-grade index at the end of five years ranged from 102.20 to 110.86. The
          comparable range for the high-yield index was 61.15 to 104.35. It is more difficult for a
          change in the reinvestment rate to compensate for price swings over a 43.20-point range
          than for price swings over an 8.66-point range.Excess returns (the difference between initial yield and annualized
          total return) on the high-yield index were not only too wide to represent a useful level
          of predictability but were also heavily skewed to the negative. This bias was observed
          despite the declining trend of interest rates during the observation period, which gave
          investment-grade excess returns a positive bias. The difference was attributable to
          high-yield bonds’ higher default losses and the high-yield index’s greater
          concentration in callable bonds.Our study’s findings have two important implications for investors. First, a value
          comparison of investment-grade and high-yield bonds should attribute a portion of high
          yield’s total return premium to the absence of predictable performance in a
          duration-targeting high-yield portfolio. Second, the negative bias in high-yield excess
          returns helps explain the chronically destabilizing mix of investors in high-yield bonds.
          If high-yield investors could reliably earn a multi-year return close to their beginning
          yield, more long-term players would probably be attracted to that asset class. Because
          they cannot do so, however, high-yield prices are more heavily influenced by short-term
          traders seeking to catch interim highs and lows—and are thus more
          volatile—than they would be if duration targeting worked the same magic in high
          yield as it does in investment grade.
Journal: Financial Analysts Journal
Pages: 28-33
Issue: 3
Volume: 70
Year: 2014
Month: 5
X-DOI: 10.2469/faj.v70.n3.2
File-URL: http://hdl.handle.net/10.2469/faj.v70.n3.2
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Author-Name: John Hull
Author-X-Name-First: John
Author-X-Name-Last: Hull
Author-Name: Alan White
Author-X-Name-First: Alan
Author-X-Name-Last: White
Title: Valuing Derivatives: Funding Value Adjustments and Fair Value
Abstract: 
 The authors examined whether a bank should make a funding value adjustment (FVA) when valuing
     derivatives. They conclude that an FVA is justifiable only for the part of a company’s
     credit spread that does not reflect default risk. They show that an FVA can lead to conflicts
     between traders and accountants. The types of transactions a bank enters into with end users
     will depend on how high its funding costs are. Furthermore, an FVA can give rise to arbitrage
     opportunities for end users.One of the most controversial issues for a derivatives dealer in the last few years has been
     whether to make what is known as a funding value adjustment (FVA)—an
     adjustment to the value of an uncollateralized derivative (or an uncollateralized derivatives
     portfolio) designed to ensure that a dealer recovers its average funding costs when it trades
     and hedges derivatives. In this article, we examine the arguments for and against FVA. We argue
     that it is correct for a derivatives dealer to take credit risk into account by making credit
     value adjustments (CVAs) and debit value adjustments (DVAs), but it is not correct for a
     derivatives dealer to attempt to recover the whole of its funding costs in its pricing and
     marking to market. It should attempt to recover only those funding costs that correspond to (1)
     the risk-free rate and (2) the part of its credit spread that is unrelated to default risk. The traders working for a bank are often charged the average funding cost on the funds they
     use. Therefore, it is natural for them to try to recover this cost in their pricing. In
     attempting to recover funding costs, however, they reduce their prices in such a way that they
     offer favorable prices on some transactions (e.g., the sale of options) and unfavorable prices
     on other transactions (e.g., the purchase of options). This outcome creates arbitrage
     opportunities for end users who are able to trade on an uncollateralized basis. An end user
     buys options from a dealer with high funding costs and sells them to a dealer with low funding
     costs.There are two components to the DVA for a bank’s own default risk. The first, referred
     to as DVA1, is an adjustment for the possibility that the bank will default on a derivatives
     portfolio with a counterparty. The second component, DVA2, is an adjustment for the possibility
     that the bank will default on the funding for the portfolio. DVA1 is always positive (a benefit
     to the bank). DVA2 is positive if the portfolio requires funding and negative if it does
     not.One argument against FVA concerns the relationship between FVA and DVA2. The default risk
     component of a bank’s credit spread is compensation provided to lenders for the
     possibility that the bank will default. Accounting bodies recognize this compensation as a
     benefit to the bank. If the whole of a bank’s credit spread is compensation for default
     risk, FVA and DVA2 cancel each other and thus it is correct to consider neither in pricing
     derivatives. In other situations, basing an FVA on the non–default risk component of the
     credit spread is justifiable.Another argument against FVA concerns fair value accounting, which aims to mark derivatives
     portfolios to market at exit prices. The exit price for a dealer’s portfolio with a
     counterparty cannot depend on the dealer’s funding costs. It will depend on the market
     prices that reflect CVAs and DVA1s. Some argue that funding costs have moved markets away from
     the “law of one price.” We argue that this notion is not valid. Only one price
     clears the market for any given product, particularly when the product can be either bought or
     sold. A troubling aspect of FVA is that it results in different market participants having
     different estimates of fair value.Some market participants incorporate FVA, but not DVA1, into their pricing. Although this
     practice is better than incorporating both, it is not the correct solution. It leads to a
     dealer’s pricing of uncollateralized transactions being out of line with the market in
     such a way that the dealer offers favorable prices on some transactions and unfavorable prices
     on others.
Journal: Financial Analysts Journal
Pages: 46-56
Issue: 3
Volume: 70
Year: 2014
Month: 5
X-DOI: 10.2469/faj.v70.n3.3
File-URL: http://hdl.handle.net/10.2469/faj.v70.n3.3
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Handle: RePEc:taf:ufajxx:v:70:y:2014:i:3:p:46-56




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# input file: UFAJ_A_12048226_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Niels Pedersen
Author-X-Name-First: Niels
Author-X-Name-Last: Pedersen
Author-Name: Sébastien Page
Author-X-Name-First: Sébastien
Author-X-Name-Last: Page
Author-Name: Fei He
Author-X-Name-First: Fei
Author-X-Name-Last: He
Title: Asset Allocation: Risk Models for Alternative Investments
Abstract: 
 Often, the lack of mark-to-market data lures investors into the misconception that
          alternative asset classes and strategies represent somewhat of a “free lunch.”
          This article proposes solutions to measuring mark-to-market risk in alternative and
          illiquid investments. The authors describe how to estimate risk factor exposures when the
          available asset return series may be smoothed (owing to the difficulty of obtaining
          market-based valuations). They show that alternative investments are exposed to many of
          the same risk factors that drive stock and bond returns.This article proposes solutions to measuring mark-to-market risk in alternative and
          illiquid investments. We describe how to estimate risk factor exposures when the available
          asset return series may be smoothed (owing to the difficulty of obtaining market-based
          valuations). We show that alternative investments are exposed to many of the same risk
          factors that drive stock and bond returns.Our approach has profound implications for risk estimation in an asset allocation
          context. We recognize that there already is a significant body of literature that attempts
          to estimate risk factor exposures for various individual alternative investments and
          strategies. However, little research has been done to estimate the risk factor exposures
          across all alternatives within an internally consistent, unified risk factor framework.
          Given increased allocations to alternative investments in institutional investors’
          portfolios, we see an urgent need to develop a consistent approach that directly
          integrates the risks of alternative assets with the rest of the investors’
          portfolios.Our model uses transformed risk factor returns that account for the lag structure of the
          index. We have kept the list of factors parsimonious and consistent with those used for
          stocks and bonds. Reported betas represent the sum of the current and lagged betas, based
          on a model that addresses liquidity biases, extended to a multifactor framework.We show that returns on alternative assets depend on changes in interest rates, as well
          as how investors value risky cash flows, as reflected in equity market valuations and
          credit spreads. Also, liquidity and other specialized factors play a role. The approach
          based on risk factors typically generates higher correlations between alternative
          investments and their public market counterparts, especially when their equity betas are
          high, in addition to higher volatility, expected drawdowns, and tail risk exposures.
Journal: Financial Analysts Journal
Pages: 34-45
Issue: 3
Volume: 70
Year: 2014
Month: 5
X-DOI: 10.2469/faj.v70.n3.4
File-URL: http://hdl.handle.net/10.2469/faj.v70.n3.4
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Handle: RePEc:taf:ufajxx:v:70:y:2014:i:3:p:34-45




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# input file: UFAJ_A_12048227_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Joseph Matthews
Author-X-Name-First: Joseph
Author-X-Name-Last: Matthews
Title: “The Arithmetic of ‘All-In’ Investment Expenses”: A Comment
Abstract: 
 This material comments on “The Arithmetic of ‘All-In’ Investment Expenses”. (January/February 2014).
Journal: Financial Analysts Journal
Pages: 14-16
Issue: 3
Volume: 70
Year: 2014
Month: 5
X-DOI: 10.2469/faj.v70.n3.5
File-URL: http://hdl.handle.net/10.2469/faj.v70.n3.5
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# input file: UFAJ_A_12048228_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Maureen O’Hara
Author-X-Name-First: Maureen
Author-X-Name-Last: O’Hara
Title: High-Frequency Trading and Its Impact on Markets
Abstract: 
 At the 2013 CFA Institute Financial Analysts Seminar, held in Chicago on 22–25
          July, Maureen O’Hara discussed a new market paradigm: Trading has become faster, and
          market structure has fundamentally changed. In today’s market, high-frequency
          traders (HFTs) act on information revealed by low-frequency traders (LFTs). To survive,
          LFTs must avoid being detected by predatory algorithms of HFTs. LFTs can thrive by
          adopting trading strategies appropriate to the high-frequency trading world. At the 2013 CFA Institute Financial Analysts Seminar, held in Chicago on 22–25
          July, Maureen O’Hara discussed a new market paradigm: Trading has become faster, and
          market structure has fundamentally changed. In today’s market, high-frequency
          traders act on information revealed by low-frequency traders. To survive, low-frequency
          traders must avoid being detected by predatory algorithms of high-frequency traders by
          using small brokers. 
Journal: Financial Analysts Journal
Pages: 18-27
Issue: 3
Volume: 70
Year: 2014
Month: 5
X-DOI: 10.2469/faj.v70.n3.6
File-URL: http://hdl.handle.net/10.2469/faj.v70.n3.6
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Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles and issue.
Journal: Financial Analysts Journal
Pages: 72-72
Issue: 3
Volume: 70
Year: 2014
Month: 5
X-DOI: 10.2469/faj.v70.n3.7
File-URL: http://hdl.handle.net/10.2469/faj.v70.n3.7
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “Rational Expectations and
            Ambiguity,” by Thomas J. Sargent, in the March/April 2014 issue of the
            Financial Analysts Journal.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 3
Volume: 70
Year: 2014
Month: 5
X-DOI: 10.2469/faj.v70.n3.8
File-URL: http://hdl.handle.net/10.2469/faj.v70.n3.8
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Author-Name: John C. Bogle
Author-X-Name-First: John C.
Author-X-Name-Last: Bogle
Title: “The Arithmetic of ‘All-In’ Investment Expenses”: Author Response
Abstract: 
 This material comments on “The Arithmetic of ‘All-In’ Investment Expenses: A Comment”. (May/June 2014).
Journal: Financial Analysts Journal
Pages: 16-17
Issue: 3
Volume: 70
Year: 2014
Month: 5
X-DOI: 10.2469/faj.v70.n3.9
File-URL: http://hdl.handle.net/10.2469/faj.v70.n3.9
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# input file: UFAJ_A_12048233_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Clifford S. Asness
Author-X-Name-First: Clifford S.
Author-X-Name-Last: Asness
Author-Name: Andrea Frazzini
Author-X-Name-First: Andrea
Author-X-Name-Last: Frazzini
Author-Name: Lasse H. Pedersen
Author-X-Name-First: Lasse H.
Author-X-Name-Last: Pedersen
Title: Low-Risk Investing without Industry Bets
Abstract: 
 The strategy of buying safe low-beta stocks while shorting (or underweighting) riskier
          high-beta stocks (“betting against beta”) has been shown to deliver
          significant risk-adjusted returns. Some have suggested, however, that such “low-risk
          investing” delivers high returns primarily because of industry bets that favor a
          slowly changing set of stodgy, stable industries. The authors refute this notion by
          showing that a strategy of betting against beta has delivered positive returns both as an
          industry-neutral bet within each industry and as a pure bet
            across industries.The strategy of buying safe low-beta stocks while shorting (or underweighting) riskier
          high-beta stocks (“betting against beta,” or BAB) has been shown to deliver
          significant risk-adjusted returns. Some have suggested, however, that such “low-risk
          investing” delivers high returns primarily because of industry bets that favor a
          slowly changing set of stodgy, stable industries over their opposites. We refute this
          notion by showing that a strategy of betting against beta has delivered positive returns
          both as an industry-neutral bet within each industry and as a pure bet
            across industries. In fact, the industry-neutral BAB strategy has
          delivered positive returns in each of 49 US industries and in 60 of 70
          global industries, a remarkable consistency. Our findings are consistent with the
          leverage-aversion theory of why low-beta investing is effective.
Journal: Financial Analysts Journal
Pages: 24-41
Issue: 4
Volume: 70
Year: 2014
Month: 7
X-DOI: 10.2469/faj.v70.n4.1
File-URL: http://hdl.handle.net/10.2469/faj.v70.n4.1
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Author-Name: Ronald Doeswijk
Author-X-Name-First: Ronald
Author-X-Name-Last: Doeswijk
Author-Name: Trevin Lam
Author-X-Name-First: Trevin
Author-X-Name-Last: Lam
Author-Name: Laurens Swinkels
Author-X-Name-First: Laurens
Author-X-Name-Last: Swinkels
Title: “The Global Multi-Asset Market Portfolio, 1959–2012”: Author Response
Abstract: 
 This material comments on “The Global Multi-Asset Market Portfolio, 1959–2012: A Comment”. (July/August 2014).
Journal: Financial Analysts Journal
Pages: 9-12
Issue: 4
Volume: 70
Year: 2014
Month: 7
X-DOI: 10.2469/faj.v70.n4.10
File-URL: http://hdl.handle.net/10.2469/faj.v70.n4.10
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# input file: UFAJ_A_12048236_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: J. Ari Pandes
Author-X-Name-First: J. Ari
Author-X-Name-Last: Pandes
Author-Name: Michael J. Robinson
Author-X-Name-First: Michael J.
Author-X-Name-Last: Robinson
Title: Is Effective Junior Equity Market Regulation Possible?
Abstract: 
 The authors examined Canada’s Capital Pool Company (CPC) program, a regulated blind
          pool program, since its inception in 1986. They found that the CPC regulations increased
          the quality of both the junior equity companies going public and the underwriters taking
          those companies public and significantly reduced the incidence of fraud in that market.
          Overall, the authors found that effective regulation can help create a viable junior
          equity market that facilitates the development of smaller companies.The existence of a viable junior equity market is critical to the economic health of a
          nation; however, many developed countries, including the United States, have experienced a
          decline in small-company IPOs over time. Previous research has attributed the IPO decline
          to a number of factors, including an ineffective regulatory structure for junior equity
          issues, and has found that the lack of IPO capital has significantly slowed the growth
          rate of smaller companies and resulted in a large number of lost jobs. Achieving the
          delicate balance between protecting investors while not creating a regulatory system that
          is too expensive or cumbersome for issuing companies seeking to raise capital has proven
          difficult in many countries.In our study, we examined Canada’s Capital Pool Company (CPC) program, a regulated
          blind pool program. In Canada, securities regulation is a provincial responsibility, and
          the CPC program began in the province of Alberta in 1986 in response to some of the same
          fraudulent behavior that was observed in the US blind pool market in the late 1980s. The
          differing responses to junior equity fraud by Canadian and US regulators create a natural
          experiment to examine the effectiveness of junior equity market regulation.Whereas previous research has documented that the US regulations effectively closed down
          the US blind pool market (for junior equity issues), we examined all Canadian junior blind
          pool IPOs from 1986 to 2010 and found that although the number of such offerings has
          fluctuated over time, it has remained high even after the senior market slowdowns during
          the early 2000s and the 2008 global financial crisis. We found that by 2010, a total of
          2,161 companies had used the CPC program to raise $726.3 million in IPO capital. Part of
          the reason why the program has remained robust over time is that it has expanded to
          include the majority of Canadian provinces and now attracts listings by companies from
          across Canada and internationally.We examined the effectiveness of the CPC regulations by comparing the performance of
          Canadian blind pool offerings that occurred before and after the adoption of the
          regulations. We found that more than 72.2% of the population of CPCs completed their
          qualifying transaction (an asset acquisition or merger with a private company that
          transforms the blind pool into a regularly listed company) and remained listed for at
          least five years following this transaction or were delisted owing to an amalgamation, a
          takeover, or graduation to a more senior exchange. In comparison, prior to the adoption of
          the CPC regulations, only 38.1% of blind pool companies became regularly listed and
          remained so for the next five years.We also found that an increasing percentage of higher-quality underwriters are willing to
          take CPCs public, especially since the program was expanded to Canada’s major
          provinces. More specifically, prior to the adoption of the CPC regulations, less than 5%
          of blind pool offerings were underwritten by a top 20 underwriter from the league tables,
          but since the regulations were adopted, more than 45% of blind pool offerings have been
          underwritten by a top 20 underwriter.Finally, we found that the adoption of the CPC regulations significantly lowered the
          incidence of fraud in the Canadian junior equity blind pool market. Prior to the adoption
          of the CPC regulations, almost one in five Canadian blind pools were investigated for or
          found guilty of fraudulent behavior. The percentage of fraud declined significantly once
          the CPC program began in Alberta and has continued to decline as the program has been
          adopted in other Canadian jurisdictions.Overall, our study provides strong support for the effectiveness of the CPC regulations
          in developing a vibrant junior equity market that strikes the right balance between
          facilitating a company’s development and protecting investors. Thus, we conclude
          that effective regulation can help create a viable junior equity market that facilitates
          the development of smaller companies.
Journal: Financial Analysts Journal
Pages: 42-54
Issue: 4
Volume: 70
Year: 2014
Month: 7
X-DOI: 10.2469/faj.v70.n4.2
File-URL: http://hdl.handle.net/10.2469/faj.v70.n4.2
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Author-Name: Gary E. Porter
Author-X-Name-First: Gary E.
Author-X-Name-Last: Porter
Author-Name: Jack W. Trifts
Author-X-Name-First: Jack W.
Author-X-Name-Last: Trifts
Title: The Career Paths of Mutual Fund Managers: The Role of Merit
Abstract: 
 This study provides evidence that merit—specifically, performance relative to peers
          measured on a style-adjusted basis—plays a significant role in the length of a
          mutual fund manager’s career. Managers who underperform their peers are more likely
          to lose their jobs. However, surviving managers of any tenure—even those who manage
          their funds for 10 or more years—generally do not outperform the market or their
          style benchmarks and do not display consistently superior performance.In this study, we examined the career performance of solo managers of 2,846 actively
          managed mutual funds over 1996–2008 using data from Morningstar. Turnover among this
          group of managers was high, with nearly 19% lasting no more than one year and more than
          75% lasting no more than five years. We measured relative monthly performance on a
          style-adjusted basis by computing each manager’s total monthly return less the
          average return to all other funds of the same Morningstar style. We also tested the
          results by expressing this relative performance in deciles and repeated the tests using
          performance measured by both Carhart and Jensen alphas. In addition, we controlled for
          managers whose funds became team managed or who changed funds, possibly owing to a
          promotion.The results provide evidence of the role of merit in the careers of managers of actively
          managed funds. Consistent with prior studies, we found that relative performance is an
          important determinant of career success as a mutual fund manager. We showed that managers
          who underperform on a style-adjusted basis are at greater risk of losing their jobs.
          However, the evidence on the role of superior performance is less strong. Surviving
          managers of all tenures, even those who lasted 10 or more years, outperformed those with
          shorter tenures, but we also showed that they did not consistently outperform the market
          on a risk-adjusted basis or their style benchmark. Data on style-adjusted monthly returns
          show that solo managers with 10 or more years of tenure outperformed about as often as
          they underperformed. When performance is calculated using Carhart or Jensen alphas, even
          solo managers with tenure of more than 10 years show no ability to beat the market on a
          risk-adjusted basis. The key to a long career in the mutual fund industry seems to be
          related more to avoiding underperformance than to achieving superior performance.The lack of significantly better performance over time by long-tenure managers suggests
          that longevity is related to the avoidance of underperformance. Additional factors may be
          at work in impairing the performance of these managers. For example, researchers have
          found evidence that some underperforming managers at smaller funds are able to retain
          their positions despite their performance. Additionally, other research has shown that a
          significant proportion of the best mutual fund managers earned their reputations with high
          rates of return early in their careers and had performance that was significantly worse
          later on. Whether this early performance was due to luck or early superior skills that
          atrophied later is subject to conjecture and further research.Many other opportunities for future research exist. For example, there are many potential
          reasons for a manager losing sole control of a fund, from board-related or professional
          considerations to personal ones. Because employers seldom announce that an
          employee’s demotion or departure is related to performance, it is difficult to
          isolate those cases where a change occurred for reasons not related to performance. We
          partially controlled and tested for this effect by isolating solo managers who left one
          fund and became solo manager of another fund. However, the robustness of our results
          suggests that better isolation of nonperformance issues would strengthen rather than
          significantly weaken our findings.
Journal: Financial Analysts Journal
Pages: 55-71
Issue: 4
Volume: 70
Year: 2014
Month: 7
X-DOI: 10.2469/faj.v70.n4.3
File-URL: http://hdl.handle.net/10.2469/faj.v70.n4.3
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Author-Name: Charles D. Ellis
Author-X-Name-First: Charles D.
Author-X-Name-Last: Ellis
Title: The Rise and Fall of Performance Investing
Abstract: 
 Performance investing has enjoyed a remarkably long life cycle, but the costs of active
          investment are so high and the incremental returns so low that, for clients, the money
          game is no longer a game worth playing. Investors—both institutions and
          individuals—are increasingly shifting toward indexing. As acceptance of indexing
          grows, clients and managers have an opportunity to stop focusing on price discovery (which
          has made our markets so efficient) and refocus on values discovery, whereby investment
          professionals can help investors achieve good performance by structuring an appropriate,
          long-term investment program and staying with it.Performance or active investing began to flourish 50 years ago, has attracted large
          numbers of the best and the brightest as practitioners, and has spawned a remarkable range
          of innovations and changes in organizations, technologies, techniques, and information and
          in the way our capital markets operate. Many managers have prospered greatly. Few, if any,
          industries have rewarded so many so generously.However, as academic studies have proclaimed for many years and as the records
          show—after correcting for the distortions of deleting the records of failed funds
          and managers and ex post incorporating the records of newly discovered
          managers—active investment managers, as a group, have underperformed their chosen
          benchmarks.This underperformance is understandable. Fees are large and have been rising over the
          past half century as skillful, diligent, hardworking investment managers have made the
          markets increasingly efficient. Thus, most managers—particularly when only one-third
          of their portfolios are “active share,” which clearly differ from index
          funds—will be unable to absorb the costs of trading and fees and still achieve
          better-than-market rates of return. Underperformance after costs is not just
          understandable; it had to be expected as professional investors’ trading went from a
          small minority 50 years ago to an overwhelming majority today.Meanwhile, the compensation accruing to investment companies and investment managers has
          been generous for firms and individual practitioners, and so the investment
            business has been superb. But the investment
            profession centered on counseling—defining with the client the
          appropriate long-term objectives, risk constraints, liquidity needs, and market
          realities—has been allowed to atrophy. This reality is shown by the focus on
          “asset gathering” and “investment products,” with little or no
          attention to each client’s specific goals and objectives.Clients—both individual and institutional—have continued to be guided by
          subjective hopes and the assuring promises of active managers rather than by experiences
          or objective analysis of the relevant data.Gradually and persistently, however, investors have been shifting from active performance
          managers to indexing. The pace may appear slow, but it has been accelerating. Why has the
          pace of change been so slow? One reason is that so much of the “chatter” about
          investing—by managers, by consultants, and by the media—centers on winners and
          winning. Another reason is that major change is usually a social process with a few
          innovators leading, early adopters following, later adopters then coming along, and then
          even slow adopters and laggards coming too.Finally, each change goes through stages: awareness, deciding whether to change, and then
          making the change. Moreover, people can believe in almost anything when they are part of a
          group of people with the same belief. Despite the extensive evidence to the contrary,
          pension and endowment fund executives still believe that their active managers will
          outperform the market by a cool 100 bps.It is ironic that the skills of active managers have made it improbable that—other
          than by random chance—any specific active manager will outperform the market index
          for the outsiders (clients). This ironic reality has become the great test of our
          profession even as our business is achieving superior results for ourselves, the insiders.
          Are we putting our clients’ interests first? If not, are we a commercial business
          rather than a noble profession? Do we care?
Journal: Financial Analysts Journal
Pages: 14-23
Issue: 4
Volume: 70
Year: 2014
Month: 7
X-DOI: 10.2469/faj.v70.n4.4
File-URL: http://hdl.handle.net/10.2469/faj.v70.n4.4
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Author-Name: Keith Ambachtsheer
Author-X-Name-First: Keith
Author-X-Name-Last: Ambachtsheer
Title: Why We Need to Change the Conversation about Pension Reform
Abstract: 
 The author discusses his views on an issue of interest to FAJ readers.
Journal: Financial Analysts Journal
Pages: 4-8
Issue: 4
Volume: 70
Year: 2014
Month: 7
X-DOI: 10.2469/faj.v70.n4.5
File-URL: http://hdl.handle.net/10.2469/faj.v70.n4.5
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Author-Name: Hans Tallis
Author-X-Name-First: Hans
Author-X-Name-Last: Tallis
Title: “My Top 10 Peeves”: A Comment
Abstract: 
 This material comments on “My Top 10 Peeves”. (January/February 2014).
Journal: Financial Analysts Journal
Pages: 9-9
Issue: 4
Volume: 70
Year: 2014
Month: 7
X-DOI: 10.2469/faj.v70.n4.6
File-URL: http://hdl.handle.net/10.2469/faj.v70.n4.6
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Author-Name: The Editors
Title: In the Future
Abstract: 
 The associate editor highlights upcoming FAJ articles and issue.
Journal: Financial Analysts Journal
Pages: 80-80
Issue: 4
Volume: 70
Year: 2014
Month: 7
X-DOI: 10.2469/faj.v70.n4.7
File-URL: http://hdl.handle.net/10.2469/faj.v70.n4.7
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Author-Name: Katja Ahoniemi
Author-X-Name-First: Katja
Author-X-Name-Last: Ahoniemi
Author-Name: Petri Jylhä
Author-X-Name-First: Petri
Author-X-Name-Last: Jylhä
Title: Flows, Price Pressure, and Hedge Fund Returns
Abstract: 
 The authors studied how capital flows affect hedge fund returns and found that funds with
     high inflows outperform funds with high outflows during the month of the flows. This immediate
     reaction, combined with feedback trading, gives rise to a cycle: Flows exert price pressure,
     this effect on returns induces more flows, and these flows cause further price pressure. The
     cycle is so strong that it takes two years for a full return reversal, and it contributes to
     the observed persistence in hedge fund performance. The impact of flows on returns has clear
     implications for performance evaluation: One-third of estimated hedge fund alphas are due to
     flows.Over the past two decades, hedge funds have experienced large inflows of capital. Academic
     literature shows that fund flows result in an uninformed demand shift, which may affect asset
     prices. In this study, we examined the effect that capital flows have on hedge fund returns.
     Our results are consistent with a mechanism whereby funds respond to flows by scaling their
     portfolios up or down, rather than diversifying. These trades have a contemporaneous price
     impact on the funds’ underlying assets, leading to an effect on fund-level returns.
     Reversal of the initial flow-induced price pressure is delayed by the price impact exerted by
     further performance-chasing flows. The sequential nature of hedge fund flows and
     returns—monthly flows are submitted before learning the concurrent return—allows us
     to quantify the contemporaneous effect that flows have on fund-level returns.Our article contains four key results. First, hedge fund returns exhibit statistically and
     economically significant flow-induced price pressure: Funds that received high inflows
     outperformed funds experiencing large outflows during the month of the flows. This effect is
     present in calendar-time portfolios sorted on flows, in fund-level time-series regressions, and
     in cross-sectional regressions. When we sorted hedge funds into five flow portfolios, the
     high-flow funds outperformed the low-flow funds by 0.96% per month, which indicates that hedge
     fund flows are sizable enough in relation to the liquidity of the underlying assets for flows
     to have a significant price impact.To obtain our second key result, we traced the cumulative outperformance of the initial
     high-flow (high-inflow) hedge funds over the low-flow (high-outflow) funds to examine the
     long-term impact of the flows. The cumulative outperformance rose gradually for the first 10
     months following the flows, after which it started to slowly revert. A full reversal of the
     initial price impact took a total of about 24 months. This delayed onset of reversal can be
     explained by a flow–return cycle: Flows exert price pressure, this effect on returns
     induces more flows, and these flows cause further price pressure.Our third result is that the flow–return cycle contributes significantly to the
     observed performance persistence in hedge funds. If both returns and flows depend on past
     returns, we should observe a relation between the two even in the absence of a causal link. We
     showed that this is not the case; both past returns and contemporaneous flows have a
     significant positive impact on hedge fund returns. We also constructed two investment
     strategies—one for the flow impact and the other for momentum—and compared their
     returns. The alpha of the flow impact strategy is both positive and significant. Further, even
     when adding the momentum returns to the model, the flow impact alpha remains positive and
     significant. We thus concluded that the two effects coexist and, if anything, flow impact is a
     driver of performance persistence, and not vice versa.Finally, our fourth set of results deals with the implications of flow impact for hedge fund
     performance attribution. If the price impact exerted by flows is not perfectly correlated with
     the risk factors used, a part of what is interpreted to be pure manager skill may be driven by
     flows. To our knowledge, we are the first to quantify the flow effect on estimated alphas. In
     practice, we augmented the Fung–Hsieh seven-factor model with a flow impact factor. The
     estimates of hedge fund alphas fell by one-third when including the flow impact factor, further
     underscoring the importance of assessing flow impacts when measuring the sources of hedge fund
     returns.
Journal: Financial Analysts Journal
Pages: 73-93
Issue: 5
Volume: 70
Year: 2014
Month: 9
X-DOI: 10.2469/faj.v70.n5.1
File-URL: http://hdl.handle.net/10.2469/faj.v70.n5.1
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Author-Name: Lawrence Bader
Author-X-Name-First: Lawrence
Author-X-Name-Last: Bader
Title: Question: How Does Investment Return Affect Pension Cost?
Abstract: 
 The author asserts that pension fund risk management rests on understanding that the
          enemy is not asset risk per se but, rather, asset–liability mismatch. He argues that to
          minimize pension risk, companies should invest their pension funds solely in high-quality
          fixed-income securities that match the projected cash flows or durations of the accrued
          pensions.
Journal: Financial Analysts Journal
Pages: 4-6
Issue: 5
Volume: 70
Year: 2014
Month: 9
X-DOI: 10.2469/faj.v70.n5.2
File-URL: http://hdl.handle.net/10.2469/faj.v70.n5.2
File-Format: text/html
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Author-Name: Roger Clarke
Author-X-Name-First: Roger
Author-X-Name-Last: Clarke
Author-Name: Harindra de Silva
Author-X-Name-First: Harindra
Author-X-Name-Last: de Silva
Author-Name: Steven Thorley
Author-X-Name-First: Steven
Author-X-Name-Last: Thorley
Title: The Not-So-Well-Known Three-and-One-Half-Factor Model
Abstract: 
 In the Fama–French three-factor model, the market return is not the return to market
     beta. By including a separate beta factor, the market portfolio without a coefficient can be
     described as only “half” a factor. Documenting the returns to a pure beta factor in
     the US equity market, the authors show that the distinction between the market return and the
     return to the cross-sectional variation in security betas also applies to portfolio performance
     measurement. The realized alphas of low-beta (high-beta) portfolios are reduced (increased)
     when a separate beta factor is included.Equity analysts conceptualize the Fama–French framework as a tool for studying the size
     and value characteristics of equity portfolios, along with traditional market beta. But the
     market portfolio return is not the return to market beta. In fact, commercial providers of
     equity risk models typically include both a market factor and a separate beta factor, along
     with size and value factors. In other words, in equity risk-modeling practice, the basic
     Fama–French framework includes four factors, not just three. Unlike the other three
     factors, the intercept term (i.e., market factor) in the original Fama–French regression
     equation does not have a coefficient that varies across securities, and so it can be described
     as just “half” a factor. Similarly, applied versions of the Fama–French plus
     Carhart momentum model include five factors—or at least four and a half.In our study, we use cross-sectional Fama–MacBeth regressions, with several econometric
     enhancements now used in industry, on essentially all US common stocks for the last half
     century (1963–2012). The econometric enhancements include market-capitalization weighting
     of multivariate regressions and scaling of stock characteristics to unit standard deviations
     (i.e., z-scores). The regressions produce returns to five factors: the Market
     intercept term and four standardized factors (z-Beta,
     z-Small, z-Value, and z-Mom). The returns to
     the “pure” z-Small, z-Value, and
      z-Mom portfolios are similar to the returns to the Fama–French SMB,
     HML, and UMD portfolios but are less correlated with each other over time. The long-term return
     to the z-Beta factor is negative, in stark contrast to the prediction of the
     traditional CAPM. The empirical security market line (SML) has been not only “too
     flat” but actually downward sloping. Direct comparison of the returns to standardized
     factors indicates that the market beta anomaly was more significant than either the size
     anomaly or the value anomaly in the US equity market from 1963 to 2012.In the absence of a separate beta factor, commonly used performance measurement (i.e.,
     time-series-based regression) specifications can lead to misconceptions about the source and
     magnitude of portfolio alpha. We illustrate an alternative performance measurement
     specification by using returns on the SSgA Sector ETFs over the most recent decade
     (2003–2012). The alphas of low-beta (high-beta) industrial sector portfolio returns
     decrease (increase) toward zero once the beta anomaly is properly acknowledged. Similarly, the
     large positive alpha of the MSCI Minimum Volatility Index is substantially reduced.
     Understanding the distinction between the market and beta factors in the not-so-well-known
     three-and-one-half-factor model can help avoid misperceptions about the sources of portfolio
     performance.
Journal: Financial Analysts Journal
Pages: 13-23
Issue: 5
Volume: 70
Year: 2014
Month: 9
X-DOI: 10.2469/faj.v70.n5.3
File-URL: http://hdl.handle.net/10.2469/faj.v70.n5.3
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Author-Name: Mark Carhart
Author-X-Name-First: Mark
Author-X-Name-Last: Carhart
Author-Name: Ui-Wing Cheah
Author-X-Name-First: Ui-Wing
Author-X-Name-Last: Cheah
Author-Name: Giorgio De Santis
Author-X-Name-First: Giorgio
Author-X-Name-Last: De Santis
Author-Name: Harry Farrell
Author-X-Name-First: Harry
Author-X-Name-Last: Farrell
Author-Name: Robert Litterman
Author-X-Name-First: Robert
Author-X-Name-Last: Litterman
Title: Exotic Beta Revisited
Abstract: 
 The authors propose portfolios comprising simple and intuitive risk premiums (exotic betas)
     that are transparent and cost effective, perform well in different market environments, and are
     uncorrelated with equities. They are an alternative to traditional portfolios that are defined
     by their asset class allocations. The authors show that exotic beta investing offers a better
     risk–return profile than risk parity and hedge fund replication and that adjusting
     exposures to capture variation in risk premiums further improves performance.As an alternative to traditional portfolios that are defined by their asset class
     allocations, we propose portfolios comprised of simple and intuitive risk premiums, which we
     call “exotic betas.” The factors underlying the exotic betas are transparent and
     cost effective to implement and perform well over a variety of market conditions. In addition,
     our portfolios are uncorrelated with equities because we proactively hedge all the exotic betas
     against fluctuations of global equity markets. In our analysis, we study the properties of the
     exotic beta portfolios in stages. We start by simulating an implementable version of each
     exotic beta and compare their properties with those of a simple global equity portfolio. We
     find compelling evidence that exotic betas typically deliver higher Sharpe ratios, smaller
     drawdowns, and very low correlations with equities (by construction) and other known factors.
     Next, we build an equal-risk combination of exotic beta factors that is analogous to risk
     parity and compare the portfolio with asset class risk parity, hedge funds, and hedge fund
     replication. Owing to its long-only exposure to traditional asset classes and substantial
     equity risk, the asset class risk parity portfolio retains a high correlation with equities,
     and it underperforms both exotic beta and hedge fund strategies. After imposing additional
     conservative assumptions on forward-looking expected returns, we perform a mean–variance
     analysis in which the assets of choice are global equities, global bonds, risk parity, hedge
     funds, and exotic beta. The resulting optimal portfolios hold a combination of global bonds,
     hedge funds, and exotic beta; global equities and risk parity are not held because of their
     limited diversification benefits and their relatively lower expected Sharpe ratios. Finally, we
     examine the predictability in the exotic beta risk factors using straightforward metrics of
     value. We find that dynamically adjusting the exposure across exotic betas to capture the time
     variation in risk premiums further improves the risk–return profile of the strategy.Authors’ note: This article is intended to educate readers about the
      concept of exotic beta. It is not an offering document for any investment vehicle, a
      recommendation to buy or sell any particular assets or fund, or a proxy for any portfolios
      that are currently managed, or may in the future be managed, by Kepos Capital. In addition,
      this article (1) does not constitute investment advice and (2) does not take into account any
      individual personal circumstances or other factors that may be important in making investment
      decisions; no advisory or fiduciary relationship is created by the distribution hereof.Editor’s note: Robert Litterman is executive editor of the
       Financial Analysts Journal. He was recused from the referee and acceptance
      processes and took no part in the scheduling and placement of this article. See the
       FAJ policies section of cfapubs.org for more information.
Journal: Financial Analysts Journal
Pages: 24-52
Issue: 5
Volume: 70
Year: 2014
Month: 9
X-DOI: 10.2469/faj.v70.n5.4
File-URL: http://hdl.handle.net/10.2469/faj.v70.n5.4
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Author-Name: The Editors
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles and issue.
Journal: Financial Analysts Journal
Pages: 96-96
Issue: 5
Volume: 70
Year: 2014
Month: 9
X-DOI: 10.2469/faj.v70.n5.5
File-URL: http://hdl.handle.net/10.2469/faj.v70.n5.5
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Author-Name: Robert M. Anderson
Author-X-Name-First: Robert M.
Author-X-Name-Last: Anderson
Author-Name: Stephen W. Bianchi
Author-X-Name-First: Stephen W.
Author-X-Name-Last: Bianchi
Author-Name: Lisa R. Goldberg
Author-X-Name-First: Lisa R.
Author-X-Name-Last: Goldberg
Title: Determinants of Levered Portfolio Performance
Abstract: 
 The cumulative return to a levered strategy is determined by five elements that fit together
     in a simple and useful formula. A previously undocumented element is the covariance between
     leverage and excess return to the fully invested source portfolio underlying the strategy. In
     an empirical study of volatility-targeting strategies over the 84-year period 1929–2013,
     this covariance accounted for a reduction in return that substantially diminished the Sharpe
     ratio in all cases.We show that the cumulative return to a levered strategy is determined by five elements that
     fit together in a simple and useful formula. Looking backward, the formula can be used to
     attribute the realized return of a levered strategy. Looking forward, the formula can be used
     to generate a forecast for the return of a levered strategy. Our formula is expressed in terms
     of the return to the source portfolio, which is the fully invested portfolio
     underlying the levered strategy.The most novel element of our multi-period attribution formula is the covariance between
     leverage and return to the source portfolio in excess of the borrowing rate. This element
     contributes to the return of any dynamically levered strategy. We illustrate the impact of
     dynamic leverage on cumulative return using a simple two-period model, in which the covariance
     term plays a crucial role. Over time, however, one might be tempted to think that the
     covariance term would wash out. The empirical examples in this article demonstrate that the
     covariance term does not wash out and has a substantial impact on the long-run return of widely
     used strategies. In empirical studies of risk parity strategies and bond strategies levered to
     volatility targets, we found that the covariance term makes a substantial contribution
      to cumulative return
     over a
     very long horizon. In all our examples, the covariance term turned out to be
     negative, diminishing annualized arithmetic return by amounts ranging from 0.64% to 4.23% over
     an 84-year period. Consequently, the Sharpe ratios of volatility-targeting strategies were
     lower than those of their source portfolios and fixed-leverage benchmarks.Also important over multiple periods is the cost of trading, which imposes a drag on any
     strategy. Leverage exacerbates turnover, so levered strategies tend to have higher trading
     costs than do unlevered strategies. On the basis of a linear model, we found that
     leverage-induced turnover diminished the annualized arithmetic return of the strategies we
     considered by amounts ranging from 0.27% to 2.59% over an 84-year period.Compounding imposes a variance drag on cumulative return that affects strategies
     differentially. For any given source portfolio, the variance drag is quadratic in leverage. If
     a levered strategy has high volatility, the variance drag can be substantial. We found that the
     variance drag diminished the annualized geometric return of the strategies we considered by
     amounts ranging from 0.41% to 2.84% over an 84-year period.That financing costs and the variance drag materially reduce the Sharpe ratio of a levered
     strategy is well known. Nevertheless, these effects are often neglected in empirical studies
     because much of our intuition about levered strategies comes from single-period models. In one
     period, there is no trading and hence there are no trading costs, there is no compounding and
     hence no variance drag, and leverage is necessarily fixed and hence there is no covariance
     term. What is new in this article is that, via the covariance term, dynamic leverage affects the
     Sharpe ratio even in the absence of trading costs.
Journal: Financial Analysts Journal
Pages: 53-72
Issue: 5
Volume: 70
Year: 2014
Month: 9
X-DOI: 10.2469/faj.v70.n5.6
File-URL: http://hdl.handle.net/10.2469/faj.v70.n5.6
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Author-Name: William F. Sharpe
Author-X-Name-First: William F.
Author-X-Name-Last: Sharpe
Author-Name: Robert Litterman
Author-X-Name-First: Robert
Author-X-Name-Last: Litterman
Title: Past, Present, and Future Financial Thinking
Abstract: 
 At the 67th CFA Institute Annual Conference, held 4–7 May 2014 in Seattle,
                    Robert Litterman interviewed William F. Sharpe to elicit his perspective on a
                    number of investment issues, including the capital asset pricing model, asset
                    allocation, behavioral finance, and retirement income. At the 67th CFA Institute Annual Conference, held 4–7 May 2014 in Seattle,
                    Robert Litterman, executive editor of the Financial Analysts Journal,
                    interviewed William F. Sharpe to elicit his perspective on a number of
                    investment issues, including the capital asset pricing model, asset allocation,
                    behavioral finance, and retirement income. Sharpe discusses the early days of
                    his career, current investment topics, and his views on the future.
Journal: Financial Analysts Journal
Pages: 16-22
Issue: 6
Volume: 70
Year: 2014
Month: 11
X-DOI: 10.2469/faj.v70.n6.1
File-URL: http://hdl.handle.net/10.2469/faj.v70.n6.1
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Author-Name: Rhodri Preece
Author-X-Name-First: Rhodri
Author-X-Name-Last: Preece
Author-Name: Sviatoslav Rosov
Author-X-Name-First: Sviatoslav
Author-X-Name-Last: Rosov
Title: Dark Trading and Equity Market Quality
Abstract: 
 Off-exchange trading in equity markets, including broker/dealer internalization and dark
     pools, has grown in recent years. An examination of the relationship between dark trading and
     market quality suggests that as dark trading increases, the marginal benefit from it declines.
     Beyond a certain threshold, increases in dark trading may be associated with deteriorating
     market quality. The level of this threshold is related to the type of dark trading and the
     market capitalization of the stock.Over the past decade, equity markets have undergone a significant structural change due to
     the combined forces of technology, regulation, globalization and competition. Trading has
     become increasingly automated, fast-paced, competitive, and spatially dispersed. This evolution
     has been accompanied by a decrease in average trade size and a significant increase in overall
     quote traffic and transaction volumes. Trading costs have fallen while liquidity has become
     increasingly fragmented over multiple venues. In particular, the fragmentation of liquidity has been associated with a significant shift of
     trading volume away from the primary listing markets and toward undisplayed off-exchange
     trading venues, including broker/dealer internalization and dark pools. Investors and
     regulators have raised a number of concerns about these changes in market structure. First,
     there has been a perceived degradation of market transparency arising from the growth in dark
     trading and the corresponding fall in the market share of “lit” venues. Second, an
     uneven playing field between different types of trading venues and between different classes of
     investors in terms of access to markets can distort competition and fairness. Finally, there is
     a greater potential for systemic risk propagation as a result of the market’s dependence
     on automation and its interconnectedness. A more fundamental concern associated with the growth
     in dark trading is that the willingness of investors to post displayed limit orders—the
     building blocks of price discovery—could be harmed if a significant proportion of orders
     are filled off exchange at the expense of the limit order submitter. This scenario could
     disincentivize investors from using the lit markets.To determine whether investors and regulators are right to be concerned about developments in
     equity market structure, the relation between dark trading and market quality is examined. We
     look at the impact of dark trading on two proxies for market quality: bid–offer spreads
     and top-of-book market depth. The results of this analysis suggest that an increase in dark
     pool activity and internalization is initially associated with an improvement in market quality
     but that this improvement persists only up to a certain threshold. When a majority of trading
     occurs in undisplayed venues, market quality benefits disappear and may actually reverse.
Journal: Financial Analysts Journal
Pages: 33-48
Issue: 6
Volume: 70
Year: 2014
Month: 11
X-DOI: 10.2469/faj.v70.n6.2
File-URL: http://hdl.handle.net/10.2469/faj.v70.n6.2
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Author-Name: Roni Israelov
Author-X-Name-First: Roni
Author-X-Name-Last: Israelov
Author-Name: Lars N. Nielsen
Author-X-Name-First: Lars N.
Author-X-Name-Last: Nielsen
Title: Covered Call Strategies: One Fact and Eight Myths
Abstract: 
 A covered call is a long position in a security and a short position in a call option on that
     security. Equity index covered calls are an attractive strategy to many investors because they
     have realized returns not much lower than those of the equity market but with much lower
     volatility. However, a number of myths about the strategy—from why it works to why an
     investor should or should not invest—have surfaced, and many of them are erroneously
     considered “common knowledge.” The authors review the underlying risk and returns
     of covered call strategies and dispel eight common myths about them.Equity index covered calls are an attractive strategy to many investors because they have
     realized returns not much lower than their underlying equity index but with much lower
     volatility. An equity index covered call owns the index and sells a call option on the index.
     These two positions expose the portfolio to two compensated risks and earn their respective
     premiums: the equity and volatility risk premiums.In order for the covered call’s risk and expected return profile to be understood, it
     must be analyzed from the perspective of its risk exposures. Because covered calls are rarely
     described in this manner, a number of myths about the strategy—from how it works to why
     an investor should or should not invest—have surfaced. Today, many of these myths are
     erroneously considered “common knowledge.” After reviewing the underlying risk and
     returns of covered call strategies, we dispel the following eight common myths about them:Risk exposure can be expressed in a payoff diagram.Covered calls provide downside protection.Covered calls generate income.Covered calls on high-volatility stocks and/or shorter-dated options provide higher
       yield.Time decay of written options works in your favor.Covered calls are appropriate if you have a neutral to moderately bullish view.Covered calls pay you for doing what you were going to do anyway.Covered calls allow you to buy a stock at a discounted price.In our view, the myths collectively conceal the simple facts that option overwriting is a
     version of selling volatility and that selling volatility is a risky strategy. If you believe
     that the underlying equity index will rise and that implied volatilities are rich, the covered
     call is a step in the right direction of expressing those views in order to capture expected
     compensation for the long equity and short volatility exposures embedded in covered call
     writing. History provides strong evidence in support of both risk premiums. However, if you
     have no view on implied volatility, there is no reason to sell options or invest in covered
     calls.
Journal: Financial Analysts Journal
Pages: 23-31
Issue: 6
Volume: 70
Year: 2014
Month: 11
X-DOI: 10.2469/faj.v70.n6.3
File-URL: http://hdl.handle.net/10.2469/faj.v70.n6.3
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Author-Name: The Editors
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles and issue.
Journal: Financial Analysts Journal
Pages: 64-64
Issue: 6
Volume: 70
Year: 2014
Month: 11
X-DOI: 10.2469/faj.v70.n6.4
File-URL: http://hdl.handle.net/10.2469/faj.v70.n6.4
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Author-Name: Bruce I. Jacobs
Author-X-Name-First: Bruce I.
Author-X-Name-Last: Jacobs
Author-Name: Kenneth N. Levy
Author-X-Name-First: Kenneth N.
Author-X-Name-Last: Levy
Title: Investing in a Multidimensional Market
Abstract: 
 Many years ago, the authors demonstrated that there is much greater dimensionality to the
          stock market than is suggested by the one-factor capital asset pricing model. Investors
          today continue to underestimate the market’s dimensionality through their recent
          embrace of “smart beta” strategies. Such strategies assume a market in which a
          few chosen factors produce persistent returns. In reality, there are numerous factors that
          produce returns, which vary over time. Those returns can best be captured by a
          multidimensional approach that emphasizes diversification across many proprietary factors
          and continuous adjustment of exposures to those factors.
Journal: Financial Analysts Journal
Pages: 6-12
Issue: 6
Volume: 70
Year: 2014
Month: 11
X-DOI: 10.2469/faj.v70.n6.5
File-URL: http://hdl.handle.net/10.2469/faj.v70.n6.5
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Author-Name: Laurence B. Siegel
Author-X-Name-First: Laurence B.
Author-X-Name-Last: Siegel
Title: After 70 Years of Fruitful Research, Why Is There Still a Retirement Crisis?
Abstract: 
 Surveying the contents of this special retrospective issue on retirement, the author
          finds that we have both the intellectual tools to avoid a retirement crisis and many of
          the needed institutional arrangements. In a free society, different people will want, and
          should have access to, different retirement solutions or combinations of solutions.
          Retirees should seek to build income guarantees by choosing the particular pension plan
          (defined benefit, defined contribution, both, or a single plan with blended
          characteristics) that meets their needs.
Journal: Financial Analysts Journal
Pages: 6-15
Issue: 1
Volume: 71
Year: 2015
Month: 1
X-DOI: 10.2469/faj.v71.n1.1
File-URL: http://hdl.handle.net/10.2469/faj.v71.n1.1
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Author-Name: William Reichenstein
Author-X-Name-First: William
Author-X-Name-Last: Reichenstein
Author-Name: Stephen M. Horan
Author-X-Name-First: Stephen M.
Author-X-Name-Last: Horan
Author-Name: William W. Jennings
Author-X-Name-First: William W.
Author-X-Name-Last: Jennings
Title: Two Key Concepts for Wealth Management and Beyond
Abstract: 
 Asset allocation is profoundly influenced by at least two underappreciated concepts.
          First, tax-deferred accounts—for example, 401(k)s—are like partnerships in
          which the investor owns (1 – tn) of the partnership principal and the
          government owns the remainder, where tn is the marginal tax rate when the funds
          are withdrawn. Second, the government shares in both the return and the risk of assets
          held in taxable accounts. The authors discuss these concepts’ implications for
          wealth management.In this study, we presented two key concepts and discussed some of their investment
          implications. The first concept is that a tax-deferred account (TDA), such as a 401(k), is
          like a partnership in which the investor owns (1 – tn)
          of the partnership principal and the government owns the remaining
            tn of principal, where tn is the
          marginal tax rate when the funds are withdrawn. The second concept is that the government
          shares in both the return and risk of assets held in taxable accounts,
          unlike funds in TDAs or tax-exempt accounts (e.g., Roth IRAs). These concepts have
          important implications for several areas in wealth management.The after-tax value of funds in a tax-deferred account grows tax
              exempt. The calculation of an individual’s or a couple’s asset allocation should
              be based on after-tax balances in each savings vehicle. In contrast, the traditional
              approach fails to distinguish between pretax and after-tax dollars.When calculating an individual’s or a couple’s asset allocation, pretax
              balances in TDAs should be converted to after-tax dollars by multiplying the pretax
              balances by (1 – tn).There is an optimal asset location, which is inextricably linked to portfolio
              optimization. Individuals should locate lightly taxed securities in taxable accounts
              and heavily taxed securities in tax-advantaged retirement accounts to the highest
              degree possible, while maintaining their risk–return preference.The main factor in the decision to save in a tax-deferred account or a tax-exempt
              account is a comparison of the marginal tax rates in the deposit year and in the
              withdrawal year. In general, if the expected marginal tax rate in retirement is lower
              than this year’s tax rate, then the individual should save in a TDA, and vice
              versa.Similarly, the most important factor in a Roth conversion decision is the comparison
              of the marginal tax rates in the conversion year and in the withdrawal year in
              retirement. If this year’s marginal tax rate is lower than the withdrawal tax
              rate, it pays to convert funds to a Roth account this year. The optimal conversion
              amount would push an investor to the top of the tax bracket just below his or her
              estimated marginal tax rate in retirement. To convert all of an individual’s
              pretax TDAs to after-tax dollars in the same year is seldom appropriate.Suppose a U.S. retiree faces a 25 percent marginal tax rate. To make the portfolio
              last as long as possible, he or she generally should withdraw funds from taxable
              accounts before TDAs or tax-exempt accounts. This rule has exceptions, however, most
              of which are based on our first key concept.For estate tax planning, choosing whether to gift or bequeath assets is analogous to
              choosing between a traditional IRA and a Roth IRA—that is, a comparison of the
              tax rates today and those expected in the future is the critical factor. Reprinted from Financial Analysts Journal, vol. 68, no. 1 (January/February 2012): 14–22.
            Author affiliations are accurate as of the original publication date. This article was
            corrected in March 2012.
Journal: Financial Analysts Journal
Pages: 70-77
Issue: 1
Volume: 71
Year: 2015
Month: 1
X-DOI: 10.2469/faj.v71.n1.10
File-URL: http://hdl.handle.net/10.2469/faj.v71.n1.10
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Author-Name: Stephen C. Sexauer
Author-X-Name-First: Stephen C.
Author-X-Name-Last: Sexauer
Author-Name: Michael W. Peskin
Author-X-Name-First: Michael W.
Author-X-Name-Last: Peskin
Author-Name: Daniel Cassidy
Author-X-Name-First: Daniel
Author-X-Name-Last: Cassidy
Title: Making Retirement Income Last a Lifetime
Abstract: 
 To enable investors to spend down the assets in their defined contribution accounts more easily, the authors propose a decumulation benchmark comprising a laddered portfolio of TIPS for the first 20 years (consuming 88 percent of available capital) and a deferred life annuity purchased with the remaining 12 percent. This portfolio can be used directly by the investor (akin to indexing) or as a benchmark for evaluating the performance of a more aggressive strategy.In the field of personal finance, a great deal of attention has been paid to asset accumulation, but much less attention has been paid to asset decumulation, which is the planned spending down of one’s accumulated savings in retirement. We designed a prototype strategy for post-retirement investing and used the cash flows from that strategy as a decumulation benchmark. Because this benchmark is most likely to be applied to a defined contribution (DC) savings plan, we call it the DCDB (defined contribution–decumulation benchmark). We believe that a well-engineered DC plan should be experienced by the participant in much the same way as the participant experiences a defined benefit plan.Our benchmark is intended to embody the lowest-risk strategy available for converting accumulated capital into post-retirement income while satisfying two essential conditions: The strategy must protect the investor against longevity risk and be appealing enough that it is likely to be used by a broad cross section of investors. Immediate life annuities achieve the first condition but not the second. The apparent reason that investors shy away from immediate life annuities is that the loss of liquidity from transferring one’s capital irrevocably to an insurance company is too onerous. Thus, the benchmark strategy preserves most of the investor’s liquidity while achieving the goals of longevity protection and minimal investment risk.The strategy that forms our benchmark is to buy, with most of one’s capital, a portfolio of laddered Treasury Inflation-Protected Securities (TIPS) out to the latest TIPS effective maturity date, currently about 20 years. The remainder of the capital is used to buy a deferred annuity that begins its payout when the cash flows from the TIPS ladder end. The proportions invested in each asset class—TIPS and a deferred annuity—are set in such a way as to make the first deferred annuity payout equal to the last TIPS payout (plus an allowance for inflation). The resulting benchmark differs from ordinary benchmarks by consisting of a set of future cash flows produced by a given amount invested. As of 30 September 2010, a single 65-year-old male who invests $100,000 in the benchmark portfolio can expect to receive a first-year payment of $5,118, increasing at the U.S. Consumer Price Index (CPI) rate until Year 20. Thereafter, the deferred life annuity pays $7,332 (in today’s money) annually until the participant dies. This schedule of expected cash flows can be compared with the those from other post-retirement investment strategies to determine which one a given investor might prefer. We evaluated three alternatives to the benchmark strategy: an immediate, real life annuity purchased from an insurance company; a target-date portfolio of risky assets; and an immediate, nominal life annuity purchased from an insurance company. The immediate real annuity pays $4,856 in the first year, almost exactly the same as the first year’s payout in the DCDB. The cash flows from both strategies inflate at the CPI rate until the 21st year, when the DCDB stops inflating but the inflation-indexed annuity continues to inflate. Thus, over any life span, the inflation-indexed annuity either matches or dominates the DCDB if the investor does not care about liquidity or counterparty risk. But most investors are strongly averse to such risks, potentially tipping the choice to the benchmark strategy.The target-date portfolio produces cash flows that cannot be accurately forecasted. Given today’s low yields, however, these cash flows are likely to be much lower than those from the benchmark in the initial years. Over time, however, the target-date portfolio should yield more than the benchmark owing to growth in earnings and dividends. The participant must thus decide which cash flow pattern she prefers: front-loaded (the benchmark) or both more uncertain and more back-loaded (the target-date fund).The immediate nominal annuity pays $6,811 (nominal) every year. The participant must weigh this certainty—and high current income—against the likelihood that inflation will erode his purchasing power unacceptably in later years.The benchmark strategy is not only useful as a measuring stick for evaluating alternatives but is also potentially an investment in itself, akin to indexing. Such an investment would have to be offered by an entity that can issue or sell deferred annuities as well as conventional investment portfolios.Reprinted from Financial Analysts Journal, vol. 68, no. 1 (January/February 2012): 74–84. Author affiliations are accurate as of the original publication date.
Journal: Financial Analysts Journal
Pages: 79-89
Issue: 1
Volume: 71
Year: 2015
Month: 1
X-DOI: 10.2469/faj.v71.n1.11
File-URL: http://hdl.handle.net/10.2469/faj.v71.n1.11
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Author-Name: The Editors
Title: In the Future
Abstract: 
 The editor highlights upcoming FAJ articles and issue.
Journal: Financial Analysts Journal
Pages: 108-108
Issue: 1
Volume: 71
Year: 2015
Month: 1
X-DOI: 10.2469/faj.v71.n1.12
File-URL: http://hdl.handle.net/10.2469/faj.v71.n1.12
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# input file: UFAJ_A_12048262_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: M. Barton Waring
Author-X-Name-First: M. Barton
Author-X-Name-Last: Waring
Author-Name: Laurence B. Siegel
Author-X-Name-First: Laurence B.
Author-X-Name-Last: Siegel
Title: The Only Spending Rule Article You Will Ever Need
Abstract: 
 After examining an array of approaches to determining a spending rule for retirees, the
     authors propose the annually recalculated virtual annuity. Each year, one
     should spend (at most) the amount that a freshly purchased annuity—with a purchase price
     equal to the then-current portfolio value and priced at current interest rates and number of
     years of required cash flows remaining—would pay out in that year. Investors who behave
     in this way will experience consumption that fluctuates with asset values, but they can never
     run out of money.Investors have long sought a spending rule for asset decumulation in retirement that would
     assure them a guaranteed stable income while making sure they never completely run out of
     money. We show that a completely stable income is possible only with riskless investments, such
     as a hypothetical laddered TIPS (Treasury Inflation-Protected Security) portfolio with cash
     flows from the portfolio timed to match those required by the investor over his or her planning
     horizon (a hedge that cannot today be perfected over long horizons), or through a riskless
     commercial annuity (which doesn’t yet exist). With risky investments, which most
     investors will hold because they seek higher returns, investors can either receive guaranteed
     cash flows but for an uncertain period (thus taking the chance of running out of money) or
     receive variable cash flows (varying with the market value of the portfolio), in which case
     they will not run out of money if the decumulation scheme is engineered correctly.We show that asset decumulation is an annuitization problem. That is, even though most
     investors do not buy actual annuities to help with decumulation, annuity thinking is required
     for setting the terms of the spend-down for a given level of wealth, time horizon, and interest
     rates. Specifically, each year the investor should spend (no more than) the amount that a
     freshly purchased fixed-term annuity would pay out in that year if the annuity were bought in a
     size equal to the then-current market value of the portfolio at then-current market interest
     rates and with a remaining time equal to the time over which consumption cash flows are desired
     to last. The annuity must be repriced every year (or on whatever periodicity the investor
     chooses), with a corresponding reset of spending such that the spend is always appropriate to
     the wealth available, which will vary with investment returns, as well as the planned time
     horizon and market interest rate conditions. We call a strategy based on this periodic
     repricing an annually recalculated virtual annuity (ARVA).The investor that isn’t fully hedged to consumption, then, faces consumption
     risk—the risk of variability in what he or she can spend—that is almost exactly
     equal to, and caused directly by, the variability of portfolio values (and interest rates).
     Smoothing techniques do not help maintain consumption when portfolio values are down; one can
     borrow from the future only what one is willing to pay back later. There is no free lunch
     either from a spending rule with risky investments or from a smoothing approach attempting to
     avoid the consequences of investment volatility. Fixed-term annuities assume certainty about the spending horizon, but because lifespans are
     uncertain, we experimented with various enhancements that take life expectancy into account. A
     simple rule is to set the time horizon equal to one’s remaining life expectancy, because
     this number grows (slowly) as one ages. However, we found that this rule front loads spending
     unacceptably, with spending falling off sharply in old age to the great disadvantage of those
     who attain such longevity. One attractive rule turned out to be to set the time horizon equal
     to the average of (1) one’s remaining life expectancy and (2) the outer limit of
     one’s possible lifespan, which we assumed was age 120. But the “shape” of
     one’s spending over time is a matter of personal preference, and there is an infinite
     number of ways to speed or slow one’s payout from a given amount of wealth.An ARVA strategy is not the only way to protect consumption for one’s entire life. Here
     are some other options:Annuitize through life insurance company commercial annuities.Create a blend of deferred life annuities and conventional investing using an ARVA
       strategy.Use insurance riders for lifetime income, such as a guaranteed withdrawal life benefit or a
       ruin-contingent life annuity.We also propose some market-focused reforms in the commercial annuity industry, in order to
     create better and safer annuities for retirees in the future and a larger and more profitable
     annuity marketplace for the issuers. Annuitizing one’s whole portfolio through commercial insurance company-provided
     annuities is unpopular because of illiquidity, credit risk, and concerns about adverse
     selection and fair pricing. Some investors commercially annuitize part of their portfolio and
     manage the rest using conventional investments.A blend of deferred life-income annuities and conventional investments managed using an ARVA
     strategy has many attractive features, although any commercial annuity portion is still subject
     to credit risk and other concerns.In conclusion, investors can only spend what they have. There is no magic formula that will
     stretch dollars available to equal dollars “needed.” However, one can improve
     tremendously on current practice. A strategy that makes full or partial use of the ARVA concept
     will succeed where other approaches, such as a fixed percentage (e.g., 4%) of peak assets
     withdrawal rule, can easily fail if investment returns are disappointing or if the investor
     should enjoy a long life.
Journal: Financial Analysts Journal
Pages: 91-107
Issue: 1
Volume: 71
Year: 2015
Month: 1
X-DOI: 10.2469/faj.v71.n1.2
File-URL: http://hdl.handle.net/10.2469/faj.v71.n1.2
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Author-Name: Richard Bookstaber
Author-X-Name-First: Richard
Author-X-Name-Last: Bookstaber
Author-Name: Jeremy Gold
Author-X-Name-First: Jeremy
Author-X-Name-Last: Gold
Title: In Search of the Liability Asset
Abstract: 
 When one looks beyond the immediate pension plan liabilities represented by existing
          obligations, one sees a stream of long-term obligations that will shift as underlying
          economic factors such as inflation and productivity change. Thus the pension liability may
          be broken down into a short-term, bond-like component and a long-term, equity-like
          component. Plan investments need to meet the immediate obligations and avoid deterioration
          of the current asset/liability ratio, but they also need to maximize long-term returns in
          order to meet the long-term obligations.An all-equity portfolio meets the latter
          need, but is far too risky in the short term. A fully hedged, dedicated portfolio will
          ensure that short-term obligations are met, but will do little to increase asset value to
          meet the incremental, long-term obligations. The task confronting the pension plan sponsor
          is to construct the liability asset—the asset that will meet these
          disparate aspects of the pension liability.Doing so requires a dynamically
          adjusted asset mix, where equity exposure is increased as the surplus value rises and
          assets are shifted to an immunized portfolio to match the interest-rate sensitivity of the
          liabilities as surplus value erodes. The resulting strategy, called surplus insurance,
          provides a minimum surplus floor value while allowing the highest expected return on plan
          assets, and therefore the greatest possibility of meeting the long-term obligations.Footnotes appear at end of article.Reprinted from Financial Analysts Journal, vol. 44, no. 1 (January/February 1988): 70–80,
            62. Author affiliations are accurate as of the original publication date.
Journal: Financial Analysts Journal
Pages: 18-28
Issue: 1
Volume: 71
Year: 2015
Month: 1
X-DOI: 10.2469/faj.v71.n1.3
File-URL: http://hdl.handle.net/10.2469/faj.v71.n1.3
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Author-Name: Mark Kritzman
Author-X-Name-First: Mark
Author-X-Name-Last: Kritzman
Title: What Practitioners Need to Know . . . About Time Diversification (corrected)
Abstract: 
 Although an investor may be less likely to lose money over a long horizon than over a
          short horizon, the magnitude of a potential loss increases with the length of the
          investment horizon.Reprinted from Financial Analysts Journal, vol. 50, no. 1 (January/February 1994): 14–18.
            Author affiliation is accurate as of the original publication date.
Journal: Financial Analysts Journal
Pages: 29-34
Issue: 1
Volume: 71
Year: 2015
Month: 1
X-DOI: 10.2469/faj.v71.n1.4
File-URL: http://hdl.handle.net/10.2469/faj.v71.n1.4
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Author-Name: Peter L. Bernstein
Author-X-Name-First: Peter L.
Author-X-Name-Last: Bernstein
Title: What Rate of Return Can You Reasonably Expect . . . or What Can the Long Run Tell Us about the Short Run?
Abstract: 
 Conventional studies of long-run returns on capital market assets, because of changes in
          valuation between the starting date and the ending date, obscure the basic return each
          asset earns. Consequently, both absolute returns and measured risk premiums are distorted.
          The basic return can be extracted by selecting widely separated dates with identical
          valuation levels. Over nearly 200 years, the analysis for equities produced 63 episodes
          averaging 35 years with a mean nominal basic return of 9.6 percent and standard deviation
          of 1.6 percent; 63 bond episodes averaging 43 years produced a mean nominal basic return
          of 4.9 percent and standard deviation of 2.3 percent. Equities revealed a tendency to
          regress to the mean over time, but no such tendency was apparent in the bond data. Thus,
          long-run equity returns were more predictable than long-run bond returns. This conclusion
          applies with even greater force to real returns.Reprinted from Financial Analysts Journal, vol. 53, no. 2 (March/April 1997): 20–28. Author
            affiliation is accurate as of the original publication date.
Journal: Financial Analysts Journal
Pages: 35-42
Issue: 1
Volume: 71
Year: 2015
Month: 1
X-DOI: 10.2469/faj.v71.n1.5
File-URL: http://hdl.handle.net/10.2469/faj.v71.n1.5
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Author-Name: Zvi Bodie
Author-X-Name-First: Zvi
Author-X-Name-Last: Bodie
Title: Thoughts on the Future: Life-Cycle Investing in Theory and Practice
Abstract: 
 Advances in financial science have made possible an improved menu of life-cycle
          investment products.Reprinted from Financial Analysts Journal, vol. 59, no. 1 (January/February 2003): 24–29.
            Author affiliation is accurate as of the original publication date.
Journal: Financial Analysts Journal
Pages: 43-48
Issue: 1
Volume: 71
Year: 2015
Month: 1
X-DOI: 10.2469/faj.v71.n1.6
File-URL: http://hdl.handle.net/10.2469/faj.v71.n1.6
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Author-Name: Keith Ambachtsheer
Author-X-Name-First: Keith
Author-X-Name-Last: Ambachtsheer
Title: Why We Need a Pension Revolution
Abstract: 
 A broad consensus exists that workplace pension arrangements around the world are sick
          and in need of strong medicine. Rather than resurrect the traditional defined-benefit (DB)
          plan or broaden defined-contribution (DC) plan coverage, this article argues that we move
          from an “either/or” to an “and/and” mindset to improve global
          workplace pension coverage, adequacy, and certainty. Pension arrangements can combine the
          best of DB and DC plans and minimize the impact of their less-attractive features.
          However, we must also redesign the institutions through which workplace pensions are
          delivered. The ideal pension-delivery institution is expert, has scale, and acts solely in
          the best interests of plan participants.A broad consensus acknowledges that workplace pension arrangements around the world are
          sick and in need of strong medicine. Pension coverage and adequacy are low, and pension
          uncertainty is high. The prescription of some pension experts is to resurrect the
          traditional defined-benefit (DB) plan. Others say broad defined-contribution (DC) plan
          coverage is the cure. This article argues that we have to move from an
          “either/or” to an “and/and” mindset if we want to seriously
          improve global workplace pension coverage, adequacy, and certainty. Integrative thinking
          about these issues leads to pension arrangements that combine the best of traditional DB
          and DC plans and minimize the impact of their less-attractive features.The kernel of “the optimal pension system” (TOPS) lies all the way back in
          Robert Merton’s seminal 1971 article that laid out the optimal consumption and
          portfolio rules in a continuous-time model. The basic idea is that informed, rational
          people strive for smooth and adequate lifetime consumption. Unfortunately, we have learned
          that the “informed, rational” part of the assumption is inoperative in the
          real world. So, we need to design a series of “autopilot” mechanisms for
          enrollment, target pension, implied contribution rate, age-based investment policy, and
          capital-to-annuity conversion processes. Although these redesign ideas might have sounded
          radical just a few years ago, they are now being widely discussed as the way to move
          forward.However, redesigning the pension formula is only half the cure. We must also redesign the
          institutional arrangements through which workplace pensions are delivered. The ideal
          pension-delivery institution is expert, has scale, and acts solely in the best interests
          of plan participants. Far too few pension funds in the world today can pass this triple
          test. Consider each in turn: Expert means that the pension institution
          would have enough internal expertise in pension finance, investments, and administration
          to be managed expertly “from the inside out” rather than by outside agents.
          That does not necessarily mean that all functions would be carried out 100 percent
          internally. It does mean that outsourcing decisions would be based on expert judgment that
          outsourcing is the cost-effective alternative. A related issue is that organization
          oversight (or governance) would be carried out by a board with sufficient expertise and
          experience to expertly perform this critical task.This kind of expertise cannot be assembled and retained without scale.
          Pension-delivery institutions must be large enough to operate at low unit costs. So,
          ideally, the institutions would manage assets in at least the tens of billions of dollars
          and would serve hundreds of thousands of plan memberships.At the same time, the institutions would have to pass the governance test: in the
            best interests of plan participants. This test requires that the ideal
          pension-delivery institution has an arms-length, co-op legal structure. Peter Drucker
          observed 30 years ago that such institutions—acting as motivated, expert
          owners—are ideally equipped to own capitalism’s means of production. Although
          a few such institutions already exist, many more are needed. Indeed, we need a literal
          pension revolution.Editor’s Note: This article is adapted from the introductory
            chapter to the author’s book Pension Revolution (John Wiley &
            Sons), which is scheduled for release in January 2007.Reprinted from Financial Analysts Journal, vol. 63, no. 1 (January/February 2007): 21–25.
            Author affiliation is accurate as of the original publication date.
Journal: Financial Analysts Journal
Pages: 49-53
Issue: 1
Volume: 71
Year: 2015
Month: 1
X-DOI: 10.2469/faj.v71.n1.7
File-URL: http://hdl.handle.net/10.2469/faj.v71.n1.7
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Author-Name: Don Ezra
Author-X-Name-First: Don
Author-X-Name-Last: Ezra
Title: Defined-Benefit and Defined-Contribution Plans of the Future
Abstract: 
 Defined-benefit pension plans are in decline. What went wrong? The lessons the investment
          community learns from this decline will help us create better plans in the
          future—plans that incorporate desirable features of both defined-benefit and
          defined-contribution plans.Two main causes explain the decline of defined benefit (DB) pension plans. One cause
          starts with the confusion between what benefits are worth (calculated by discounting
          benefits at bond yields) and what constitutes the best estimate of the long-term funding
          target (where discounting includes an equity risk premium). This confusion led to overly
          generous benefit promises. And with funding based solely on the best estimate, without an
          additional reserve for investment risk, benefits became underfunded when the risk premium
          did not arrive. The second cause is legislation that, on the old-fashioned assumption that
          most corporations last forever, permitted underfunding to continue.The next generation of DB plans will look different from yesterday’s plans. The
          benefit will probably start as a career average (possibly enhanced periodically by a
          catch-up provision). It will be valued and funded on the basis of bond yields, with a full
          funding requirement. There will be no benefit confiscation on an employee’s early
          death or termination; the benefit will transparently be the reserve held for the employee
          and will be communicated to the employee each year. Investment risk will require an
          additional reserve.Future defined contribution (DC) plans will have “autopilot”
          features—default options designed to mimic desirable DB features, such as extended
          coverage, contributions increasing with age and pay, and a sensible investment policy that
          is professionally executed. Other arrangements will be able to convert the
          employee’s account into postretirement income less expensively than through
          individual annuity purchases.When we have transparency of DB and DC plans, we will be able to see that retirement
          income guarantees are expensive. We will have to make individual decisions about bridging
          the gap between what we wish for and what pension plans can help us achieve. That
          situation is no different from the past, but perhaps we will confront it more explicitly
          in the future.Reprinted from Financial Analysts Journal, vol. 63, no. 1 (January/February 2007): 26–30.
              Author affiliation is accurate as of the original publication date.
Journal: Financial Analysts Journal
Pages: 56-60
Issue: 1
Volume: 71
Year: 2015
Month: 1
X-DOI: 10.2469/faj.v71.n1.8
File-URL: http://hdl.handle.net/10.2469/faj.v71.n1.8
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Author-Name: Jason S. Scott
Author-X-Name-First: Jason S.
Author-X-Name-Last: Scott
Title: The Longevity Annuity: An Annuity for Everyone?
Abstract: 
 As of 2005, U.S. individuals had an estimated $7.4 trillion invested in IRAs and employer-sponsored retirement accounts. Many retirees will thus face the difficult problem of turning a pool of assets into a stream of retirement income. Purchasing an immediate annuity is a common recommendation for retirees trying to maximize retirement spending. The vast majority of retirees, however, are unwilling to annuitize all their assets. This research demonstrates that a “longevity annuity,” which is distinct from an immediate annuity in that payouts begin late in retirement, is optimal for retirees unwilling to fully annuitize. For a typical retiree, allocating 10–15 percent of wealth to a longevity annuity creates spending benefits comparable to an allocation to an immediate annuity of 60 percent or more.Note: The views expressed herein are those of the author and not necessarily those of Financial Engines.Reprinted from Financial Analysts Journal, vol. 64, no. 1 (January/February 2008): 40–48. Author affiliation is accurate as of the original publication date.
Journal: Financial Analysts Journal
Pages: 61-69
Issue: 1
Volume: 71
Year: 2015
Month: 1
X-DOI: 10.2469/faj.v71.n1.9
File-URL: http://hdl.handle.net/10.2469/faj.v71.n1.9
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Author-Name: Ignacio Ruiz
Author-X-Name-First: Ignacio
Author-X-Name-Last: Ruiz
Author-Name: Piero Del Boca
Author-X-Name-First: Piero
Author-X-Name-Last: Del Boca
Author-Name: Ricardo Pachón
Author-X-Name-First: Ricardo
Author-X-Name-Last: Pachón
Title: Optimal Right- and Wrong-Way Risk from a Practitioner Standpoint
Abstract: 
 There are a number of right- and wrong-way-risk methodologies in the literature, but they
     hardly touch on the most difficult part of those methodologies: model calibration. The authors
     extend the research on right- and wrong-way-risk methodologies with a comprehensive empirical
     analysis of the market credit dependency structure. Using 150 case studies, they found evidence
     of the real market credit dependency structure and produced market-calibrated model parameters.
     Using these realistic calibrations, they examined right-way and wrong-way risk in both real and
     fundamental trades by calculating the change in major credit risk metrics that banks use. They
     show that these metrics can vary significantly, in both the “right” and the
     “wrong” ways. The authors explain why having a good right- and wrong-way-risk model
     is important and describe the consequences of not having one.Right-way and wrong-way-risk modeling have received increasing attention in the past few
     years. A number of models have been proposed. At present, there is no indication in the
     literature as to which of these proposed models is optimal, and calibration is only loosely
     touched on. Although the existing literature focuses on credit value adjustment (CVA), other
     very important credit-driven risk metrics, such as initial margin, exposure management, and
     regulatory capital, can also be affected by right-way and wrong-way risk. The authors extend
     the current state-of-the-art research on right- and wrong-way-risk methodologies with a
     comprehensive empirical analysis of the market credit dependency structure. Using 150 case
     studies, they provide evidence of the real market credit dependency structure and give
     market-calibrated model parameters. This article offers the pillars of a stochastic correlation
     model, driven by empirical data, that could be optimal for pricing and risk management of
     complex structures. Using these realistic calibrations, the authors carry out an impact study
     of right-way and wrong-way risk in real trades (in all relevant asset classes) and in
     fundamental trades by calculating the change in many major credit risk metrics that banks use
     (CVA, initial margin, exposure measurement, capital) when this risk is taken into
     account—all of this for both collateralized and uncollateralized trades. The results show
     that these metrics can vary quite significantly, in both the “right” and the
     “wrong” ways. Finally, on the basis of this impact study, the authors explain why a
     good right- and wrong-way-risk model is central to financial institutions and describe the
     consequences of not having one.
Journal: Financial Analysts Journal
Pages: 47-60
Issue: 2
Volume: 71
Year: 2015
Month: 3
X-DOI: 10.2469/faj.v71.n2.1
File-URL: http://hdl.handle.net/10.2469/faj.v71.n2.1
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Handle: RePEc:taf:ufajxx:v:71:y:2015:i:2:p:47-60




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# input file: UFAJ_A_12048272_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Kirsten A. Cook
Author-X-Name-First: Kirsten A.
Author-X-Name-Last: Cook
Author-Name: William Meyer
Author-X-Name-First: William
Author-X-Name-Last: Meyer
Author-Name: William Reichenstein
Author-X-Name-First: William
Author-X-Name-Last: Reichenstein
Title: Tax-Efficient Withdrawal Strategies
Abstract: 
 The authors considered an individual investor who holds a financial portfolio with funds
          in at least two of the following accounts: a taxable account, a tax-deferred account, and
          a tax-exempt account. They examined various strategies for withdrawing these funds in
          retirement. Conventional wisdom suggests that the investor should withdraw funds first
          from the taxable account, then from the tax-deferred account, and finally from the
          tax-exempt account. The authors provide the underlying intuition for more tax-efficient
          withdrawal strategies and demonstrate that these strategies can add more than three years
          to the portfolio’s longevity relative to the strategy suggested by the conventional
          wisdom.The conventional wisdom suggests that a retiree should withdraw funds from taxable
          accounts until they are exhausted; then from tax-deferred accounts (TDAs), like a 401(k),
          until they are exhausted; and finally from tax-exempt accounts (TEAs), like a Roth 401(k).
          We demonstrate that the conventional wisdom is wrong.Properly viewed, a TDA is like a partnership in which the investor effectively owns 1
          – t of the partnership’s current principal, where
            t is the marginal tax rate when the funds are withdrawn in retirement.
          The government effectively owns the remaining t of the partnership. When
          viewed from this perspective, the after-tax value of the investor’s portion of funds
          in the TDA grows tax exempt. Thus, assuming a flat tax rate, a retiree’s portfolio
          would last precisely the same length of time if the order of withdrawals were taxable
          account, then TDA, then TEA—or taxable account, then TEA, then TDA.The partnership principle is useful in devising tax-efficient withdrawal strategies in
          the presence of progressive tax rates. In particular, one tax-efficient withdrawal
          strategy is to time withdrawals from TDAs for years when those funds would be subject to
          an unusually low marginal tax rate for that investor. For example, suppose a taxpayer will
          usually be subject to a 25% marginal rate once required minimum distributions begin. Each
          year, she could withdraw funds from her TDA up to the top of the 15% tax bracket and then
          withdraw additional funds from the taxable account. After the taxable account has been
          exhausted and the TDA and TEA remain, she could withdraw funds from her TDA up to the top
          of the 15% bracket and then withdraw additional funds from her TEA. The objective is to
          minimize the average of marginal tax rates on the TDA withdrawals.We also present two tax-efficient withdrawal strategies that use Roth conversions. In the
          first of these strategies, this same taxpayer converts sufficient funds from the TDA to a
          Roth IRA to fully use the 15% tax bracket. Then, she withdraws additional funds as needed
          to meet her spending needs from the taxable account. Once the taxable account has been
          exhausted, she withdraws sufficient funds each year from the TDA to fully use the 15%
          bracket and then withdraws additional funds from the TEA. The advantage of this strategy
          compared with the prior strategy is that the taxpayer has more funds in the TEA growing
          tax-free but fewer funds in the taxable account growing at an after-tax rate of
          return.In the second tax-efficient strategy that uses the Roth conversion, the taxpayer makes
          two separate Roth conversions at the beginning of the first 27 retirement years, with each
          conversion amount being sufficient to fully use the 15% tax bracket. At the end of the
          year, she retains the funds in the Roth TEA with the higher returns and recharacterizes
          the other Roth TEA back to the TDA. This strategy allows her to avoid taxes on the returns
          earned in the year on the converted funds, and these funds henceforth will grow tax-free
          in the TEA.In a detailed example using the 2013 federal tax brackets, we demonstrate that the most
          tax-efficient withdrawal strategy can add more than six years compared with a
          tax-inefficient strategy. In addition, the most tax-efficient withdrawal strategy can add
          more than three years compared with the strategy advocated by the conventional wisdom.Sensitivity analyses confirm that the portfolio longevities increase as we progress from
          Strategy 1 through Strategy 5 even if we change such key assumptions as assets’
          rates of return and asset allocation. In short, the ideas in the detailed example also
          apply to other investors and for other key assumptions.Finally, we show the advantage of holding some funds in TDAs to meet the nontrivial
          probability of large tax-deductible expenses, such as medical costs, which often occur
          late in life. Although these TDA withdrawals are subject to taxes, the individual probably
          will be in a low tax bracket, possibly the 0% bracket, owing to the medical expenses. 
Journal: Financial Analysts Journal
Pages: 16-29
Issue: 2
Volume: 71
Year: 2015
Month: 3
X-DOI: 10.2469/faj.v71.n2.2
File-URL: http://hdl.handle.net/10.2469/faj.v71.n2.2
File-Format: text/html
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Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Author-Name: Anthony Bova
Author-X-Name-First: Anthony
Author-X-Name-Last: Bova
Author-Name: Stanley Kogelman
Author-X-Name-First: Stanley
Author-X-Name-Last: Kogelman
Title: Bond Ladders and Rolling Yield Convergence
Abstract: 
 Most investment-grade bond portfolios have stable durations and can be regarded as
          “duration targeted” (DT). For DT portfolios, multiyear returns converge to the
          starting rolling yield if the yield curve undergoes a sequence of strictly parallel
          shifts. The theoretical convergence horizon is one year less than twice the duration
          target. The laddered portfolios favored by private investors are essentially DT, and
          surprisingly, their convergence return coincides with the starting yield of the
          ladder’s “top-rung” bond.This article addresses the expected performance of “duration-targeted” (DT)
          bond portfolios—those with a more or less stable duration—when the curvature
          of the starting yield curve is maintained but parallel curve shifts alter the level of the
          curve. According to historical data, most actively or passively managed diversified
          investment-grade bond funds and bond indexes have rather stable durations over long time
          periods. Thus, these portfolios undergo some form of duration-targeting process that
          maintains duration stability through either explicit or implicit portfolio rebalancing.
          For example, in the case of year-end rebalancing, the aged portfolio is repriced and bond
          positions are adjusted to insure that the portfolio duration is the same as it was at the
          start of the year. This rebalancing process stands in stark contrast to a buy-and-hold
          strategy in which there is no rebalancing and the duration simply declines over time.In this study, we extend previous results on flat yield curves to curves with a
          persistent curvature. A key finding is that when a shaped yield curve is subject to
          sequential “trendline” parallel shifts of equal magnitude, the theoretical
          convergence horizon is precisely the same as in the flat yield curve case—that is,
          one year less than twice the duration target. An important implication of this return
          convergence is that multiyear return volatility is likely to be much less than the
          volatility anticipated in traditional mean–variance models.In contrast to flat curves, with shaped curves, a DT portfolio converges not back to its
          initial yield but, rather, to its starting “rolling yield”—the
          hypothetical one-year return that would result as each bond ages to a shorter-maturity
          point along an unchanging yield curve. When the yield curve has a positive slope, the
          year-end yield of each bond will always be lower than its starting yield, so the rolling
          yield will incorporate a positive price gain from the roll down. Thus, in such (admittedly
          nonequilibrium) situations, the rolling yield for any bond will always be greater than the
          starting yield.In a general portfolio context, a positive curve slope implies that the portfolio’s
          average rolling yield will always be greater than the portfolio’s average yield.
          When such general DT portfolios are subject to parallel shifts, it will be this greater
          rolling yield that serves as the expected return over the convergence horizon.The rolling yield concept plays a key role in the important special case of bond ladders.
          A ladder is a bond portfolio that comprises roughly equal-weighted bond positions with
          maturities spaced one year apart. Laddered portfolios are widely used by private
          investors, especially in the municipal bond market. Although bond ladders are not
          typically viewed as DT portfolios, they are, in fact, a special case of duration
          targeting. The DT structure results because over time, the proceeds of maturing bonds are
          reinvested in such a way as to maintain the equal-weighted laddered structure—a
          process that at least roughly preserves the initial duration, which is approximately half
          the ladder’s length.Because bond ladders are implicitly DT, their multiyear returns under parallel shifts
          should converge toward the average rolling yield of the constituent bonds. One of our most
          surprising findings is that for any starting yield curve shape, the
          average rolling yield for any laddered portfolio corresponds to the
          starting yield of its “top-rung” bond. Therefore, with parallel shifts of
            any magnitude over the convergence horizon, a ladder’s annualized
          return should move back toward this starting top-rung yield.To empirically test these theoretical rolling yield results, we focused on the municipal
          bond market because its yield curves generally have a more persistently positive slope
          than taxable yield curves have. By using the Barclays Municipal Bond Index as a broadly
          diversified proxy portfolio, we found strong evidence that in markets with consistently
          positive yield curves, general DT portfolios do, in fact, converge back to their starting
          rolling yields rather than to their lower average yields. And for the special case of
          laddered portfolios, additional tests with historical municipal yield curves also confirm
          that a ladder’s annualized return converges back to its starting top-rung yield
          rather than to its lower average yield.
Journal: Financial Analysts Journal
Pages: 32-46
Issue: 2
Volume: 71
Year: 2015
Month: 3
X-DOI: 10.2469/faj.v71.n2.4
File-URL: http://hdl.handle.net/10.2469/faj.v71.n2.4
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Author-Name: Barbara S. Petitt
Author-X-Name-First: Barbara S.
Author-X-Name-Last: Petitt
Title: In the Future
Abstract: 
  The editor highlights upcoming FAJ articles and issue.
Journal: Financial Analysts Journal
Pages: 64-64
Issue: 2
Volume: 71
Year: 2015
Month: 3
X-DOI: 10.2469/faj.v71.n2.5
File-URL: http://hdl.handle.net/10.2469/faj.v71.n2.5
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Author-Name: Barbara S. Petitt
Author-X-Name-First: Barbara S.
Author-X-Name-Last: Petitt
Title: 2014 Report to Readers
Journal: Financial Analysts Journal
Pages: 4-5
Issue: 2
Volume: 71
Year: 2015
Month: 3
X-DOI: 10.2469/faj.v71.n2.6
File-URL: http://hdl.handle.net/10.2469/faj.v71.n2.6
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Author-Name: David Chambers
Author-X-Name-First: David
Author-X-Name-Last: Chambers
Author-Name: Elroy Dimson
Author-X-Name-First: Elroy
Author-X-Name-Last: Dimson
Title: The British Origins of the US Endowment Model
Abstract: 
 The US endowment model is an approach to investing popularized by Yale University that
          emphasizes diversification and active management of equity-oriented, illiquid assets. The
          writings of the British economist John Maynard Keynes were a considerable influence on the
          investment philosophy of Yale’s chief investment officer, David Swensen. How did
          Keynes gain these insights? We track Keynes’s experiences managing the King’s
          College, Cambridge, endowment and show how some of the lessons he learned remain relevant
          to endowments and foundations today.In recent years, much attention has been given to the so-called Yale model, an approach
          to investing practiced by the Yale University Investments Office in managing its US$24
          billion endowment. The core of this model is an emphasis on diversification and on active
          management of equity-oriented, illiquid assets. Yale has generated annual returns of 13.9%
          per year over the last 20 years—well in excess of the 9.2% average return of US
          college and university endowments. Other leading US university endowments have followed
          this model; other types of investors have considered adopting it, either in part or in
          whole.In reflecting on the characteristics of the Yale model, it is clear that the writings of
          British economist John Maynard Keynes were a considerable influence on the investment
          philosophy of David Swensen, Yale’s chief investment officer. The central ideas that
          Swensen takes from Keynes are cited in his 2009 book Pioneering Portfolio
            Management: the importance of a long-term focus (p. 297); the benefits of an
          equity bias (p. 64); the futility of market timing (p. 64); the case for value investing
          (p. 89); the attractions of contrarianism (p. 92); the process of bottom-up security
          selection (p. 188); the excessive preoccupation with liquidity (p. 88); the challenges of
          active management (p. 246); and the difficulties inherent in group decision making, which
          push an investment organization toward a situation in which, in Keynes’s own words,
          “it is better for reputation to fail conventionally than to succeed
          unconventionally” (p. 298).A natural question to consider is, from where did Keynes gain these insights? In this
          article, we review how Keynes drew on his experiences managing the King’s College,
          Cambridge, endowment for more than a quarter of a century to provide lessons on
          long-horizon investing that are still relevant to endowments and foundations today.
Journal: Financial Analysts Journal
Pages: 10-14
Issue: 2
Volume: 71
Year: 2015
Month: 3
X-DOI: 10.2469/faj.v71.n2.7
File-URL: http://hdl.handle.net/10.2469/faj.v71.n2.7
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to two reprinted articles in the
                    January/February 2015 issue of the Financial Analysts Journal:
                    “What Practitioners Need to Know . . . About Time Diversification,”
                    by Mark Kritzman, CFA, and “Two Key Concepts for Wealth Management and
                    Beyond” by William Reichenstein, CFA, Stephen M. Horan, CFA, CIPM, and
                    William W. Jennings, CFA.
Journal: Financial Analysts Journal
Pages: 7-7
Issue: 3
Volume: 71
Year: 2015
Month: 5
X-DOI: 10.2469/faj.v71.n3.1
File-URL: http://hdl.handle.net/10.2469/faj.v71.n3.1
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# input file: UFAJ_A_12048279_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Luis Garcia-Feijóo
Author-X-Name-First: Luis
Author-X-Name-Last: Garcia-Feijóo
Author-Name: Lawrence Kochard
Author-X-Name-First: Lawrence
Author-X-Name-Last: Kochard
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Author-Name: Peng Wang
Author-X-Name-First: Peng
Author-X-Name-Last: Wang
Title: Low-Volatility Cycles: The Influence of Valuation and Momentum on Low-Volatility Portfolios
Abstract: 
 Research showing that the lowest-risk stocks tend to outperform the highest-risk
                    stocks over time has led to rapid growth in so-called low-risk equity investing
                    in recent years. The authors examined the performance of both the low-risk
                    strategy previously considered in the literature and a beta-neutral low-risk
                    strategy that is more relevant in practice. They found that the historical
                    performance of low-risk investing, like that of any quantitative investment
                    strategy, is time varying. They also found that both low-risk strategies exhibit
                    dynamic exposure to the well-known value, size, and momentum factors and appear
                    to be influenced by the overall economic environment. Their results suggest that
                    time variation in the performance of low-risk strategies is probably influenced
                    by the approach to constructing the low-risk portfolio strategy and by the
                    market environment and associated valuation premiums.We have extended prior research on the low-volatility anomaly by examining the
                    time-varying performance of, and the influence of well-known investment factors
                    on, the low-risk strategy. We have done so primarily by reporting a strong
                    dynamic link between the performance of low-volatility strategies and initial
                    valuations—investigating the performance of both a zero-cost and a
                    beta-neutral low-volatility strategy—and by reporting an important
                    connection between the strategy and both economic activity and momentum.In putting together our study’s findings, an interesting picture has
                    emerged. Low-risk stocks tend to outperform high-risk stocks but are most likely
                    to do so when initial valuation levels favor low-risk stocks. Thus, investment
                    success seems to depend importantly on the price paid. In addition, once the
                    well-known cross-sectional factors of style and momentum are controlled for,
                    alphas and information ratios for our two long–short portfolio strategies
                    decline. We have also shown that there have been extended periods over the last
                    85 years when high-risk stocks have cumulatively outperformed low-risk stocks.
                    These periods have tended to coincide, to some degree, with economic cycles. The practical implication of our results is that the performance of low-risk
                    strategies is influenced by the approach to constructing the low-risk portfolio
                    strategy and by time-varying exposure to the market environment and valuation
                    premiums. Investors can benefit from a fuller understanding of how these factors
                    may influence future performance of low-risk portfolio strategies.Editor’s note: Rodney N. Sullivan, CFA, was the editor and Luis
                            Garcia-Feijóo, CFA, CIPM, was an associate editor of the
                        Financial Analysts Journal at the time this article was
                            submitted. Mr. Sullivan and Dr. Garcia-Feijóo were both recused
                            from the peer-review and acceptance processes, and the reviewers were
                            unaware of their identities. In addition, they are ineligible to receive any award. The article was accepted in August 2014; it
                            is published in this issue to abide with the FAJ
                            conflict-of-interest policies then in place, which stipulated that,
                            should the paper be accepted, the editor is allowed to publish one
                            research article or Perspectives piece per calendar year. For
                            information about the current conflict-of-interest policies, see
                                www.cfapubs.org/page/faj/policies.
                            The authors may have a commercial interest in the topics discussed in
                            this article.
Journal: Financial Analysts Journal
Pages: 47-60
Issue: 3
Volume: 71
Year: 2015
Month: 5
X-DOI: 10.2469/faj.v71.n3.2
File-URL: http://hdl.handle.net/10.2469/faj.v71.n3.2
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# input file: UFAJ_A_12048280_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert Litterman
Author-X-Name-First: Robert
Author-X-Name-Last: Litterman
Title: David Swensen on the Fossil Fuel Divestment Debate
Abstract: 
 Many educational endowments and other investment organizations are struggling
                    with the question whether to comply with the widespread demands of students and
                    other constituencies to divest their fossil fuel stocks. Some have announced
                    decisions to divest, whereas others have announced decisions not to divest.
                    Although Yale University announced that it would not divest, David Swensen, its
                    chief investment officer, wrote a letter to Yale’s external investment
                    managers emphasizing that in analyzing potential investments, they should favor
                    companies that consider the effects of climate change. 
Journal: Financial Analysts Journal
Pages: 11-12
Issue: 3
Volume: 71
Year: 2015
Month: 5
X-DOI: 10.2469/faj.v71.n3.3
File-URL: http://hdl.handle.net/10.2469/faj.v71.n3.3
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# input file: UFAJ_A_12048281_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rui Albuquerque
Author-X-Name-First: Rui
Author-X-Name-Last: Albuquerque
Author-Name: Raquel M. Gaspar
Author-X-Name-First: Raquel M.
Author-X-Name-Last: Gaspar
Author-Name: Allen Michel
Author-X-Name-First: Allen
Author-X-Name-Last: Michel
Title: Investment Analysis of Autocallable Contingent Income Securities
Abstract: 
 Autocallable contingent income securities (autocalls) have payouts contingent on
                    the performance of an underlying asset and give investors an opportunity to earn
                    high yields in a low-interest environment. The authors collected data on
                    US-issued autocalls and modeled a typical autocall under various assumptions,
                    finding that they are issued on underlying assets that display high volatility,
                    high prices, and negative skewness. Incorporating stochastic volatility into the
                    model explains some of the overpricing routinely reported in prior studies.Autocallable contingent income securities, or autocalls, are a relatively new
                    type of structured finance security whose payout is contingent on the
                    performance of an underlying asset and that gives investors an opportunity to
                    earn high yields in a low-interest environment. These complex products, which
                    have many payoff features to consider, are often targeted primarily at retail
                    investors, which, as a result, has provided challenges for both investors and
                    regulators. We collected data on autocalls issued in the United States and
                    described their contractual properties and the properties of their underlying
                    assets at issuance. We found that the autocalls are generally issued on
                    underlying assets that display high volatility, high prices, and negative
                    skewness. Following our analysis of autocall characteristics at issuance, we
                    modeled a typical autocall under different assumptions about the price of the
                    underlying asset, analyzed the rationale behind the characteristics of the
                    underlying asset at issuance, and discussed the valuation of autocalls using
                    various models. We conclude that the traditional use of the geometric Brownian
                    motion model is inappropriate because of several factors, including (1) our
                    empirical findings regarding underlying assets’ price characteristics at
                    issuance that suggest underwriters do not choose underlying assets at random,
                    (2) the large body of evidence of stochastic volatility showing differences in
                    short- and long-term volatility, and (3) the vast evidence suggesting reversals
                    in stock prices. Although the literature has consistently found that structured
                    products are overpriced, we found that incorporating stochastic volatility into
                    the pricing model eliminates some of the overpricing routinely reported in prior
                    studies.
Journal: Financial Analysts Journal
Pages: 61-83
Issue: 3
Volume: 71
Year: 2015
Month: 5
X-DOI: 10.2469/faj.v71.n3.4
File-URL: http://hdl.handle.net/10.2469/faj.v71.n3.4
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# input file: UFAJ_A_12048282_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David M. Blanchett
Author-X-Name-First: David M.
Author-X-Name-Last: Blanchett
Author-Name: Philip U. Straehl
Author-X-Name-First: Philip U.
Author-X-Name-Last: Straehl
Title: No Portfolio Is an Island
Abstract: 
 The authors incorporated nonfinancial assets—industry-specific human
                    capital, region-specific housing wealth, and pensions—into a traditional
                    portfolio optimization and found that the optimal portfolio varies materially
                    for different compositions of total wealth. In particular, they found that the
                    optimal equity allocation decreases with age, riskier employment, and riskier
                    homeownership, whereas it increases with guaranteed pension income. These
                    results suggest that every portfolio needs to be considered in the context of an
                    investor’s total wealth.Such assets as human capital, real estate, and pensions often represent a
                    significant portion of an investor’s total wealth, even though stocks,
                    bonds, and similar financial assets get more attention. Investors ignore these
                    nonfinancial assets when building portfolios, despite the risks they share with
                    financial assets. In our study, we explored the impact of incorporating these
                    nonfinancial assets into the optimal portfolio by using a single-period
                    optimization routine. We found that across 1,000 total wealth compositions
                    considered, incorporating nonfinancial wealth results in an average increase in
                    risk-adjusted return of 30 bps.We provide evidence that the optimal asset allocation varies materially for
                    different compositions of total wealth. Specifically, the optimal equity
                    allocation decreases gradually from 61% at age 25 to 26% at age 65 as a
                    person’s human capital erodes and housing wealth and financial wealth
                    rise. We demonstrate that the optimal portfolio varies significantly for various
                    industry-specific types of human capital. For instance, the optimal equity
                    allocation is higher for a person with less volatile human capital, and vice
                    versa. Similarly, we found that human capital is correlated with the value
                    factor and that region-specific housing wealth also affects the optimal equity
                    weight.Our findings suggest that investment portfolio efficiency must be gauged with
                    respect to its risk contribution to an investor’s total wealth as opposed
                    to financial wealth alone. Therefore, when developing portfolios for clients,
                    private wealth managers should consider clients’ holistic wealth and not
                    focus exclusively on their financial assets.Editor’s note: The authors may have a commercial interest in
                            the topics discussed in this article.
Journal: Financial Analysts Journal
Pages: 15-33
Issue: 3
Volume: 71
Year: 2015
Month: 5
X-DOI: 10.2469/faj.v71.n3.5
File-URL: http://hdl.handle.net/10.2469/faj.v71.n3.5
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# input file: UFAJ_A_12048283_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Barbara S. Petitt
Author-X-Name-First: Barbara S.
Author-X-Name-Last: Petitt
Title: From the Editor
Journal: Financial Analysts Journal
Pages: 4-5
Issue: 3
Volume: 71
Year: 2015
Month: 5
X-DOI: 10.2469/faj.v71.n3.6
File-URL: http://hdl.handle.net/10.2469/faj.v71.n3.6
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# input file: UFAJ_A_12048284_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Timothy K. Chue
Author-X-Name-First: Timothy K.
Author-X-Name-Last: Chue
Author-Name: Yong Wang
Author-X-Name-First: Yong
Author-X-Name-Last: Wang
Author-Name: Jin Xu
Author-X-Name-First: Jin
Author-X-Name-Last: Xu
Title: The Crash Risks of Style Investing: Can They Be Internationally Diversified?
Abstract: 
 The crash risks of momentum tend to be higher than those of size and value.
                    International diversification lowers the crash risks of size and value but not
                    momentum. The authors examined the conditional correlations and return
                    co-exceedances of style portfolios across countries and found that this
                    difference in the effect of diversification is due to the left (right) tails of
                    momentum (size and value) portfolios being more correlated than the right (left)
                    tails across countries. Motivated by the growth in popularity of style investing and the concerns about
                    extreme events among investors, we examined the tail risks of style investing in
                    the G–7 countries over 1981–2010. We evaluated whether portfolios
                    with different size, value, and momentum tilts—the SMB (small minus big),
                    HML (high minus low), and UMD (up minus down, or past winners minus past losers)
                    portfolios—experience different crash risks and whether these risks can be
                    mitigated through international diversification. We found that the crash risks
                    of momentum tend to be higher than those of size and value, where crash risks
                    are measured by return skewness and expected shortfall. International
                    diversification lowers the crash risks of size and value but has only limited
                    effects on momentum. Specifically, a diversified world UMD portfolio
                    (equal-weighted portfolio of the G–7 countries) tends to be more
                    left-skewed and has a more negative expected shortfall than the momentum
                    portfolios of particular countries. In contrast, the world SMB and HML
                    portfolios tend to have less negative skewness and expected shortfall than their
                    country-specific counterparts. By examining the conditional correlations and
                    return co-exceedances of style portfolios across countries, we found that the
                    extreme negative returns on UMD in different markets tend to occur together,
                    whereas those on SMB and HML tend to be country specific. In fact, for SMB and
                    HML, the right-tail events tend to be more global in nature. These results
                    suggest that the difference in the effect of international diversification is
                    due to the left (right) tails of momentum (size and value) portfolios being more
                    correlated than the right (left) tails across countries.
Journal: Financial Analysts Journal
Pages: 34-46
Issue: 3
Volume: 71
Year: 2015
Month: 5
X-DOI: 10.2469/faj.v71.n3.7
File-URL: http://hdl.handle.net/10.2469/faj.v71.n3.7
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# input file: UFAJ_A_12048285_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: In Memoriam
Journal: Financial Analysts Journal
Pages: 8-8
Issue: 3
Volume: 71
Year: 2015
Month: 5
X-DOI: 10.2469/faj.v71.n3.8
File-URL: http://hdl.handle.net/10.2469/faj.v71.n3.8
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# input file: UFAJ_A_12048287_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Paul Brockman
Author-X-Name-First: Paul
Author-X-Name-Last: Brockman
Author-Name: Xu Li
Author-X-Name-First: Xu
Author-X-Name-Last: Li
Author-Name: S. McKay Price
Author-X-Name-First: S. McKay
Author-X-Name-Last: Price
Title: Differences in Conference Call Tones: Managers vs. Analysts
Abstract: 
 In this study, the authors extracted the linguistic tones of managers and analysts during
          earnings conference calls and examined the differences between them. The authors found
          that manager tones convey much more optimism (less pessimism) than their analyst
          counterparts and that investors (particularly institutional investors) react more strongly
          to analyst tones than to manager tones. Following the August 2000 adoption of Regulation Fair Disclosure (Reg FD) by the US
          Securities and Exchange Commission, interest in the conference call disclosure medium
          within the investment community, among corporate executives, and by academics has
          increased substantially. Quarterly earnings conference calls are now open to the public,
          and recent research has shown that market participants react to the incremental
          information contained therein. However, prior work has not disentangled the most prominent
          and interesting aspect of these interactive corporate events—the open dialogue
          between managers and analysts. The ability to distinguish and examine “who said
          what” during conference calls has important implications for understanding the
          mechanisms by which information is mapped into stock prices. Most studies to date have
          treated these important interactions between managers and analysts as a black-box process:
          we know who goes in (managers and analysts), and we know what comes out (abnormal stock
          returns), but we do not know who is responsible for which aspect of what comes out.In this study, we conducted just such an in-depth examination of conference call
          transcripts by identifying and comparing the linguistic tones of managers and analysts. We
          used call transcripts to construct a sample that includes conference calls over the
          16-quarter period from 2004 through 2007. For each call, we parsed the transcript into its
          basic components and, using a specialized textual analysis program, extracted the
          linguistic content (i.e., “tone”) of managers and analysts separately.Our results provide several contributions to our understanding of the informational roles
          played by managers and analysts. First, we measured and compared the linguistic tones of
          managers and analysts during conference calls and showed that managers present more
          optimistic tones, on average, than analysts present. This finding suggests that investors
          should pay close attention to managerial incentives when weighing the content and meaning
          of managerial disclosures. Second, we documented that analyst tones are subject to less
          discounting by market participants than manager tones are. This finding highlights the
          important role of information intermediaries, such as financial analysts, in discerning
          the information content of public disclosures. Third, we showed that institutional
          investors appear to be more capable of analyzing and interpreting linguistic tones than
          individual investors are. This finding adds to our knowledge of the sources of
          institutional investors’ information advantages.
Journal: Financial Analysts Journal
Pages: 24-42
Issue: 4
Volume: 71
Year: 2015
Month: 7
X-DOI: 10.2469/faj.v71.n4.1
File-URL: http://hdl.handle.net/10.2469/faj.v71.n4.1
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# input file: UFAJ_A_12048288_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Patrick Geddes
Author-X-Name-First: Patrick
Author-X-Name-Last: Geddes
Author-Name: Lisa R. Goldberg
Author-X-Name-First: Lisa R.
Author-X-Name-Last: Goldberg
Author-Name: Stephen W. Bianchi, CFA
Author-X-Name-First: Stephen W.
Author-X-Name-Last: Bianchi, CFA
Title: What Would Yale Do If It Were Taxable? (corrected January 2016)
Abstract: 
 The distinctive financial goals and constraints of ultra-high-net-worth individuals together
     with their aggregate growth in assets have led to the emergence of “New
     Institutional” investing, which includes the best practices from institutional investors
     but also incorporates the critical element of tax management. The authors design New
     Institutional asset allocations that incorporate traditional investment metrics in a tax-aware
     setting. Specifically, they show how risk and after-tax returns need to be combined from
     inception when seeking an optimal after-tax asset allocation. Diversification is especially
     important for taxable investors because low asset class correlations can facilitate the
     inclusion of attractive but tax-inefficient asset classes in a tax-aware allocation. Asset allocation is an essential element of every investment process, and much thought has
     been devoted to the subject. Historically, the literature has revolved around institutional
     investors because they have accounted for the better part of growth in assets under
     management.Since the start of the millennium, however, and especially in the wake of the financial
     crisis, a “New Institutional” class of ultra-high-net-worth (UHNW) investors has
     emerged. Asset allocations for new and traditional institutional investors differ because UHNW
     investors pay taxes whereas most institutional investors do not. Taxes make the wholesale
     adoption of a successful pretax allocation a losing strategy for New Institutional investors.
     The construction of a winning strategy requires additional analysis, and we provide a framework
     for part of that analysis in this article. We show how tax management and risk control are
     inseparable elements of asset allocation for a taxable investor.To illustrate the interplay between risk and taxes, we modified the asset allocation of Yale
     University’s endowment to be tax efficient. The Yale endowment is an attractive starting
     point for our analysis for two reasons. First, Yale posts the required data—its asset
     class weights—on its website. Asset class weights are the most concrete representation of
     the asset allocation process because the weights tell us exactly how funds are invested.
     Second, Yale’s asset allocation is shaped by the principle of diversification, as well as
     the premium for illiquidity that can be wrung from private asset classes by investors who are
     either skilled or lucky. These features are attractive to tax-exempt and taxable investors
     alike. However, a taxable investor pursuing a strategy based directly on the Yale model may
     find the benefits of the strategy to be negated by an unwanted tax bill.We combined Yale’s asset class weights with risk estimates to obtain a consistent set
     of pretax implied returns for the asset classes in the Yale allocation. We accomplished this
     using reverse optimization, which was developed by William F. Sharpe. We penalized or augmented
     each implied return in accordance with its tax efficiency. These modifications are necessarily
     coarse estimates because taxes vary from investor to investor, from year to year, and from
     implementation to implementation. However, our estimates incorporate important qualitative
     features. For example, both active equity and hedge funds are less tax efficient than indexed
     equity, and municipal bonds are very tax efficient.After adjusting the implied return of each asset class for tax considerations, we used a
     quantitative optimizer to reallocate funds. Our framework facilitates an even-handed comparison
     between Yale’s actual pretax allocation and a new, after-tax allocation that we derive as
     an optimal portfolio if Yale were taxable. Following is a summary of the results.Accounting for taxes in an asset allocation drives funds from asset classes that are less
       tax efficient to those that are more tax efficient.A tax-efficient asset class that can harvest losses to offset capital gains plays a special
       role in a taxable asset allocation. In our study, we relied on tax-efficient equity for
       this.Tax-efficient equity is preferred to indexed or active equity in an after-tax
       allocation.There is a natural place in an after-tax asset allocation for a tax-inefficient class so
       long as two conditions are satisfied. First, the allocation must include a tax-efficient
       class that harvests capital gain–offsetting losses. Second, the tax-inefficient class
       must provide sufficient diversification.When we adjusted the risk estimates for tax considerations, our results became
       stronger.The new framework and the accompanying metrics can help investors and advisers pursue many of
     the benefits of the endowment model in a way that takes into account the harsh after-tax
     reality of the world of UHNW investors. So what would Yale do if it were taxable? A world-class
     shop like Yale would integrate tax considerations into its asset allocation process from the
     beginning rather than layering them in after the fact.
Journal: Financial Analysts Journal
Pages: 10-23
Issue: 4
Volume: 71
Year: 2015
Month: 7
X-DOI: 10.2469/faj.v71.n4.2
File-URL: http://hdl.handle.net/10.2469/faj.v71.n4.2
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# input file: UFAJ_A_12048289_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Gert Elaut
Author-X-Name-First: Gert
Author-X-Name-Last: Elaut
Author-Name: Michael Frömmel
Author-X-Name-First: Michael
Author-X-Name-Last: Frömmel
Author-Name: John Sjödin
Author-X-Name-First: John
Author-X-Name-Last: Sjödin
Title: Crystallization: A Hidden Dimension of CTA Fees
Abstract: 
 The authors investigated the impact on fee load of variations in the frequency with which
     commodity trading advisers update their high-water mark. They documented crystallization
     frequencies used in practice, analyzed the effect on fee load, and found that the
     crystallization frequency set by the manager significantly affects fee load and should thus be
     a relevant consideration for investors. We investigated the impact on fees paid by investors of variations in the frequency with
     which commodity trading advisers (CTAs) or managed futures update their high-water mark (HWM).
     Although this aspect of hedge funds’ fee structure might be neglected in fee
     negotiations, the “crystallization” frequency has a material impact on the fee
     level that investors pay. Therefore, the issue is of high relevance for investors that are
     invested in or wish to allocate to CTAs or other hedge fund categories. The crystallization
     frequency is an important element of any performance-based fee structure that includes a
     high-water-mark provision.In our study, we first documented the crystallization frequency commonly used by managed
     futures. We found that in the majority of cases, the high-water mark is updated quarterly. This
     finding contrasts with the view expressed in prior academic research that hedge funds commonly
     charge the incentive fee annually, at the end of the year. Furthermore, using data on managed
     futures from BarclayHedge for 1994–2012, we studied the impact of crystallization
     frequency on the average annual fee load that investors pay. We first estimated CTAs’
     gross returns by using the funds’ headline fee levels and assuming quarterly
     crystallization. We then used gross returns as inputs for a block bootstrap approach to
     simulate the track record of CTA funds. The final step consisted of applying a standard 2/20
     fee structure but varying the crystallization frequency. In this way, we were able to quantify
     the average annual fee load for different crystallization frequencies under realistic
     conditions.The results that we report in the article provide investors with a number of useful insights.
     We found that the expected total fee load charged by the hedge fund manager increases with the
     crystallization frequency. In the case of CTAs and assuming a 2/20 fee structure, shifting from
     annual to quarterly crystallization leads to a 49 bp increase in the average annual fee load
     (as a percentage of assets under management). These results imply that funds with different
     (identical) headline fee levels can have remarkably similar (different) fee loads. We
     quantified the trade-off between crystallization frequency and performance fee level.
     Specifically, our results suggest that an incentive fee of 15% under monthly crystallization
     leads to the same total fee load as an incentive fee of 20% under annual crystallization.Our results imply that the effect of crystallization frequency on fees is important for
     investors evaluating and comparing different fund investments. Headline fee levels do not tell
     the whole story when a high-water-mark provision is used. Considering the crystallization
     frequency should allow a more informed choice when investing in CTAs or other investment
     vehicles with a high-water-mark provision.
Journal: Financial Analysts Journal
Pages: 51-62
Issue: 4
Volume: 71
Year: 2015
Month: 7
X-DOI: 10.2469/faj.v71.n4.3
File-URL: http://hdl.handle.net/10.2469/faj.v71.n4.3
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# input file: UFAJ_A_12048290_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Morten Sorensen
Author-X-Name-First: Morten
Author-X-Name-Last: Sorensen
Author-Name: Ravi Jagannathan
Author-X-Name-First: Ravi
Author-X-Name-Last: Jagannathan
Title: The Public Market Equivalent and Private Equity Performance
Abstract: 
 The authors show that the public market equivalent approach is equivalent to assessing the
     performance of private equity (PE) investments using Rubinstein’s dynamic version of the
     CAPM. They developed two insights: (1) one need not compute betas of PE investments, and any
     changes in PE cash flow betas due to changes in financial leverage, operating leverage, or the
     nature of the business are automatically taken into account; (2) the public market index used
     in evaluations should be the one that best approximates the wealth portfolio of the investor
     considering the PE investment opportunity.We provide the theoretical foundation for the use of the public market equivalent (PME)
     measure, which is often used to evaluate private equity (PE) performance. We show that the PME
     is equivalent to valuing cash flows using Rubinstein’s dynamic capital asset pricing
     model. Establishing this link enables us to show that the Kaplan and Schoar PME measure is
     surprisingly robust. The PME gives an estimate of the risk-adjusted performance of PE funds
     without having to calculate any betas, even if the betas of the cash flows vary over the life
     of the investments, for example, owing to changes in financial leverage, operating leverage, or
     the nature of the businesses. Further, a PE fund cannot artificially increase its PME by
     increasing its leverage. The discount rate used to calculate the PME should approximate the
     return on the investor’s overall wealth portfolio, and it may vary across investors, even
     for the same fund. Unlike the standard CAPM, the PME does not evaluate performance relative to
     the market returns of other investments with similar risks. Instead, the PME evaluates
     investment performance as an integrated part of the investor’s overall portfolio. Because the PME is derived from a formal asset-pricing model, it does not suffer from the
     problems of the internal rate of return (IRR), which is an alternative performance measure that
     is often used to evaluate PE performance. Unlike the IRR, the PME always exists, and it is
     always unique. Because the PME is equivalent to a present value (PV) calculation, it cannot be
     manipulated, for example, by PE funds’ deliberately choosing the timing and magnitudes of
     their investments, unlike the IRR. Compared with the standard CAPM, the PME also has several
     advantages: it is easier to calculate, it does not require any betas—which are typically
     estimated from the market risks of comparable traded companies—and it doesn’t
     require any assumptions about the expected market risk premium. Overall, the PME appears to be an attractive, robust, and easily applicable method for
     evaluating PE funds’ past performance or the performance of other alternative assets for
     which regularly quoted market prices and returns are unavailable.
Journal: Financial Analysts Journal
Pages: 43-50
Issue: 4
Volume: 71
Year: 2015
Month: 7
X-DOI: 10.2469/faj.v71.n4.4
File-URL: http://hdl.handle.net/10.2469/faj.v71.n4.4
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Author-Name: Charles D. Ellis
Author-X-Name-First: Charles D.
Author-X-Name-Last: Ellis
Title: In Defense of Active Investing
Abstract: 
 The author reflects on the benefits of active investing that the narrow focus on “beating the market” continues to miss.
Journal: Financial Analysts Journal
Pages: 4-7
Issue: 4
Volume: 71
Year: 2015
Month: 7
X-DOI: 10.2469/faj.v71.n4.5
File-URL: http://hdl.handle.net/10.2469/faj.v71.n4.5
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Author-Name: Lawrence N. Bader
Author-X-Name-First: Lawrence N.
Author-X-Name-Last: Bader
Title: How Public Pension Plans Can (and Why They Shouldn’t) Ignore Financial Economics
Abstract: 
 Public pension plan sponsors claim that their perpetual existence and taxing power exempt
          them from financial economics. They therefore ignore current market conditions and rely on
          patience and intergenerational risk sharing to overcome risk. The author shows that their
          use of discount rates that far exceed current market levels produces financial opacity,
          retirement insecurity, and intergenerational inequity, leaving the solvency of these plans
          dependent on the systematic mistreatment of future generations of taxpayers.Long-term US Treasuries are yielding less than 3%, while US public pension plans are
          discounting their liabilities and basing their funding on rates of 7%–8%. This
          article focuses on the United States but notes that similar discrepancies between public
          plan discount rates and the local default-free rate appear in most developed countries,
          particularly in Western Europe. These discrepancies produce financial opacity, retirement
          insecurity, and intergenerational inequity.Insurance companies manage their annuity business roughly in accordance with the
          principles of financial economics, which call for discounting insured liabilities at rates
          that are default-free or nearly so. Public plan sponsors ignore these principles. They
          invest substantially in equities and often in such alternative investments as private
          equity, real estate, and hedge funds. They estimate, generously, the risk premiums they
          expect to earn on these investments. They reflect the hoped-for risk premiums in the
          discount rates that underlie their financial reporting, plan contributions, and pricing of
          negotiated plan improvements.Public pension plan authorities claim various justifications for their deviations from
          financial economics, observing that, unlike insurance companies, they have taxing power
          and will exist in perpetuity. They can share their investment risks among multiple
          generations of taxpayers—long enough for those risks to become minimal and
          manageable. Public pension plan authorities can thus count on earning the risk premiums
          embedded in the higher expected rates of return. In the worst case, they can fall back on
          their taxing power.This long-term argument implicitly relies on an extreme mean reversion process. It
          implies that the variance of a risky portfolio’s cumulative return
            decreases as the measurement period extends, rather than merely
          increasing more slowly than under a simple random walk model. The idea that risk shrinks
          over sufficiently long periods has been refuted by financial economists.The intergenerational-risk-sharing argument is also flawed. This article considers a
          two-period illustration in which the first taxpayer generation funds the pensions earned
          during its tenure. The discount rate used to determine the pension contribution includes a
          risk premium—in effect, the first generation uses the risk premium to reduce its
          contribution. It then exits the scene, having borne no risk and leaving the new generation
          to settle up in the second period. The second generation enjoys gains or faces losses with
          an average value of zero; that is, it bears the risk of gains or losses but can expect no
          risk premium. The risk premium, which can exceed half the true pension cost, has been
          confiscated by the first generation, which bore no risk. In practice, where immediate
          settlement is not required, risks continually pass to future generations, with surpluses
          swept off the table and deficits allowed to run for as many generations as possible.Thus, the true benefit of the long government time horizon is not that it overcomes risk
          but, rather, that it delivers a steady supply of future involuntary risk bearers on whom
          the government can exert its taxing power—at least until it runs out of sufficiently
          affluent generations of taxpayers. In such failures, the victims can include not only
          taxpayers but also plan members and municipal bondholders.Apart from the risk of demographic collapse, the dependence on future generations of
          taxpayers violates the fundamental principle of public finance: each generation should pay
          in full for the services it consumes, without passing either direct costs or funding risks
          to future generations. Ensuring sustainability and fairness for all generations of plan
          participants and taxpayers requires economically correct discount rates for financial
          reporting, determination of contributions, and pricing of benefit increases.Editor’s note: This article was reviewed and accepted by
            Executive Editor Robert Litterman.
Journal: Financial Analysts Journal
Pages: 14-16
Issue: 5
Volume: 71
Year: 2015
Month: 9
X-DOI: 10.2469/faj.v71.n5.1
File-URL: http://hdl.handle.net/10.2469/faj.v71.n5.1
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Author-Name: Hassan Espahbodi
Author-X-Name-First: Hassan
Author-X-Name-Last: Espahbodi
Author-Name: Pouran Espahbodi
Author-X-Name-First: Pouran
Author-X-Name-Last: Espahbodi
Author-Name: Reza Espahbodi
Author-X-Name-First: Reza
Author-X-Name-Last: Espahbodi
Title: Did Analyst Forecast Accuracy and Dispersion Improve after 2002 Following the Increase in Regulation?
Abstract: 
 This article examines the accuracy and dispersion of analyst earnings forecasts from October 1993 to September 2013. The authors found an improvement in these forecast properties in the short run following various regulations in the early 2000s. Over the extended period, however, forecast accuracy significantly declined and dispersion significantly increased. The results are robust to various sensitivity tests and indicate that these regulations did not collectively improve the information environment despite the reduction in analyst conflicts of interest. The problem seems to be largely due to the quality of financial reports.In the early 2000s, several high-profile accounting scandals and violations of securities laws triggered concerns about the reliability and accuracy of corporate disclosures and suggested that investors were being misled by biased analyst forecasts and recommendations. These concerns led to the passage of Regulation Fair Disclosure, the Sarbanes–Oxley Act (SOX), and the Global Analyst Research Settlement in the early 2000s.These regulations were intended to reduce analyst biases due to conflicts of interest and to restore investor confidence in the financial reports of public companies by improving the reliability of companies’ disclosures and governance quality. The improvements in the quality of information available to market participants (including analysts), in turn, were expected to reduce analyst forecast error and dispersion. Prior research has generally shown an improvement in the information environment and in analyst forecast accuracy and dispersion in the few years after the regulations (supporting association but not proving causation). Whether such improvements persisted in the long run is the question that this article addresses.Specifically, we examined the patterns in the properties of analyst forecasts made from October 1993 to September 2013 to determine whether analyst forecast accuracy and dispersion improved in the short term and long term after the regulations. Obviously, as with prior studies, we were not able to attribute any observed improvement to a specific regulation. Given that all the regulations were aimed at improving the accuracy and reliability of accounting information and reducing analyst conflicts of interest, however, the absence of any lasting improvement in analyst forecast properties suggests that, ultimately, these regulations were collectively ineffective in achieving their objectives.Our univariate and multivariate tests indicate that the level and reliability of companies’ disclosures improved slightly in the few years after the regulations (i.e., forecast error and dispersion trended downward during the short-term post-regulation period). Our tests show, however, that analyst forecast error and dispersion significantly increased over the long-term post-regulation period. Therefore, even if we assume that these regulations caused the improvement in the observed analyst forecast properties in the short run, they did not have a lasting effect. The results are robust to alternative measures of error and dispersion, specifications of pre- and post-regulation periods, and sample composition, and they imply that these regulations did not collectively improve the information environment despite the reduction in analyst conflicts of interest. The continued problem with the information environment, therefore, seems to be largely due to the quality of financial reports.Given that the improvement in forecast properties is not sustained, we conclude that there is no improvement in—and there may actually be a reduction in—the quality of information from financial analysts in the long run. The initial improvements in forecast properties after these regulations were implemented may have been in response to the increased scrutiny companies and analysts experienced immediately after the passage of the regulations. For example, the increased legal liability associated with SOX may have made managers less willing to disclose “softer” information. Therefore, a future research question is whether regulations in general lose their effectiveness in the long run, either because managers and others find ways to avoid violating the regulations while pursuing their agenda or because the fear of penalties subsides over time (reflecting the Hawthorne effect and availability bias). Our findings suggest that regulators need to weigh the cost of regulations against both their short- and long-term benefits and that investment practitioners must recognize that regulations may or may not have the intended consequences for the reliability and accuracy of information reported by companies and analyst forecasts, at least in the long run.Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.
Journal: Financial Analysts Journal
Pages: 20-37
Issue: 5
Volume: 71
Year: 2015
Month: 9
X-DOI: 10.2469/faj.v71.n5.2
File-URL: http://hdl.handle.net/10.2469/faj.v71.n5.2
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Author-Name: J. Benson Durham
Author-X-Name-First: J. Benson
Author-X-Name-Last: Durham
Title: Can Long-Only Investors Use Momentum to Beat the US Treasury Market?
Abstract: 
 The literature on momentum is vast. No previous study, however, has examined trading rules along government bond term structures. Under index-duration-neutral and long-only constraints and with low trading costs, an equally weighted average strategy across 20 look-back windows produces an information ratio of 0.46, given US Treasury total return data from March 1985 through December 2013. Unlike momentum in other asset classes, excess relative returns for this asset class are positively skewed and load favorably on risk metrics. Returns correlate with term premium estimates and yield curve factors, but substantial variance remains unexplained and the alphas are meaningfully positive.An extensive literature documents a sizable momentum anomaly across financial asset classes. Portfolios of securities with the most positive (negative) prior excess returns subsequently tend to have superior (inferior) risk-adjusted results. Studies have documented momentum profits with respect to individual shares, aggregate equity market indexes, currencies, commodities, and speculative-grade, rather than investment-grade, corporate bonds. Empirical tests usually consist of sorting portfolios on the basis of past returns, going long or overweighting past winners while shorting or underweighting past losers, calculating corresponding returns, and estimating risk exposure. Despite strong incentives, to date, analyses of cross-sectional momentum along government bond term structures (i.e., momentum patterns with respect to duration buckets along the curve), rather than across different markets or individual curves over time, remain unreported. This study finds sizable excess returns, notably under the index-duration-neutral constraint, of up to 57 bps in annual terms, with information ratios (IRs) as great as 0.66, given all necessary available US Treasury data to cover a breadth of maturities of up to 30 years from March 1985 through December 2013. A strategy based on a weighted average of signals across 20 alternative look-back windows produces average excess returns (over the index) of about 34 bps and an IR of about 0.46. Unlike momentum strategies in other asset classes or carry trades, relative returns are skewed to the upside and do not load on common risk factors. If anything, they correlate favorably as a hedge against risky assets and liquidity proxies. Moreover, in contrast to a common misconception, the short side does not predominantly drive returns.Perhaps unfortunately for practitioners, these momentum returns are not conditioned on ex ante factors. There is limited evidence that term-structure momentum is “Treasury market state dependent,” at least contemporaneously, given a positive correlation between overall market and momentum returns. But the result is much less pronounced compared with evidence on shares, and contemporaneous conditionality does not connote risk exposure per se. Also, there is no positive relationship between the underlying magnitude of the momentum signal and subsequent returns. In addition, on the basis of the hypothesis that momentum may reflect compensation consistent with forward term premium estimates, I found that momentum returns do correlate to a degree with returns from portfolios based on arbitrage-free Gaussian affine term-structure models. Excess relative returns correlate with some principal components of the yield curve as well as key lagged forward rates. Nonetheless, substantial variance remains unexplained, the betas are less than 1, and the alphas are largely positive as well as demonstrably more robust compared with other published fixed-income momentum anomalies. Lastly, these results do not constitute confirmation of previously published findings of duration-based momentum in bond markets; rather, they represent unreported return persistence unrelated to the level of the term structure.Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.
Journal: Financial Analysts Journal
Pages: 57-74
Issue: 5
Volume: 71
Year: 2015
Month: 9
X-DOI: 10.2469/faj.v71.n5.3
File-URL: http://hdl.handle.net/10.2469/faj.v71.n5.3
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Author-Name: William Fallon
Author-X-Name-First: William
Author-X-Name-Last: Fallon
Author-Name: James Park
Author-X-Name-First: James
Author-X-Name-Last: Park
Author-Name: Danny Yu
Author-X-Name-First: Danny
Author-X-Name-Last: Yu
Title: Asset Allocation Implications of the Global Volatility Premium
Abstract: 
 The authors examined the role of volatility premiums in institutional investment portfolios. They began by defining and calculating standardized returns to volatility exposure for a variety of global asset markets. They found that shorting volatility offers not only a very high and statistically significant Sharpe ratio of approximately 1.0 but also substantial tail risk. Although classic diversification benefits are limited, the authors show that modest allocations to short volatility exposure could have enhanced long-term returns, in one case increasing the portfolio’s combined Sharpe ratio by 12%. This empirical study provides a comprehensive statistical and economic analysis of the global volatility risk premium, with a special emphasis on its practical role in institutional asset allocation. Our inferences about the premium are based on a composite return series, which we call the Grand Volatility Composite Portfolio (GVCP). We derived the GVCP from a dynamic trading strategy applied to a variety of instruments, including swaptions, variance swaps, and options on futures. The GVCP blends the returns of volatility-sensitive instruments in 34 unique markets across four asset classes: equities, bonds, currencies, and commodities. Our data begin in January 1995 and end in May 2013 and thus include the recent global financial crisis. A strategy-based approach is required to derive the GVCP not only because pure volatility returns are not universally available, but also because risks vary among instruments, across asset classes, and over time. Our derivation also accounts for transaction costs, which have a material impact on performance.To facilitate comparison, we combined the 34 volatility return series on an equal risk–weighted basis within each asset class to form four composite asset class series, and then among asset classes to form the GVCP. We chose an equal-weighting scheme because of its simplicity and transparency. We found that negative (short) volatility premiums are widespread, statistically significant, and economically meaningful. Consistent with earlier studies, we found that shorting volatility offers not only a very high Sharpe ratio of approximately 1.0 but also substantial tail risk, which we defined as the worst monthly return in our sample. Selling volatility is consistently profitable, including during the five-year period surrounding September 2008. We found that transaction costs played a significant role, reducing gross returns by 47% on average in our sample. The left-tail risk of volatility returns was substantial and far larger than that of primary assets. For volatility assets, the median worst monthly return, expressed as a fraction of annual standard deviation, was –1.6, whereas the corresponding median figure across primary assets (equities, fixed income, currencies, commodities, and even hedge funds) was just –1.2. The worst return of the GVCP was –2.3%, more than twice its annual standard deviation. We also found, however, that lengthening the period of evaluation for the GVCP reduced the severity and impact of tail events, primarily because of the GVCP’s high mean and how its risk is managed.We evaluated the GVCP’s economic significance both by confirming that its returns could not be explained by common linear factors, per the global Fama–French model, and by evaluating the performance of hypothetical strategic investment benchmarks when the returns of the GVCP were added in small measures. We found in a portfolio context that the worst returns of the GVCP tended to coincide with large losses in primary markets, thus limiting the GVCP’s role in institutional portfolios as a cornerstone strategic risk premium, like stocks and bonds. Nevertheless, our analysis suggests that investors without short positions in volatility may be forfeiting a profitable investment opportunity, as adding the GVCP in small amounts to typical portfolios would have enhanced long-term returns, increasing the combined Sharpe ratio by as much as 12% in our sample.Editor’s notes: The authors may have a commercial interest in the topics discussed in this article. This article was reviewed and accepted by Executive Editor Robert Litterman.Authors’ note: The views and opinions expressed herein are those of the authors and do not reflect the views of Goldman Sachs. The backtests and analysis described herein are provided for educational purposes in reliance on past market data with the benefit of hindsight and do not reflect actual results. If any assumptions used do not prove to be true, results may vary substantially. Our research does not take into account specific investment objectives, investor guidelines, or restrictions. Investors must also consider suitability, liquidity needs, and investment objectives when determining appropriate asset allocation. All swap and swaption data are courtesy of J.P. Morgan Research, copyright 2014. 
Journal: Financial Analysts Journal
Pages: 38-56
Issue: 5
Volume: 71
Year: 2015
Month: 9
X-DOI: 10.2469/faj.v71.n5.4
File-URL: http://hdl.handle.net/10.2469/faj.v71.n5.4
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Author-Name: Robert C. Pozen
Author-X-Name-First: Robert C.
Author-X-Name-Last: Pozen
Title: The Role of Institutional Investors in Curbing Corporate Short-Termism
Abstract: 
 Institutional investors are the majority owners of most publicly traded companies but allow activist hedge funds with smaller positions to push through corporate changes. The author offers various reasons why institutional investors may be reluctant to actively participate in proxy fights but then suggests several practical forms of investor engagement that support long-term value creation. So, in future campaigns by hedge funds, institutional investors should actively participate to ensure that the outcome promotes long-term growth instead of temporary price spurts. Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.
Journal: Financial Analysts Journal
Pages: 10-12
Issue: 5
Volume: 71
Year: 2015
Month: 9
X-DOI: 10.2469/faj.v71.n5.5
File-URL: http://hdl.handle.net/10.2469/faj.v71.n5.5
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Author-Name: Barbara S. Petitt
Author-X-Name-First: Barbara S.
Author-X-Name-Last: Petitt
Title: From the Editor
Journal: Financial Analysts Journal
Pages: 4-4
Issue: 5
Volume: 71
Year: 2015
Month: 9
X-DOI: 10.2469/faj.v71.n5.6
File-URL: http://hdl.handle.net/10.2469/faj.v71.n5.6
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Author-Name: Clifford S. Asness
Author-X-Name-First: Clifford S.
Author-X-Name-Last: Asness
Author-Name: Benjamin T. Hood
Author-X-Name-First: Benjamin T.
Author-X-Name-Last: Hood
Author-Name: John J. Huss
Author-X-Name-First: John J.
Author-X-Name-Last: Huss
Title: “Determinants of Levered Portfolio Performance”: A Comment
Abstract: 
 This material comments on “Determinants of Levered Portfolio Performance”. (September/October 2014).
Journal: Financial Analysts Journal
Pages: 6-7
Issue: 5
Volume: 71
Year: 2015
Month: 9
X-DOI: 10.2469/faj.v71.n5.7
File-URL: http://hdl.handle.net/10.2469/faj.v71.n5.7
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Author-Name: Robert M. Anderson
Author-X-Name-First: Robert M.
Author-X-Name-Last: Anderson
Author-Name: Stephen W. Bianchi
Author-X-Name-First: Stephen W.
Author-X-Name-Last: Bianchi
Author-Name: Lisa R. Goldberg
Author-X-Name-First: Lisa R.
Author-X-Name-Last: Goldberg
Title: “Determinants of Levered Portfolio Performance”: Author Response
Abstract: 
 This material comments on “Determinants of Levered Portfolio Performance: A Comment”. (September/October 2015).
Journal: Financial Analysts Journal
Pages: 8-9
Issue: 5
Volume: 71
Year: 2015
Month: 9
X-DOI: 10.2469/faj.v71.n5.8
File-URL: http://hdl.handle.net/10.2469/faj.v71.n5.8
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Author-Name: Roni Israelov
Author-X-Name-First: Roni
Author-X-Name-Last: Israelov
Author-Name: Lars N. Nielsen
Author-X-Name-First: Lars N.
Author-X-Name-Last: Nielsen
Title: Covered Calls Uncovered
Abstract: 
 Typical covered call strategies collect the equity and volatility risk premiums but also embed exposure to a naive equity reversal strategy that is uncompensated. This article presents a novel risk and performance attribution methodology that deconstructs the strategy into these three exposures. Historically, the equity exposure contributed most of the risk and return. The short volatility exposure realized a Sharpe ratio of nearly 1.0 but contributed only 10% of the risk. The equity reversal exposure contributed approximately 25% of the risk but provided little return in exchange. The authors propose a risk-managed covered call strategy that eliminates the uncompensated equity reversal exposure. This modified covered call strategy has a superior Sharpe ratio, reduced volatility, and reduced downside equity beta.Equity index covered calls have historically provided attractive risk-adjusted returns, largely because they collect an equity risk premium and a volatility risk premium from their long equity exposure and short volatility exposure, respectively. However, they also embed exposure to an uncompensated risk, a naive equity market reversal strategy. In this article, the authors present a novel performance attribution methodology, which deconstructs the strategy into these three identified exposures, in order to measure each exposure’s contribution to the covered call’s return. The covered call’s equity exposure is responsible for most of the strategy’s risk and return. The strategy’s short volatility exposure has had a realized Sharpe ratio close to 1.0, but its contribution to risk has been less than 10%. The equity reversal exposure is responsible for about one-quarter of the covered call’s risk but provides little reward. Finally, the authors propose a risk-managed covered call strategy that hedges the equity reversal exposure in an attempt to eliminate this uncompensated risk. Their proposed strategy improves the covered call’s Sharpe ratio and reduces its volatility and downside equity beta.Editor’s note: Roni Israelov and Lars N. Nielsen manage option portfolios and covered calls at AQR Capital Management and may have a commercial interest in the topics discussed in this article. Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.Authors’ note: The views and opinions expressed herein are those of the authors and do not necessarily reflect the views of AQR Capital Management, LLC (“AQR”), its affiliates, or its employees, nor do they constitute an offer, a solicitation of an offer, or any advice or recommendation to purchase any securities or other financial instruments by AQR.
Journal: Financial Analysts Journal
Pages: 44-57
Issue: 6
Volume: 71
Year: 2015
Month: 11
X-DOI: 10.2469/faj.v71.n6.1
File-URL: http://hdl.handle.net/10.2469/faj.v71.n6.1
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Author-Name: Benedict S.K. Koh
Author-X-Name-First: Benedict S.K.
Author-X-Name-Last: Koh
Author-Name: Francis Koh
Author-X-Name-First: Francis
Author-X-Name-Last: Koh
Author-Name: David Lee Kuo Chuen
Author-X-Name-First: David Lee Kuo
Author-X-Name-Last: Chuen
Author-Name: Lim Kian Guan
Author-X-Name-First: Lim Kian
Author-X-Name-Last: Guan
Author-Name: David Ng
Author-X-Name-First: David
Author-X-Name-Last: Ng
Author-Name: Phoon Kok Fai
Author-X-Name-First: Phoon Kok
Author-X-Name-Last: Fai
Title: A Risk- and Complexity-Rating Framework for Investment Products
Abstract: 
 Many investors who bought such investments as Lehman Brothers’ minibonds did not understand the products’ complicated features. This fact suggests that if the inherent risk and complexity of products’ structure are not clearly understood by investors, they will be unable to make informed decisions. Some practitioners have recently attempted to calibrate product complexity. The authors propose a framework for classifying investment product risk and complexity separately with a list of factors that contribute to these attributes. They demonstrate the framework’s simplicity and usefulness in helping investors make informed decisions, showing that it can be used to calibrate a variety of investment products.Investors often do not have a clear understanding of the complicated features embedded in complex investment products. In the aftermath of the 2008 global financial crisis, regulators have increasingly looked for various ways to provide such information, motivated by the need to enhance consumer protection. Although risk indicators are well developed and widely adopted, the financial industry as a whole does not have a common methodology to calibrate the complexity of investment products. In this article, we propose a simple, integrated framework to classify both the risk and the complexity of investment products. Risk is decomposed into six main factors: volatility, liquidity, credit rating, duration, leverage, and the degree of diversification. Product complexity is measured by five basic factors: the number of structural layers, the expansiveness of derivatives used, the availability and use of known valuation models, the number of scenarios determining return outcomes, and the transparency/ease of understanding. We simulated and stress tested the proposed framework with a range of weights for the chosen factors and found it to be technically robust. The framework can be used by industry players to enhance product transparency as well as to offer their clients suitable products, appropriately classified by risk and complexity.Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.
Journal: Financial Analysts Journal
Pages: 10-28
Issue: 6
Volume: 71
Year: 2015
Month: 11
X-DOI: 10.2469/faj.v71.n6.2
File-URL: http://hdl.handle.net/10.2469/faj.v71.n6.2
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Author-Name: Larry Harris
Author-X-Name-First: Larry
Author-X-Name-Last: Harris
Author-Name: Albert S. Kyle
Author-X-Name-First: Albert S.
Author-X-Name-Last: Kyle
Author-Name: Erik R. Sirri
Author-X-Name-First: Erik R.
Author-X-Name-Last: Sirri
Title: Statement of the Financial Economists Roundtable, April 2015: The Structure of Trading in Bond Markets
Abstract: 
 The Financial Economists Roundtable, a group of distinguished senior financial
                    economists, discusses the current structure of the corporate and municipal bond
                    markets and offers suggestions regarding the regulation of these markets. Editor’s note: Larry Harris may have a commercial
                        interest in the topics discussed in this article.Editor’s note: This article was reviewed and accepted
                        by Executive Editor Robert Litterman.Authors’ note: This statement is an outcome of the
                        Financial Economists Roundtable discussion at its annual meeting on
                        19–21 July 2014 in Quebec City. It reflects a consensus of more than
                        two-thirds of the attending members. Although the statement provides
                        suggestions to the US Securities and Exchange Commission for how to improve
                        bond market quality, the issues involved affect bond markets throughout the
                        world. If adopted, these suggestions would improve all global bond
                        markets.
Journal: Financial Analysts Journal
Pages: 5-8
Issue: 6
Volume: 71
Year: 2015
Month: 11
X-DOI: 10.2469/faj.v71.n6.3
File-URL: http://hdl.handle.net/10.2469/faj.v71.n6.3
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Author-Name: Benjamin R. Auer
Author-X-Name-First: Benjamin R.
Author-X-Name-Last: Auer
Author-Name: Frank Schuhmacher
Author-X-Name-First: Frank
Author-X-Name-Last: Schuhmacher
Title: Liquid Betting against Beta in Dow Jones Industrial Average Stocks
Abstract: 
 The authors considered liquidity and transaction costs in the practical implementation of betting against beta (BAB) strategies. Using the 30 highly liquid stocks of the Dow Jones Industrial Average over 1926–2013, they analyzed whether the beta anomaly exists and, if so, whether it can be exploited within that universe. With respect to its existence, they found strong evidence of an inverse risk–return relationship. With respect to its exploitability, they found that pure BAB trading portfolios and mixed portfolios (combinations of the pure portfolios and the S&P 500 Index) generate significant abnormal returns that cannot be explained by standard asset-pricing factors. Their results hold both before and after transaction costs and are robust in various settings.The beta anomaly can be considered a persistent anomaly in finance because it has been documented worldwide and is based on solid theory. A recent study, however, argues that the trading efficacy of betting against beta (BAB) strategies may be limited because of illiquidity barriers. To investigate this issue, we explicitly considered liquidity and the role of transaction costs in the practical implementation of BAB strategies. Using the 30 highly liquid stocks of the Dow Jones Industrial Average over 1926–2013, we analyzed whether the anomaly exists and, if so, whether it can be exploited within that universe. With regard to its existence, we found strong evidence of an inverse risk–return relationship. Our results concerning its exploitability reveal that BAB trading portfolios generate significant abnormal returns that cannot be explained by the standard asset-pricing factors of size, book-to-market, and momentum. For example, a portfolio that is long in the 15 stocks with the lowest betas and short in the 15 stocks with the highest betas has historically had a monthly Sharpe ratio of 0.086 after transaction costs. Also, combining this portfolio with the S&P 500 Index increases the monthly Sharpe ratio from 0.089 (for the S&P 500 alone) to 0.146 (for the optimal mix) after transaction costs.Editor’s note: The authors may have a commercial interest in the topics discussed in this article.Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.
Journal: Financial Analysts Journal
Pages: 30-43
Issue: 6
Volume: 71
Year: 2015
Month: 11
X-DOI: 10.2469/faj.v71.n6.4
File-URL: http://hdl.handle.net/10.2469/faj.v71.n6.4
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Author-Name: Mehmet Umutlu
Author-X-Name-First: Mehmet
Author-X-Name-Last: Umutlu
Title: Idiosyncratic Volatility and Expected Returns at the Global Level
Abstract: 
 The author investigated the existence and significance of a global cross-sectional relation between idiosyncratic volatility and expected returns by introducing a global idiosyncratic volatility measure and globally diversified test assets. He found that portfolios with the highest and lowest global idiosyncratic volatility do not earn significantly different average returns, indicating no link between global idiosyncratic volatility and expected returns. His results show that global diversification is effective in stabilizing the returns of global test assets and that benefits from global diversification can be gained by diversifying across either countries or industries.In this study, I investigated the existence and significance of a cross-sectional relationship between global idiosyncratic volatility and expected return. This study extends the debate on whether idiosyncratic volatility matters for expected returns at the global level by taking the perspective of a global investor. I introduced a global idiosyncratic volatility measure that is defined as the residual volatility in which the residuals are obtained by regressing the returns of globally diversified test assets on the global systematic risk factors in an international asset pricing framework. I formed global test assets from characteristic-sorted local supersector, local stock market, and global sector indexes. The use of characteristic-sorted indexes facilitates diversification at the domestic, international, and industrial levels and thus leads to the formation of globally well-diversified test assets. I sorted the test assets on the basis of global idiosyncratic volatility and formed three portfolios. Portfolio 1 consisted of the test assets with the lowest global idiosyncratic volatility; Portfolio 3 contained the test assets with the highest global idiosyncratic volatility. I performed average return difference tests for Portfolios 3 and 1 to see whether a relationship exists between global idiosyncratic volatility and expected return. I consistently found no statistically significant return difference between the highest- and lowest-GIVOL portfolios and thus found no evidence of a relationship between global idiosyncratic volatility and expected return.Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.
Journal: Financial Analysts Journal
Pages: 58-71
Issue: 6
Volume: 71
Year: 2015
Month: 11
X-DOI: 10.2469/faj.v71.n6.5
File-URL: http://hdl.handle.net/10.2469/faj.v71.n6.5
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Author-Name: Ronald N. Kahn
Author-X-Name-First: Ronald N.
Author-X-Name-Last: Kahn
Author-Name: Michael Lemmon
Author-X-Name-First: Michael
Author-X-Name-Last: Lemmon
Title: The Asset Manager’s Dilemma: How Smart Beta Is Disrupting the Investment Management Industry
Abstract: 
 Smart beta products are a disruptive financial innovation with the potential to significantly
     affect the business of traditional active management. They provide an important component of
     active management via simple, transparent, rules-based portfolios delivered at lower fees. They
     clarify that what investors need from their active managers is pure alpha—returns beyond
     those from static exposures to smart beta factors. To effectively position themselves for this
     evolution in active management, asset managers need to understand the mix of smart beta and
     pure alpha in their products, as well as their comparative advantages relative to competitors
     in delivering these important components.Editor’s note: This article was reviewed and accepted by Executive Editor
       Robert Litterman.Authors’ note: This article reflects the opinions of the authors and not
       necessarily those of their employer.
Journal: Financial Analysts Journal
Pages: 15-20
Issue: 1
Volume: 72
Year: 2016
Month: 1
X-DOI: 10.2469/faj.v72.n1.1
File-URL: http://hdl.handle.net/10.2469/faj.v72.n1.1
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Author-Name: Andrew Kalotay
Author-X-Name-First: Andrew
Author-X-Name-Last: Kalotay
Title: Tax-Efficient Trading of Municipal Bonds
Abstract: 
 The author proposes a dynamic strategy to optimize the after-tax performance of a
          municipal bond portfolio. This study extends previous work on one-time tax-loss selling.
          He considers a potential tax-driven trading opportunity as an option with quantifiable
          value, acquired automatically and without cost in a taxable account. Within this
          formulation, selling a bond and reinvesting in another also entails the swap of the
          associated tax options. When considering the value of the tax option acquired upon
          reinvestment, the time to optimum execution is drastically reduced in comparison to
          one-time selling. The author assumes that the choice of reinvestment bonds maintains the
          same interest rate exposure as that from before the sale.The summary was prepared by Jennie I. Sanders, CFA, New York City.What’s Inside?Municipal bonds (munis) held in taxable accounts provide a unique opportunity for
            tax-driven divesting because the realized capital gains and losses present a taxable event,
            contrary to the interest that is tax exempt. By ignoring the tax option acquired by selling
            a muni and reinvesting the proceeds into a similar bond, a one-time sale may miss subsequent
            opportunities to improve after-tax performance. In contrast, dynamic management, which
            involves selling a muni and then reinvesting the proceeds into a similar muni, has the
            potential to create more value by swapping into a new option and extending the time value.
            Such a strategy could increase the after-tax return by 30–100 bps annually depending
            on the duration of the portfolio and the investor’s tax situation.How Is This Research Useful to Practitioners?Because of trade size constraints and transaction costs, this research is intended for
            holdings in a separately managed account. In a one-time sale, the benefit of selling
            consists entirely of cash flow savings, which are equal to the difference between the
            after-tax proceeds from the sale of the muni and the hold value, in which the hold value is
            the worth of the muni to its holder. Thus, investors have to wait for the price of a muni to
            drop sufficiently to realize a large enough cash flow savings to justify the sale. In
            contrast, under a dynamic strategy, the benefit of selling includes two components: cash
            flow savings as well as the value of the new option acquired by reinvesting the proceeds
            from the sale of the muni into another muni. Thus, the sale of a muni can be executed sooner
            (i.e., at a smaller cash flow savings) under dynamic management compared with a one-time
            sale because reinvestment of the proceeds from the sale provides additional free
            optionality, whose value can be incorporated into the dynamic strategy to maximize after-tax
            performance.This research expands on previous work that explored the tax-neutral approach, the optimal
            time to sell without considering how the proceeds are reinvested, and the value added by
            active tax management compared with buy-and-hold investing.How Did the Author Conduct This Research?The author considers four strategies: buy and hold, sell now (if beneficial), one-time
            sale, and dynamic management. He defines the key concepts of after-tax valuation of munis,
            such as the tax basis, liquidation value, hold value, cash flow benefit from selling, and
            tax option. The tax option is acquired automatically and without cost upon the purchase of a
            muni, and its value depends on both investor-specific information and market data, such as
            the price volatility of the muni and transaction costs.The author notes that the tax option value depends on the management strategy. For the
            buy-and-hold strategy, the option value is worthless. For the sell-now strategy, the option
            value is equal to the intrinsic value. The distinction between the one-time sale and dynamic
            management strategies is the role of the option acquired upon reinvestment of the proceeds
            from the sale of the muni into another muni. Reinvestment is a potential enhancer of
            performance.The author illustrates how selling a muni at par purchased a year before at par and then
            purchasing a similar muni at a slightly higher price could add additional value by writing
            off a loss at the short-term capital gains tax rate, which is significantly higher than the
            long-term capital gains tax rate. The value of the tax option embedded in a muni increases
            as the price of the muni drops and as volatility rises. The incentive to sell the muni
            increases as its price drops. Regarding the dynamic strategy, volatility and the price of
            the muni to be sold are not the major factors affecting the sale decision. Instead, the sale
            decision is driven by the time value of the tax option embedded in the new muni in which the
            proceeds of the old muni will be reinvested as well as by the cash flow savings. For the purpose of his illustrations, the author assumes that interest rates evolve
            consistent with the Black–Karasinski process with a modest mean-reversion factor as
            well as the abundance of 5% coupon munis callable at par any time after 10 years. The 5%
            callable curve must be converted into an optionless par curve for valuation purposes by
            using a stochastic model for interest rates as described in Kalotay and Dorigan
            (Journal of Fixed Income 2009). The author also assumes that the
            effective duration is constant (i.e., that the interest rate risk of the portfolio stays the
            same after the tax-driven trade). Otherwise, there would be an incentive to increase the tax
            optionality by extending duration.Abstractor’s ViewpointThis research is helpful in educating investors about the additional opportunities
            presented by munis. For many investors, munis are attractive instruments for inclusion in
            taxable accounts because of their tax-exempt interest. But investors may overlook the
            opportunity they also present for tax-loss harvesting and the advantage of reinvesting the
            proceeds from selling munis to preserve the embedded tax option. Although it is common to
            think of equities in taxable accounts as candidates for tax-loss harvesting, investors may
            be biased by a buy-and-hold mentality regarding munis when making tax-related decisions.
            This research offers them an additional tool for tax-efficient portfolio management.Editor’s note: The author may have a commercial interest in the
            topics discussed in this article.Editor’s note: This article was reviewed and accepted by
            Executive Editor Robert Litterman.Author’s note: The methods discussed in this article are patent
            pending.
Journal: Financial Analysts Journal
Pages: 48-57
Issue: 1
Volume: 72
Year: 2016
Month: 1
X-DOI: 10.2469/faj.v72.n1.2
File-URL: http://hdl.handle.net/10.2469/faj.v72.n1.2
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Author-Name: Stephen J. Brown
Author-X-Name-First: Stephen J.
Author-X-Name-Last: Brown
Title: From the Editor
Journal: Financial Analysts Journal
Pages: 5-6
Issue: 1
Volume: 72
Year: 2016
Month: 1
X-DOI: 10.2469/faj.v72.n1.3
File-URL: http://hdl.handle.net/10.2469/faj.v72.n1.3
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Author-Name: Ilia Dichev
Author-X-Name-First: Ilia
Author-X-Name-Last: Dichev
Author-Name: John Graham
Author-X-Name-First: John
Author-X-Name-Last: Graham
Author-Name: Campbell R. Harvey
Author-X-Name-First: Campbell R.
Author-X-Name-Last: Harvey
Author-Name: Shiva Rajgopal
Author-X-Name-First: Shiva
Author-X-Name-Last: Rajgopal
Title: The Misrepresentation of Earnings
Abstract: 
 The authors conducted a survey of nearly 400 chief financial officers on the definition
          and drivers of earnings quality, with an emphasis on the prevalence and detection of
          earnings misrepresentation. The respondents believe that the hallmarks of earnings quality
          are sustainability, absence of one-time items, and backing by actual cash flows. However,
          they also believe that in any given period, a remarkable 20% of companies intentionally
          distort earnings, even while adhering to GAAP. The magnitude of the misrepresentation is
          large: 10% of reported earnings.The summary was prepared by Marla Howard, CFA, University of Maryland University
          College.What’s Inside?The authors explore the definition of earnings quality as described by chief financial
            officers (CFOs), the producers of earnings quality. Earnings quality is characterized by
            sustainability in profits, the absence of one-time items, and backing by actual cash
            flows. The CFOs surveyed believe that, in any given period, 20% of public companies and
            30% of private companies distort earnings, and the magnitude of the misrepresentation is
            at least 10% of reported earnings.How Is This Research Useful to Practitioners?With a deeper understanding of the factors that determine earnings quality and
            awareness of the red flags of misrepresented earnings, financial analysts and investors
            can temper their reliance on certain financial information that shows signs of potential
            misrepresentation.The CFOs surveyed identified characteristics of high-quality earnings, such as
            sustainability and predictability of future earnings, accruals that are reflected as
            cash flows, consistent reporting choices over time, and avoidance of long-term estimates
            for which assumptions can be unreliable and subject to interpretation. CFOs believe that
            earnings quality is determined equally by controllable factors (internal controls and
            corporate governance) and non-controllable factors (industry membership and
            macroeconomic conditions). The determinant of earnings quality most agreed on by CFOs is
            the business model of the company. The authors point out that this link between
            fundamentals and earnings quality is not appreciated enough.CFOs face internal and external pressures to smooth earnings and meet earnings
            benchmarks. They also protect their own career and compensation, fearing adverse
            consequences if earnings targets are not met. The CFOs surveyed believe that 20% of
            public companies and 30% of private companies use discretion within GAAP (generally
            accepted accounting principles) to report earnings that misrepresent the economic
            performance of the company and that the extent of the misrepresentation is around 10% of
            reported earnings for public companies and even higher for private companies. It is
            interesting that the CFOs think that one in three cases involves understating reported
            earnings.Earnings misrepresentation is difficult to detect. The surveyed CFOs presented a list
            of red flags that includes lack of correlation between earnings and cash flow from
            operations, deviation from industry or peer norms, consistently meeting or beating
            earnings targets, large or frequent one-time or special items, and a lot of accruals.
            The CFOs also provided some specific areas that lend themselves to earnings management,
            such as acquisition and pension accounting, the use of subsidiaries and
            off-balance-sheet entities, and tax accruals.The CFOs emphasized the importance of managers, audit teams, assumptions used in
            estimates, and clear and open disclosures to help avoid earnings misrepresentation.How Did the Authors Conduct This Research?Past research about earnings misrepresentation has been based on published financial
            information. The authors go straight to the producers of earnings quality for their
            insights about intentional misrepresentation of earnings. They interviewed 12 CFOs and
            surveyed 375 CFOs (169 from public companies and 206 from private companies).The CFOs anonymously answered questions about factors that influence earnings quality;
            the extent, magnitude, and direction of earnings misrepresentation; and the motivations
            of CFOs to use earnings to misrepresent economic performance. The CFOs also provided
            lists of potential indicators of earnings misrepresentation for investors and financial
            analysts to monitor. The authors summarize survey responses and provide excerpts from
            interviews with CFOs.Although the interviews supported the survey results, the authors did not indicate how
            they selected the 12 CFOs for personal interviews. Knowing that the 12 CFOs are
            representative of the CFO population strengthens the ability of the survey results to be
            generalized.Abstractor’s ViewpointAlthough the survey and interview methodologies provide the inside view from CFOs with
            firsthand knowledge about managerial intent regarding earnings decisions, CFO judgment
            about the misrepresentation of reported earnings can be subjective. A reader may wonder
            whether earnings misrepresentation is more widespread than the CFOs believe or whether
            they may exaggerate or extrapolate based on isolated instances. Future research seeking
            viewpoints from auditors, board audit committees, accounting standards setters, and
            regulators may be helpful.Editor’s note: This article was reviewed and accepted by
            Executive Editor Robert Litterman.Authors’ note: This article is an augmented version of
            “Earnings Quality: Evidence from the Field,” published in the
              Journal of Accounting and Economics, vol. 56, no. 2–3
            (Supplement 1, 15 December 2013): 1–33. We have added additional interviews with
            chief financial officers and present results that are not contained in our earlier
            work.
Journal: Financial Analysts Journal
Pages: 22-35
Issue: 1
Volume: 72
Year: 2016
Month: 1
X-DOI: 10.2469/faj.v72.n1.4
File-URL: http://hdl.handle.net/10.2469/faj.v72.n1.4
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Author-Name: John C. Bogle
Author-X-Name-First: John C.
Author-X-Name-Last: Bogle
Title: The Index Mutual Fund: 40 Years of Growth, Change, and Challenge
Abstract: 
 The author marks the 40th anniversary of the creation of the first index mutual fund (now
          the Vanguard 500 Index Fund) by examining decades of data, which reveal that passive index
          funds have consistently outperformed their actively managed counterparts. Editor’s note: This article was reviewed and accepted by
            Executive Editor Stephen J. Brown.Author’s note: The views expressed in this essay are solely
            those of the author and do not necessarily reflect the opinions of Vanguard’s
            present management.
Journal: Financial Analysts Journal
Pages: 9-13
Issue: 1
Volume: 72
Year: 2016
Month: 1
X-DOI: 10.2469/faj.v72.n1.5
File-URL: http://hdl.handle.net/10.2469/faj.v72.n1.5
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Author-Name: Xi Li
Author-X-Name-First: Xi
Author-X-Name-Last: Li
Author-Name: Rodney N. Sullivan
Author-X-Name-First: Rodney N.
Author-X-Name-Last: Sullivan
Author-Name: Luis Garcia-Feijóo
Author-X-Name-First: Luis
Author-X-Name-Last: Garcia-Feijóo
Title: The Low-Volatility Anomaly: Market Evidence on Systematic Risk vs. Mispricing
Abstract: 
 The authors explored whether the well-publicized anomalous returns associated with
     low-volatility stocks can be attributed to market mispricing or to compensation for higher
     systematic factor risk. The results of their study, covering a 46-year period, indicate that
     the relatively high returns of low-volatility portfolios cannot be viewed solely as
     compensation for systematic factor risk. The results from their cross-sectional analyses
     indicate that average returns to low-volatility portfolios are determined by common variations
     associated with the idiosyncratic-volatility characteristic rather than factor loadings. This
     finding suggests that the excess returns are more likely driven by market mispricing connected
     with volatility as a stock characteristic.The summary was prepared by Priyank Singhvi, CFA, India.What’s Inside?Low-volatility portfolios, both in the United States and international markets, tend to
      outperform high-volatility portfolios, which contradicts the CAPM. The authors look at the
      empirical data for the period of January 1966–December 2011 and find that this
      outperformance is not related to compensation for some hidden systematic (undiversifiable)
      risk factor but is likely driven by market mispricing and/or limits to arbitrage.How Is This Research Useful to Practitioners?The outperformance of previously low-return-volatility portfolios relative to previously
      high-return-volatility portfolios is inconsistent with the conventional theory that higher
      expected returns compensate for higher risk as predicated by the CAPM. There are two
      possible explanations for this anomaly: (1) There is some pervasive systematic risk factor
      directly associated with volatility, or (2) investors prefer high-volatility stocks over
      low-volatility stocks because of behavioral considerations and/or limitations on arbitraging
      away any mispricing.The authors’ empirical evidence suggests that market mispricing best characterizes
      the link between low volatility and future returns and that the low-volatility anomaly
      cannot be viewed as compensation for some pervasive systematic risk factor.This work adds to the research into the source of abnormal returns across companies and
      over time, which can enable investors to improve portfolio construction and risk management.
      Low-volatility strategies have the potential to add diversification to portfolios and lead
      to higher Sharpe ratios, but those strategies also tend to increase tracking errors relative
      to index-based benchmarks.How Did the Authors Conduct This Research?The authors investigate whether the low-risk anomaly can be attributed to compensation for
      higher systematic risk or market mispricing. To carry out this investigation, they rely on
      the methodologies previously used in research examining other well-known anomalies, such as
      size, book to market, and momentum. To identify whether the returns on high- and
      low-volatility stocks can be attributed to factor loadings (systematic risk) or to company
      characteristics (mispricing), the authors test whether variations in the loading on a factor
      created on the basis of volatility can explain future stock returns after controlling for
      actual return variability. In line with previous studies, the authors focus on idiosyncratic volatility (IVOL), which
      has been shown to be negatively associated with subsequent stock returns. They measure IVOL
      each month as the standard deviation of the residual returns from the Fama–French
      three-factor model by regressing the daily returns of individual stocks in excess of the
      one-month T-bill rate on the returns to the common factors related to size and book to
      market. To estimate factor loadings (betas) on the IVOL factor, the authors conduct rolling
      regressions of monthly excess stock returns on the three Fama–French factors plus the
      IVOL factor over the previous 36 months. They obtain IVOL factor loadings for 552 months for
      the period of January 1966–December 2011. The authors separate low-IVOL stocks with high and low loadings on the IVOL factor. If the
      systematic risk explanation is correct, a low-IVOL stock with a low-IVOL factor loading
      should have a low average return. In contrast, if the characteristics, rather than factor
      loadings, determine prices, a low-IVOL stock should have a high return regardless of its
      loading on the IVOL factor. Because the results show that loadings on the IVOL factor cannot
      explain cross-sectional stock returns, the authors conclude that the low-volatility anomaly
      is inconsistent with the systematic risk explanation but consistent with market
      mispricing.The results indicate that the IVOL characteristic can predict subsequent stock returns at
      the 1% significance level with the inclusion of control variables. The IVOL effect was very
      strong from 1966 to 1989, but it disappeared after 1990. Thus, there is no evidence to
      support the view that the IVOL effect will continue to explain stock returns.Abstractor’s ViewpointThe low-volatility anomaly is often considered one of the greatest anomalies of the CAPM,
      which is part of the foundation of modern portfolio theory. The anomaly was first pointed
      out by Haugen and Heins in the early 1970s (working paper 1972), and since then, it has been
      an area of interest for both academics and practitioners. This work provides additional
      support to the conjecture that the market mispricing related to the low-risk anomaly may be
      related to behavioral considerations and/or to limitations to arbitrage. Thus, it is related
      to the works of Baker, Bradley, and Wurgler (Financial Analysts Journal
      2011), Frazzini and Pedersen (Journal of Financial Economics
      2014), and Li, Sullivan, and Garcia-Feijóo (Financial Analysts
       Journal 2014). As explained by the delegated asset management model by Baker et
      al., large investors may not be able to arbitrage away the mispricing because of index
      benchmarking, thus explaining why the low-volatility anomaly has persisted for a long period
      of time. Further research is necessary to disentangle the underlying sources of abnormal
      returns.Editor’s note: Rodney N. Sullivan, CFA, was the editor and Luis
       Garcia-Feijóo, CFA, CIPM, was an associate editor of the Financial Analysts
      Journal at the time this article was submitted. Mr. Sullivan and Dr.
       Garcia-Feijóo were both recused from the peer-review and acceptance processes, and the
       reviewers were unaware of their identities. The article was accepted in June 2013; it is
       published in this issue to abide by the FAJ conflict-of-interest policies
       then in place, which stipulated that, should the paper be accepted, the editor is allowed to
       publish one research article or Perspectives piece per calendar year. For information about
       the current conflict-of-interest policies, see www.cfapubs.org/page/faj/policies.Editor’s note: The authors may have a commercial interest in the topics
       discussed in this article.Editor’s note: This article was reviewed and accepted by Executive Editor
       Robert Litterman.Authors’ note: The views and opinions expressed herein are those of the
       authors and do not necessarily reflect the views of AQR Capital Management, LLC, its
       affiliates, or its employees.
Journal: Financial Analysts Journal
Pages: 36-47
Issue: 1
Volume: 72
Year: 2016
Month: 1
X-DOI: 10.2469/faj.v72.n1.6
File-URL: http://hdl.handle.net/10.2469/faj.v72.n1.6
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “What Would Yale Do If It Were Taxable?,” by Patrick Geddes, Lisa R.
          Goldberg, and Stephen W. Bianchi, CFA, in the July/August 2015 issue of the
          Financial Analysts Journal.
Journal: Financial Analysts Journal
Pages: 4-41
Issue: 1
Volume: 72
Year: 2016
Month: 1
X-DOI: 10.2469/faj.v72.n1.7
File-URL: http://hdl.handle.net/10.2469/faj.v72.n1.7
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Author-Name: Barbara S. Petitt
Author-X-Name-First: Barbara S.
Author-X-Name-Last: Petitt
Title: From the Editor
Journal: Financial Analysts Journal
Pages: 8-8
Issue: 1
Volume: 72
Year: 2016
Month: 1
X-DOI: 10.2469/faj.v72.n1.8
File-URL: http://hdl.handle.net/10.2469/faj.v72.n1.8
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Author-Name: William W. Jennings
Author-X-Name-First: William W.
Author-X-Name-Last: Jennings
Author-Name: Brian C. Payne
Author-X-Name-First: Brian C.
Author-X-Name-Last: Payne
Title: Fees Eat Diversification’s Lunch
Abstract: 
 Although diversification is often spoken of as the only free lunch in investing, the authors
     show that it is not free and that it must be considered in light of its costs. They also show
     that fees on diversifying asset classes are high relative to their risk-adjusted
     diversification benefit, with the more exotic asset classes carrying higher price tags. Because
     there is meaningful cross-sectional variation, fees need to be considered when making strategic
     asset allocation decisions.The summary was prepared by Derek W. Johnson, CFA.What’s Inside?The authors critique the widely quoted phrase that diversification is the only free lunch
      in investing by looking at the “true” alpha generated by asset classes and the
      fees associated with investing in those asset classes. They examine asset classes with
      regard to their allocation alpha, which is the alpha derived strictly from the asset class
      and not from market exposure. They refer to an editorial by Charles Ellis, CFA, published in
      the May/June 2012 issue of the Financial Analysts Journal
      (FAJ), that showed that active investment management fees are
      astonishingly high. The authors also incorporate the work of Martin L. Leibowitz and Anthony
      Bova, CFA, published in the July/August 2005 issue of the FAJ, that showed
      that exposure to the US equity market is a key driver of portfolio risk and identified the
      allocation alpha as the true alpha independent of US equities. Building on these two previous articles, the authors examine the relationship between
      allocation alpha and fees. They find that the bulk of the excess return based on allocation
      decreases significantly when fees are applied. This decrease is more pronounced for exotic
      asset classes, such as hedge funds, private equity, global bonds, and narrow mandates in
      public equity. Once fees are subtracted from allocation alphas, the true benefits of
      diversification into non-US equities are reduced significantly for most investors. The
      authors conclude that some asset classes should not be used, whereas others should be given
      lower weights in a diversified portfolio depending on the type and size of the investors and
      the fees they are able to negotiate.How Is This Research Useful to Practitioners?Diversification is one of the hallmarks of wealth management. But understanding the costs
      and fees versus the benefits of diversification is important for investors. The authors
      point out that fees are undergoing heightened scrutiny by large pension plans. They also
      note that diversification in some asset classes comes with added risk. Investors should
      assess whether the added risk is worth taking given the allocation alpha after fees.The authors examine the split of allocation alpha between investors and active managers for
      different diversifying asset classes. Because many managers use relationship pricing, the
      authors advise small investors who want to lower fees to consolidate funds and have larger
      accounts with fewer managers. The authors also look at the allocation alpha after fees on
      passive investment vehicles, such as exchange-traded funds, and find that fees still lower
      the allocation alpha but not as severely as with active management.The authors identify some important practical implications. For example, investors should
      ensure that fee levels are part of the asset allocation decisions. In addition, it is
      usually unwise to separate asset allocation decisions from manager selection and investment
      vehicle decisions. How Did the Authors Conduct This Research?The authors use two data sources for their research. They use J.P. Morgan’s
      “Long-Term Capital Market Return Assumptions: 2013 Estimates and the Thinking behind
      the Numbers,” which is a publicly available report on asset class risk, return, and
      correlation assumptions covering 45 asset classes and is updated annually. They narrow the
      list to 11 asset classes that are typically used in diversified portfolios. To examine fees,
      the authors use the biennial fee survey from Callan Associates, which is a major
      institutional investment consulting firm with more than $2 trillion in advised client
      assets. They examine actual and negotiated fees for three investor types that vary in asset
      size and fee level: an average small endowment, an average state pension fund, and a
      high-quality foundation that would benefit from the lowest fees.Abstractor’s ViewpointAlthough diversification is one of the most important aspects of managing risk in a
      portfolio, it should not come at the expense of added fees, especially if the fees consume
      most if not all of the benefits. The authors build on a growing body of literature that
      examines fees with respect to alpha in general and true or pure alpha in particular. Their
      work should help investors assess the true benefits of diversification, especially with
      regard to the more exotic asset classes.Editor’s note: This article was reviewed and accepted by Executive Editor
       Robert Litterman.Authors’ note: The opinions expressed in this article are those of the
       authors and do not necessarily reflect the opinions of the US Air Force Academy, the US Air
       Force, or any other federal agency.
Journal: Financial Analysts Journal
Pages: 31-40
Issue: 2
Volume: 72
Year: 2016
Month: 3
X-DOI: 10.2469/faj.v72.n2.1
File-URL: http://hdl.handle.net/10.2469/faj.v72.n2.1
File-Format: text/html
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Author-Name: Andrea Frazzini
Author-X-Name-First: Andrea
Author-X-Name-Last: Frazzini
Author-Name: Jacques Friedman
Author-X-Name-First: Jacques
Author-X-Name-Last: Friedman
Author-Name: Lukasz Pomorski
Author-X-Name-First: Lukasz
Author-X-Name-Last: Pomorski
Title: Deactivating Active Share
Abstract: 
 The authors investigate “active share,” a measure meant to determine the level
     of active management in investment portfolios. Using the same sample that was used by Cremers
     and Petajisto (2009) and Petajisto (2013), they find that active share correlates with
     benchmark returns but does not predict actual fund returns; within individual benchmarks,
     active share is as likely to correlate positively with performance as it is to correlate
     negatively. Their findings do not support an emphasis on active share as a manager selection
     tool or an appropriate guideline for institutional portfolios.The summary was prepared by Pamela G. Yang, CFA.What’s Inside?Previous studies seem to indicate that high-active-share funds outperform their reported
      benchmarks and that the benchmark-adjusted returns of high-active-share funds are higher
      than the benchmark-adjusted returns of low-active-share funds. Some investors have
      interpreted these studies as implying that it is better to select fund managers with high
      active share. The authors question this interpretation. Using the same methodology and
      sample as those used in previous studies, the authors find no statistically significant
      relationship between active share and fund returns. However, although active share may not
      be useful for predicting outperformance, the authors point out that it may be useful for
      evaluating management fees.How Is This Research Useful to Practitioners?This study is important because the previous studies by Cremers and Petajisto
      (Review of Financial Studies 2009) and Petajisto (Financial
       Analysts Journal 2013) have attracted considerable attention and led certain
      investors, investment professionals, and regulators to believe that high-active-share funds
      achieve higher alphas than low-active-share funds.The authors find three important results. First, high-active-share funds tend to have
      small-cap benchmarks, whereas low-active-share funds tend to have large-cap benchmarks.
      Thus, sorting funds on active share is similar to sorting on benchmark type, and the
      relationship between active share and mutual fund returns in excess of their benchmarks is
      driven by the correlation between active share and benchmark type. Second, the authors find
      no reliable statistical evidence that differentiates the returns of high-active-share funds
      and low-active-share funds from each other. Third, for a given benchmark, the authors do not
      find reliable statistical evidence that high-active-share funds earn higher returns than
      low-active-share funds.This new study suggests that active share is not a valuable measure of managers’
      skill. The authors remind us that active share is a measure of active risk and simply
      taking on more risk does not necessarily lead to outperformance. Because pursuing investment
      returns is in aggregate a zero-sum game, there will be winners and losers among
      high-active-share investors. But as a group, high-active-share investors cannot
      systematically outperform low-active-share investors (i.e., indexers).However, the authors point out that active share may be useful in evaluating fees charged
      by fund managers. Fees should be in line with the active risk taken by the fund, but active
      share is only one of several measures used to determine the degree of
      “activity.” Other measures include predicted and realized tracking errors and
      other concentration measures. Using multiple measures in tandem could help investors
      identify managers who might be overcharging for the active risk they take.How Did the Authors Conduct This Research?The authors closely replicate the work of Cremers and Petajisto (2009) and Petajisto (2013)
      and use data on active share and benchmark assignment for all actively managed US domestic
      mutual funds from 1990 to 2009.The analysis of the correlation between benchmark type and benchmark alpha shows that
      small-cap indexes (which tend to be the benchmark of high-active-share funds) underperformed
      large-cap indexes (which tend to be the benchmark of low-active-share funds). This result is
      consistent with those of Cremers, Petajisto, and Zitzewitz (Critical Finance Review
      2013). Following Petajisto (2013), the authors sort mutual funds into five active share portfolios
      on the basis of their active share results and realized tracking errors. Along with the
      average benchmark-adjusted returns to each active share grouping, they also show
      benchmark-adjusted returns regressed on factors (market, size, value, and momentum) to
      calculate alphas. They decompose annualized net-of-fee returns and alphas of the five active
      share portfolios into two elements: the contribution from fund returns and the contribution
      from each fund’s benchmark.The results show that stock pickers (managers who are in the highest quintile of active
      share intersected with all but the highest quintile of tracking error) earn significantly
      higher benchmark-adjusted returns and alphas than closet indexers (managers who are in the
      lowest quintile of active share intersected with all but the highest quintile of tracking
      error). However, the decomposition shows that the difference in fund returns and alphas is
      statistically insignificant; only the difference in alpha between the benchmark indexes of
      the two active share portfolios (stock pickers and closet indexers) is statistically
      significant. In other words, the authors do not find reliable statistical evidence that
      high-active-share funds achieve higher returns or alphas than low-active-share funds;
      rather, benchmarks drive the difference in benchmark-adjusted performance between low- and
      high-active-share funds. After controlling for benchmarks, the authors find that the performance difference between
      stock pickers and closet indexers, although positive, is not significantly different from
      zero. This result is consistent with the finding that the performance improvements
      associated with active share are driven by the correlation between active share and
      benchmark rather than by manager’s skill.Abstractor’s ViewpointAre investors better off if they select active managers? Intuitively, certain investors
      expect that managers who “appear to do something active” will generate higher
      returns. Investors often do not realize that such an expectation is a myth. As the authors
      show, although active share correlates with benchmark returns, it does not predict actual
      fund returns. Diminishing the role of active share in assessing manager’s skill is
      important. Hopefully, using active share as a measure of manager’s degree of activity
      will save investors from paying fees to undeserving managers. But I doubt that the
      investment community will change its behavior by abandoning its pursuit of active share.Editor’s note: The authors may have a commercial interest in the topics
       discussed in this article.Editor’s note: This article was reviewed and accepted by Executive Editor
       Stephen J. Brown.
Journal: Financial Analysts Journal
Pages: 14-21
Issue: 2
Volume: 72
Year: 2016
Month: 3
X-DOI: 10.2469/faj.v72.n2.2
File-URL: http://hdl.handle.net/10.2469/faj.v72.n2.2
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Author-Name: Don Ezra
Author-X-Name-First: Don
Author-X-Name-Last: Ezra
Title: Most People Need Longevity Insurance rather than an Immediate Annuity
Abstract: 
 An immediate annuity is precisely the sum of two parts. One is a deferred annuity
          commencing at a specified date, with no death benefit before that date. The remainder,
          before the deferred annuity commences, is a reverse whole life insurance policy with
          limited premiums. That reverse policy is effectively one underwritten by the annuitant,
          with the insurance company as beneficiary—a policy that benefits few retirees.
          However, the deferred annuity (called “longevity insurance” in the
          literature) is a valuable component of a retirement portfolio that supplements components
          that focus on safety and growth.The summary was prepared by Jennie I. Sanders, CFA, New York City.What’s Inside?Longevity assumptions are a critical component of financial planning. Many retirees have
            sufficient resources to allocate on the basis of the goals of safety, growth, and longevity.
            The probability of living past one’s life expectancy is relatively low, but to do so
            means outliving one’s resources, resulting in a high financial impact. Longevity
            insurance should be akin to fire insurance in that the cost to insure should be low, paying
            off only if the risk occurs and paying nothing if the risk does not materialize. Obtaining
            longevity insurance through an immediate annuity results in unnecessary costs.How Is This Research Useful to Practitioners?Those retiring in the next decade are increasingly concerned about outliving their savings,
            and practitioners and researchers have been seeking solutions to this uncertainty. Prior
            research—for example, Yaari (Review of Economic Studies 1965) and
            Ameriks, Veres, and Warshawsky (Journal of Financial Planning
            2001)—has focused on how immediate annuities provide some certainty by means
            of a lifetime income. Dus, Maurer, and Mitchell (Financial Services Review
            2005) found a benefit in having a deferred annuity that initiates if the retiree
            lives beyond a certain advanced age. Milevsky and Robinson (Financial Analysts
              Journal 2005) suggested that retirees should plan their spending similar to how
            insurance companies consider expected payments, mortality tables, and investment returns in
            achieving a high probability of adequate reserves. Scott (Financial Analysts
              Journal 2008) discussed the “spending improvement quotient”
            (Q), arguing that an immediate annuity is more economical than saving all
            one’s money for an expected drawdown. He suggested incorporating a deferred annuity
            as a more agreeable solution, which pays off at some future date only if the purchaser is
            still alive. In an earlier paper (Rotman International Journal of Pension Management
            2011), the author found that after age 75, the risk of longevity exceeds the risk
            of being invested in 100% equities in terms of the relative financial impact (supporting the
            usefulness of annuities).In this article, the author points out that immediate annuities remain underutilized by
            most retirees despite the research supporting their benefits. He makes a plea to insurance
            companies to consider writing longevity insurance and explores immediate annuities as the
            next-best solution. He indicates that an immediate annuity is essentially two products: a
            reverse whole life insurance policy and a deferred annuity. He argues that a reverse whole
            life policy benefits the insurance company far more than the immediate annuitant, who is
            essentially underwriting the policy on the annuitant’s own life. More retirees may
            see the value of a deferred annuity, which does not have the cost associated with a reverse
            whole life policy.How Did the Author Conduct This Research?To illustrate the components of an immediate annuity, the author considers a 68-year-old
            male purchaser, assuming longevity according to Canadian annuitant tables and a contractual
            fixed rate of return of 2.5% a year. The mortality table suggests an equal split between
            68-year-olds dying before and after the age of 86. Payments are made by the insurance
            company once a year starting immediately, with a high probability of adequate reserves
            (ignoring spousal features).The immediate annuity cost of providing $1 a year for life to the 68-year-old male is a
            lump sum of $14.78. It costs $2.53 today if the purchaser wants to forgo annual payments
            until age 85 and buy a longevity annuity that pays only $1 a year if the purchaser lives
            past 85—which implies that the reverse whole life policy (with limited premiums) costs
            $12.26.A typical whole life policy requires the purchaser to make annual payments, and upon the
            purchaser’s death, the insurance company pays a lump sum. The first part of an
            immediate annuity is structured in reverse—that is, the purchaser pays the lump sum up
            front and the insurance company makes annual payments but only until age 84. The first part
            of an immediate annuity and the first part of a traditional whole life insurance policy are
            actuarially equivalent when adjusted for the limited premiums.Abstractor’s ViewpointThe author makes a plea to financial advisers, who typically do not like annuities,
            “to recognize the huge risk-mitigating effect of longevity insurance.” I often
            say that annuities meet the needs of some investors but tend to be sold to those for whom
            there are better alternatives. I appreciate the author’s perspective of risk
            pooling—the way we buy fire insurance—for risk events that have a lower
            probability but a higher financial impact. I recognize the value of reasonably priced
            longevity insurance and hope that this article leads to insurance companies’
            structuring contracts to meet this need.Editor’s note: This article was reviewed and accepted by
            Executive Editor Stephen J. Brown.
Journal: Financial Analysts Journal
Pages: 23-29
Issue: 2
Volume: 72
Year: 2016
Month: 3
X-DOI: 10.2469/faj.v72.n2.3
File-URL: http://hdl.handle.net/10.2469/faj.v72.n2.3
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Author-Name: Moshe A. Milevsky
Author-X-Name-First: Moshe A.
Author-X-Name-Last: Milevsky
Title: It’s Time to Retire Ruin (Probabilities)
Abstract: 
 Concerned about the growing use of ruin probabilities as the guiding risk metric for
          retirement income planning, the author introduces the idea of portfolio longevity being
          parallel to the biological longevity of human life and discusses how to educate clients
          regarding the most important factors influencing their money’s longevity. He
          suggests that advisers start by providing clients with an estimate of the number of years
          their portfolio will last—assuming they continue on the current path—using a
          framework that can be easily understood and communicated.Editor’s note: The author may have a commercial interest in the topics
              discussed in this article.Editor’s note: This article was reviewed and accepted by Executive
              Editor Stephen J. Brown.
Journal: Financial Analysts Journal
Pages: 8-12
Issue: 2
Volume: 72
Year: 2016
Month: 3
X-DOI: 10.2469/faj.v72.n2.4
File-URL: http://hdl.handle.net/10.2469/faj.v72.n2.4
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Author-Name: Tzee-Man Chow
Author-X-Name-First: Tzee-Man
Author-X-Name-Last: Chow
Author-Name: Engin Kose
Author-X-Name-First: Engin
Author-X-Name-Last: Kose
Author-Name: Feifei Li
Author-X-Name-First: Feifei
Author-X-Name-Last: Li
Title: The Impact of Constraints on Minimum-Variance Portfolios
Abstract: 
 Optimized minimum-variance strategies tend to have low liquidity; high turnover; high
     tracking error; and concentrated stock, sector, and country positions. Minimum-variance index
     providers typically mitigate these implementation problems by imposing constraints. The authors
     construct minimum-variance portfolios for the United States, global developed markets, and
     emerging markets and apply commonly used constraints to determine their effect on simulated
     portfolio characteristics, performance, and trading costs. The constraints they test succeed in
     improving investability but shift portfolio characteristics toward those of the
     capitalization-weighted benchmark. In particular, each additional constraint increases
     volatility. Nonetheless, minimum-variance strategies are a valid choice for risk-averse
     investors.The summary was prepared by Mark K. Bhasin, CFA, Basis Investment Group LLC.What’s Inside?The authors focused on the implementation challenges related to optimization-based
      low-volatility strategies. Index providers typically address these implementation challenges
      by applying various constraints in the portfolio construction process. These constraints
      include minimum weight, maximum weight, capacity, sector concentration, regional
      concentration, and turnover. The authors provided insight into the effect of these
      constraints on the portfolio characteristics, performance, and trading costs of
      low-volatility strategies. Their main findings are that constraints help improve
      investability but lead to greater-than-minimal volatility and shift portfolio
      characteristics toward those of the capitalization-weighted (cap-weighted) benchmark.How Is This Research Useful to Practitioners?This research provides investors with a clearer understanding of the potential outcome from
      the investment vehicles available in the marketplace, which may allow them to make better
      investment decisions. By studying the individual and combined effect of constraints
      typically used by major index providers, the authors help investors understand the trade-off
      between investability and performance when implementing low-volatility strategies. This
      research may also enable investors to create customized approaches that suit their needs
      better than index providers’ solutions.In addition, the fact that the authors demonstrated that their findings are fairly
      consistent across international markets makes this research appealing to global active
      investors.How Did the Authors Conduct This Research?The simulations and tests were performed separately for three markets: the United States,
      developed markets (including the United States), and emerging markets. The authors obtained
      historical stock return data from CRSP for the United States (1967–2014) and
      Datastream for international markets (1987–2014). To ensure investability, the
      starting universe in January of each year consisted of the 1,000 stocks with the largest
      market capitalizations as of the prior year-end. For each market, the authors constructed a
      long-only minimum-variance portfolio with an optimization routine under various constraints
      at the beginning of each January and held it for one year, which allowed them to obtain
      several simulated return series. They also constructed cap-weighted portfolios from the same
      starting universes to assess the effect of the various constraints on the structure of the
      minimum-variance portfolios.The constraints imposed on the hypothetical minimum-variance portfolios included minimum
      weight, maximum weight, capacity, sector concentration, regional concentration, and
      turnover. The authors tested the combined effect of these constraints on the investability,
      sectoral, and regional allocations, as well as the performance and risk attribution of the
      minimum-variance portfolios. The results show that the constraints generally lower turnover
      and increase investability. In analyzing performance and risk, the authors explored the
      effect of constraints on the strategies’ market sensitivities to other risk factors,
      including size, value, and momentum. The results show that the constraints push the
      characteristics and performance of minimum-variance portfolios toward the corresponding
      market portfolios. The authors concluded that the fully constrained minimum-variance
      portfolio is a sensible alternative to the cap-weighted benchmark because it offers higher
      risk-adjusted returns in all three markets.The authors also studied the standalone effect of each constraint. They observed that the
      turnover constraint plays an effective role in reducing trading costs, that the capacity and
      turnover constraints are crucial for improving liquidity, and that there is a trade-off
      between liquidity and volatility.In addition, the authors performed several tests to evaluate the robustness of
      minimum-variance strategies in the presence of constraints, including shortening the
      historical period in which the covariance matrix is based, reducing the number of eligible
      stocks, and rebalancing more than once a year.Abstractor’s ViewpointThe simulated minimum-variance portfolios produce higher Sharpe ratios than the
      corresponding cap-weighted benchmarks. Thus, this research seems to confirm that
      risk-adjusted returns can be improved by creating minimum-variance portfolios. However,
      investors should be aware of the trade-offs between investability and performance when
      implementing low-volatility strategies and understand the effect of constraints on the
      portfolio characteristics, performance, and trading costs.Editor’s note: The authors may have a commercial interest in the topics
       discussed in this article.Editor’s note: This article was reviewed and accepted by Executive Editor
       Robert Litterman.
Journal: Financial Analysts Journal
Pages: 52-70
Issue: 2
Volume: 72
Year: 2016
Month: 3
X-DOI: 10.2469/faj.v72.n2.5
File-URL: http://hdl.handle.net/10.2469/faj.v72.n2.5
File-Format: text/html
File-Restriction: Access to full text is restricted to subscribers.
Handle: RePEc:taf:ufajxx:v:72:y:2016:i:2:p:52-70




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Author-Name: Barbara S. Petitt
Author-X-Name-First: Barbara S.
Author-X-Name-Last: Petitt
Title: Editor’s Corner
Journal: Financial Analysts Journal
Pages: 5-6
Issue: 2
Volume: 72
Year: 2016
Month: 3
X-DOI: 10.2469/faj.v72.n2.6
File-URL: http://hdl.handle.net/10.2469/faj.v72.n2.6
File-Format: text/html
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# input file: UFAJ_A_12048323_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Thomas W. Doellman
Author-X-Name-First: Thomas W.
Author-X-Name-Last: Doellman
Author-Name: Sabuhi H. Sardarli
Author-X-Name-First: Sabuhi H.
Author-X-Name-Last: Sardarli
Title: An Investigation of Administrative Fees in Defined Contribution Plans
Abstract: 
 The administration of defined contribution retirement plans is generally outsourced by
          plan sponsors to third-party financial institutions, resulting in two primary types of
          plan fees. Although investment fund fees in defined contribution plans have been heavily
          scrutinized, the administrative fees paid to third-party plan administrators are less well
          understood. The authors highlight the importance of securing fee reimbursements from
          third-party plan administrators to avoid excessive administrative fees, as well as
          situations in which the plan sponsor must be particularly careful to ensure that such
          reimbursements are secured. The authors’ findings have important implications as
          the scrutiny of plan fees intensifies with continued regulatory change.The summary was prepared by Thomas P. Bernardi, CFA.What’s Inside?The authors analyze the effect of plan administrative fees charged by third-party
            administrators (TPAs) on the long-term performance of defined contribution (DC) retirement
            plans. They find that administrative fees do affect long-term plan performance and that plan
            participants should be better informed about these effects. There are ways to reduce
            administrative fees, such as fee reimbursements, that should also be reviewed. TPAs can help
            by educating investors about plan fees and making retirement plan fee structures as
            economically suitable as possible.How Is This Research Useful to Practitioners?The study determines that administrative fees are an “economically
            significant” cost of DC retirement plans. On average, administrative fees account for
            an additional 22 bps in fees annually for each plan. The highest administrative fees reached
            234 bps annually. The authors find that investments in proprietary funds of the TPA had
            significantly lower administrative fees. In contrast, investments in proprietary funds of
            non-TPAs did not lead to lower-than-average administrative fees.The authors look into ways DC retirement plans could reduce overall administrative fees.
            The easiest way is through fee reimbursements. Plans typically receive fee reimbursements
            when mutual funds share a portion of their revenue (i.e., expense ratios) with the TPA. This
            revenue is shared because the TPA will take over some of the responsibilities normally
            attributed to the mutual fund (i.e., recordkeeping). These fee reimbursements should flow
            back into the plan, but it often does not happen. Fund sponsors should be aware of these
            situations because they lead to overcharging plan participants.The authors find that when TPAs provide both the fund administrative services and
            proprietary investment funds, fee reimbursement is the highest. They observed that TPAs,
            such as Vanguard and Fidelity, provided higher reimbursements than others.The study and findings are beneficial to TPAs, plan sponsors, and plan participants. All
            parties involved should be aware of options to reduce costs that ultimately harm plan
            participants. TPAs and plan sponsors should work together to educate plan participants on
            the various aspects of the investment funds available, including fees and reimbursements, if
            applicable. Plan participants should also educate themselves, beyond what is provided by the
            TPAs and sponsors, to be aware of how their assets are being invested.How Did the Authors Conduct This Research?The authors use a BrightScope database to gather information about 6,809 401(k) plans at
            the end of 2007. The database provides such metrics as balances, investment fund options,
            investment fund fees, administrative fees, and plan sponsor and TPA information. The authors
            focus on DC retirement plans in which plan participants pay the administrative fees. More
            than half of the plans provide investment funds from one single fund family. When plans have
            a TPA that also provides proprietary funds, almost 90% of those plans invest in the funds of
            the TPA.Regressions are run for a variety of variables to determine which factors lead to lower
            administrative fees and higher fee reimbursements. It is within these regressions that the
            authors find that administrative fees posed a significant cost to plan participants. They
            also analyze the performance of various funds and whether higher expense ratios were offset
            by superior performance (which was not the case).Abstractor’s ViewpointThe study is timely in the current low-fee-focused environment. There have been many
            studies on investment fund fees and their effect on long-term portfolio performance. This
            study opens another part of the fee discussion with the introduction of administrative fees.
            As the authors note, administrative fees, on average, cost funds 22 bps annually, which has
            an economically significant effect on fund performance over the long run. It is important
            for sponsors to be cognizant of all costs, including administrative fees, and any
            reimbursement or cost-saving opportunities available. It is of equal importance for plan
            participants to be educated in the investments and their costs. This burden should be placed
            on all three parties involved: administrators, sponsors, and participants.An additional research development would be to expand the sample outside the realm of DC
            retirement plans and to provide international evidence to help continue the discussion about
            the role administrative fees play in plan management.Editor’s note: This article was reviewed and accepted by Executive
              Editor Robert Litterman.
Journal: Financial Analysts Journal
Pages: 41-51
Issue: 2
Volume: 72
Year: 2016
Month: 3
X-DOI: 10.2469/faj.v72.n2.7
File-URL: http://hdl.handle.net/10.2469/faj.v72.n2.7
File-Format: text/html
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Author-Name: Jeremy J. Siegel
Author-X-Name-First: Jeremy J.
Author-X-Name-Last: Siegel
Title: The Shiller CAPE Ratio: A New Look
Abstract: 
 Robert Shiller’s cyclically adjusted price–earnings ratio, or CAPE ratio, has
     served as one of the best forecasting models for long-term future stock returns. But recent
     forecasts of future equity returns using the CAPE ratio may be overpessimistic because of
     changes in the computation of GAAP earnings (e.g., “mark-to-market” accounting)
     that are used in the Shiller CAPE model. When consistent earnings data, such as NIPA (national
     income and product account) after-tax corporate profits, are substituted for GAAP earnings, the
     forecasting ability of the CAPE model improves and forecasts of US equity returns increase
     significantly.The summary was prepared by Mark K. Bhasin, CFA, Basis Investment Group LLC.How Did the Author Conduct This Research?The author performs regressions on the CAPE ratio using three measures of earnings. He
      plots the CAPE ratio from 1881 through 2014, which shows that the model explains about
      one-third of the movement in future 10-year real stock returns. He also plots after-tax per
      share earnings for S&P reported earnings, S&P operating earnings, and NIPA real
      after-tax corporate profits as published in the NIPAs. The latter plot shows that sharp
      declines of S&P reported earnings have increased significantly since 1991.To show that the volatility of S&P reported earnings has increased significantly in the
      last three business cycles, the author reports earnings declines in recessions from 1929 to
      2014. In the last three recessions (1990, 2001, and 2008–2009), S&P reported
      earnings decreased by more than twice as much as NIPA corporate profits. The author points
      out that the change in the computation of S&P reported earnings has resulted in a shift
      from understating earnings declines during economic downturns to significantly overstating
      them.The author concludes that using NIPA corporate profits instead of the S&P reported
      earnings produces higher projected stock market returns.Abstractor’s ViewpointThe CAPE ratio is used by finance practitioners in an attempt to gauge the S&P
      500’s level of valuation. The author convincingly argues that changes in US
      accounting standards have led to an overstatement of earnings declines in recessions and an
      artificially high CAPE ratio. Given the current popularity of the CAPE ratio by finance
      practitioners and the media, the author’s research demonstrates that further analysis
      is required to successfully use this ratio for investment purposes.Editor’s note: The article was reviewed and accepted by Executive
      Editor Robert Litterman.
Journal: Financial Analysts Journal
Pages: 41-50
Issue: 3
Volume: 72
Year: 2016
Month: 5
X-DOI: 10.2469/faj.v72.n3.1
File-URL: http://hdl.handle.net/10.2469/faj.v72.n3.1
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# input file: UFAJ_A_12048326_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Marielle de Jong
Author-X-Name-First: Marielle
Author-X-Name-Last: de Jong
Author-Name: Anne Nguyen
Author-X-Name-First: Anne
Author-X-Name-Last: Nguyen
Title: Weathered for Climate Risk: A Bond Investment Proposition
Abstract: 
 With scientific evidence regarding the contribution of carbon emissions to global warming
     mounting, pressure is building for corrective policy actions. The potential for such policies
     poses a risk for invested capital. We describe how bond investors using traditional portfolio
     construction techniques can hedge portfolios against this climate risk without introducing
     unintended exposures that could sacrifice the portfolio’s benchmark-tracking properties.
     We hypothesize how a pickup in low-carbon investing may send out a pricing signal and preempt
     the connoted price correction. In that event, the transition toward a world economy with a
     sustainable level of carbon pollution would be accelerated, which would be beneficial for both
     the low-carbon investor and the environment.The summary was prepared by Sandra Krueger, CFA.What’s Inside?Government policies relating to climate change may affect the value of carbon-intensive
      issuers, such as utilities and energy companies. Research by Andersson, Bolton, and Samama
      (Financial Analysts Journal 2016) on equity markets suggests that at the
      end of 2014, climate change risk was probably not fully priced yet. But credit rating
      agencies, such as Standard & Poor’s and Moody’s, are expressing concern,
      and general awareness is growing. The authors extend climate risk research into fixed-income
      portfolio management and use traditional portfolio construction techniques that
      “decarbonise” corporate bond portfolios by reducing the portfolio’s
      exposure to carbon-intensive issuers.How Is This Research Useful to Practitioners?With interest rates currently at such a low level, capital preservation is a priority for
      investors. It is difficult to forecast the extent or duration of the effect that potential
      government climate policies may have on financial markets. But if, as the authors claim, the
      carbon footprint of a fixed-income portfolio can be lowered by 50% without sacrificing the
      portfolio’s benchmark-tracking properties, investment committees may consider
      implementing this type of strategy.Considering climate risk in the investment decision-making process can create a
      win–win situation in which investments are protected and industries are incentivized
      to reduce carbon emissions.How Did the Authors Conduct This Research?The authors construct two portfolios to track a corporate bond index: one regular
      index-tracking portfolio and one low-carbon portfolio. They gather data from January 2011 to
      December 2014 for the index constituents, such as monthly total returns, index weights,
      modified durations, credit spreads, countries, and sectors, as well as carbon-intensity
      scores.The screening process to build the low-carbon portfolio begins by selecting bonds with the
      highest duration times spread (DTS) and/or highest weight in the index. Next, the authors
      run an algorithm that iteratively examines pairwise combinations of bonds within a
      stratified sector, making adjustments in their relative weights to improve the DTS match
      with their sector. Finally, bonds are screened and chosen based on their carbon-saving
      score, which is the inverse of their carbon-intensity score. Because there may be conflicts
      between the carbon reduction target and the DTS fit, the authors calibrate the test to
      uncover whether carbon intensity could be lowered by 50% or more without sacrificing
      tracking error volatility versus the index.The biggest reduction in carbon intensity came in the heavy industries, such as utilities
      and cement producers. The authors note that the most carbon-intensive companies in the index
      are not necessarily excluded from the low-carbon index-tracking portfolio because a
      company’s market weight in the index is taken into consideration to minimize tracking
      risk.The authors provide tracking performance results for the regular index-tracking portfolio
      and the low-carbon portfolio. They show that the low-carbon portfolio reduces carbon
      intensity between 55% and 65%, but it produces almost the same tracking error as the regular
      index-tracking portfolio.Abstractor’s ViewpointClimate policy changes have been shown to reduce portfolio returns. After the carbon tax
      was enacted in Australia in 2011, the stock prices of some major carbon emitters dropped by
      around 6%. Such headlines as “Billions Wiped from Blue Chips as Carbon Tax Hits
      Australia” and voter displeasure led to negative perceptions and the eventual repeal
      of the carbon tax.This research offers a potential solution to fixed-income investors who need to manage
      downside climate risk. Although three years of data are not enough to draw any conclusions,
      the authors describe a methodology to partially eliminate carbon risk while maintaining a
      target tracking error. It is useful reading for asset managers who generally benchmark their
      fixed-income portfolios but seek protection from this complex risk.Editor’s note: The authors’ firm may have a commercial interest in the
       topics discussed in this article. Editor’s note: This article was reviewed and accepted by Executive Editor
       Stephen J. Brown.Authors’ note: The views expressed in this article are those of the authors
       and do not necessarily reflect those of Amundi.
Journal: Financial Analysts Journal
Pages: 34-39
Issue: 3
Volume: 72
Year: 2016
Month: 5
X-DOI: 10.2469/faj.v72.n3.2
File-URL: http://hdl.handle.net/10.2469/faj.v72.n3.2
File-Format: text/html
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Author-Name: Ari Levine
Author-X-Name-First: Ari
Author-X-Name-Last: Levine
Author-Name: Lasse Heje Pedersen
Author-X-Name-First: Lasse Heje
Author-X-Name-Last: Pedersen
Title: Which Trend Is Your Friend?
Abstract: 
 Managed futures funds and commodity trading advisers (CTAs) use heuristics or statistical
     measures often called “filters” to trade on price trends. Two key statistical
     measures of trends are “time-series momentum” and “moving-average
     crossovers.” We show, empirically and theoretically, that these trend indicators are
     closely related. In fact, they are equivalent representations in their most general forms. They
     also capture many other types of filters, such as the Hodrick–Prescott (HP) filter, the
     Kalman filter, and all other linear filters. We show how these filters can be represented
     through “trend signature plots,” demonstrating their dependence on past prices and
     returns by horizon.The summary was prepared by Pamela G. Yang, CFA.What’s Inside?The trend-following investment strategy is a widely practiced investment style, especially
      for futures, commodities, and hedge fund traders. Trend indicators rely on past prices and
      returns. On an empirical and a theoretical basis, generalized forms of different trend-based
      investment strategies are closely related. The authors use two key statistical measures to capture trends: the time-series momentum
      (TSMOM) method, which shows the return over some recent time period, and
      the moving-average crossover (MACROSS) method, which shows different price
      levels over different time periods. The academic literature and practitioners have put forth
      a host of strategies that, on the surface, appear unique but are all related to trend
      following at a high level. The authors seek to unify many of these seemingly disparate
      strategies in a simple, robust, and intuitive framework.How Is This Research Useful to Practitioners?Momentum investors like to follow trends. Trend strategy is intuitive and based on the
      belief that trends are likely to continue. Understanding how to identify a price trend is
      essential for investors. Day-to-day price changes can be noisy, and the random walk
      hypothesis suggests that future price moves are completely unpredictable and that
      trend-following strategies should not work. Nevertheless, trend-following investors believe
      that markets are not completely efficient and that risk premiums change over time; thus,
      under certain circumstances, trend following may add value.A TSMOM signal, on one hand, shows the return over some recent time period. To simplify
      with an example, assume that investing in gold has resulted in a positive return over the
      past 12 months. The trend is assessed to be upward, and the TSMOM signals to buy gold. On
      the other hand, a MACROSS signal shows the crossover of two moving averages, a fast-moving
      average that puts more weight on recent prices and a slow-moving average that puts more
      weight on past prices. In our example, assume that the moving average of gold prices over
      the past 20 days crosses over the moving average of gold prices over the past 260 days. As
      recent prices are above where prices used to be, the trend is assessed to be upward, and
      MACROSS signals to buy gold.The authors examine both methods packaged in various ways and demonstrate that the most
      general form of MACROSS can be viewed as a special case of the most general form of TSMOM,
      and vice versa. They further demonstrate that a large set of linear filters—for
      example, the Hodrick–Prescott filter, the Kalman filter, or any other trend estimation
      using an ordinary least-squares trend regression—are equivalent to a generalized TSMOM
      or MACROSS signal. In conclusion, TSMOM and MACROSS filters capture prominently all of the
      other filters and features in applications.How Did the Authors Conduct This Research?The authors show, via detailed mathematical formulas with variations and different
      combinations of coefficients, how TSMOM and MACROSS work. They illustrate how each trend
      signal can be represented graphically using trend signature plots based on either past
      prices (MACROSS) or past returns (TSMOM). The conclusion is that TSMOM and MACROSS are
      essentially equivalent.To support this conclusion, the authors perform an empirical study that relies on 58
      instruments ranging from currency pairs to commodity futures and covers prices from 1985 to
      2015. They calculate signals from a return index rather than from prices by rolling futures
      and forward prices. They construct three standard TSMOM strategies and three standard
      MACROSS strategies that are relatively comparable. To put the trading signals on an equal footing, the authors use the same portfolio
      construction methodology for signals related to both strategies. The result is that both
      strategies perform similarly for all horizons, including in terms of annual returns (excess
      of cash), annualized volatility, and Sharpe ratios. However, some deviations are observed.
      For example, the authors note the positive significance in the alphas of some of the TSMOM
      signals when they are regressed on the MACROSS signals, which may simply mean that MACROSS
      signals have a harder time mimicking a TSMOM signal. The reverse is not true because the
      shape of TSMOM signals more easily fit an arbitrary MACROSS signal.Abstractor’s ViewpointTrend or momentum trading versus valuation trading has always separated investors into two
      camps. Over the long run, both strategies may deliver similar results, although each may add
      value at different stages. This study focuses on momentum trading and may not generate much
      interest from valuation investors. However, for those who are trend followers, this research
      shows that various measures to capture trends are, in essence, merely variations of one
      another and do not affect outcomes materially. Although common implementations of these
      trend signals may not be exactly the same in practice, the authors’ findings confirm
      that no matter what methodology investors use to identify trends, they will not stray far
      from the trend as long as they have a robust and disciplined implementation.Editor’s note: This article was reviewed and accepted by Executive Editor
       Stephen J. Brown.Editor’s note: Both authors are affiliated with AQR, a global investment
       management firm running long-only and alternative investment products, including managed
       futures funds.
Journal: Financial Analysts Journal
Pages: 51-66
Issue: 3
Volume: 72
Year: 2016
Month: 5
X-DOI: 10.2469/faj.v72.n3.3
File-URL: http://hdl.handle.net/10.2469/faj.v72.n3.3
File-Format: text/html
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Author-Name: Mats Andersson
Author-X-Name-First: Mats
Author-X-Name-Last: Andersson
Author-Name: Patrick Bolton
Author-X-Name-First: Patrick
Author-X-Name-Last: Bolton
Author-Name: Frédéric Samama
Author-X-Name-First: Frédéric
Author-X-Name-Last: Samama
Title: Hedging Climate Risk
Abstract: 
 We present a simple dynamic investment strategy that allows long-term passive investors to
     hedge climate risk without sacrificing financial returns. We illustrate how the tracking error
     can be virtually eliminated even for a low-carbon index with 50% less carbon footprint than its
     benchmark. By investing in such a decarbonized index, investors in effect are holding a
     “free option on carbon.” As long as climate change mitigation actions are pending,
     the low-carbon index obtains the same return as the benchmark index; but once carbon dioxide
     emissions are priced, or expected to be priced, the low-carbon index should start to outperform
     the benchmark.Editor’s note: The views expressed in this article are those of the authors
       and do not necessarily reflect the views of the Amundi Group, AP4, or MSCI.Editor’s note: This article was reviewed and accepted by Executive Editor
       Stephen J. Brown and Executive Editor Robert Litterman.
Journal: Financial Analysts Journal
Pages: 13-32
Issue: 3
Volume: 72
Year: 2016
Month: 5
X-DOI: 10.2469/faj.v72.n3.4
File-URL: http://hdl.handle.net/10.2469/faj.v72.n3.4
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Author-Name: Stephen J. Brown
Author-X-Name-First: Stephen J.
Author-X-Name-Last: Brown
Title: Climate Risk
Journal: Financial Analysts Journal
Pages: 9-10
Issue: 3
Volume: 72
Year: 2016
Month: 5
X-DOI: 10.2469/faj.v72.n3.5
File-URL: http://hdl.handle.net/10.2469/faj.v72.n3.5
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Author-Name: Stephen J. Brown
Author-X-Name-First: Stephen J.
Author-X-Name-Last: Brown
Author-Name: Barbara S. Petitt
Author-X-Name-First: Barbara S.
Author-X-Name-Last: Petitt
Title: 2015 Report to Readers
Journal: Financial Analysts Journal
Pages: 5-6
Issue: 3
Volume: 72
Year: 2016
Month: 5
X-DOI: 10.2469/faj.v72.n3.6
File-URL: http://hdl.handle.net/10.2469/faj.v72.n3.6
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Author-Name: Attilio Meucci
Author-X-Name-First: Attilio
Author-X-Name-Last: Meucci
Author-Name: Angela Loregian
Author-X-Name-First: Angela
Author-X-Name-Last: Loregian
Title: Neither “Normal” nor “Lognormal”: Modeling Interest Rates across All Regimes
Abstract: 
 We introduce a simple approach to managing portfolio interest rate risk that is consistent
     and performs well across different interest rate regimes, including when interest rates are low
     or even negative. Inspired by Fischer Black, this approach uses a novel “inverse-call
     transformation” methodology to convert interest rates into “shadow rates.”
     We show that this methodology is more appropriate than the standard “normal” and
     “lognormal” models for forecasting and managing the distribution of the profits
     and losses of portfolios affected by the term structure of interest rates, producing more
     reliable forecasts and thus risk estimates for purposes of both internal and regulatory risk
     management.Editor’s note: This article was reviewed and accepted by Executive Editor
       Stephen J. Brown and Executive Editor Robert Litterman.
Journal: Financial Analysts Journal
Pages: 68-82
Issue: 3
Volume: 72
Year: 2016
Month: 5
X-DOI: 10.2469/faj.v72.n3.7
File-URL: http://hdl.handle.net/10.2469/faj.v72.n3.7
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# input file: UFAJ_A_12048333_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jean-François L’Her
Author-X-Name-First: Jean-François
Author-X-Name-Last: L’Her
Author-Name: Rossitsa Stoyanova
Author-X-Name-First: Rossitsa
Author-X-Name-Last: Stoyanova
Author-Name: Kathryn Shaw
Author-X-Name-First: Kathryn
Author-X-Name-Last: Shaw
Author-Name: William Scott
Author-X-Name-First: William
Author-X-Name-Last: Scott
Author-Name: Charissa Lai
Author-X-Name-First: Charissa
Author-X-Name-Last: Lai
Title: A Bottom-Up Approach to the Risk-Adjusted Performance of the Buyout Fund Market
Abstract: 
 We use the Burgiss dataset to study private equity buyout fund performance. Our findings
          on performance before risk adjustments are consistent with those in the literature and
          indicate significant outperformance of buyout fund investments. Using a bottom-up
          approach, we identify the systematic risks of underlying companies in buyout funds to
          inform an appropriate risk-adjusted benchmark, which we determine to be a levered size-
          and sector-adjusted public index. After making these risk adjustments, we find no
          significant outperformance of buyout fund investments versus the public market equivalent
          on a dollar-weighted basis. We contend that even without significant risk-adjusted
          outperformance, buyout funds can play a valuable role in institutional investors’
          portfolios.Editor’s note: This article was reviewed and accepted by Robert
            Litterman, executive editor at the time the article was submitted.Authors’ note: Because this article was prepared by the authors
            in their personal rather than organizational capacities, the views expressed in this
            article are those of the authors alone and do not necessarily reflect the positions of
            either the Abu Dhabi Investment Authority (ADIA) or the Canada Pension Plan Investment
            Board (CPPIB) nor their policies and practices. Although the authors have taken every
            care to ensure that the information contained in this article is true and correct at the
            time of publication, neither the authors, the ADIA, nor the CPPIB make any
            representation or warranty with respect to the accuracy or completeness of this
            article.
Journal: Financial Analysts Journal
Pages: 36-48
Issue: 4
Volume: 72
Year: 2016
Month: 7
X-DOI: 10.2469/faj.v72.n4.1
File-URL: http://hdl.handle.net/10.2469/faj.v72.n4.1
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Author-Name: Antti Petajisto
Author-X-Name-First: Antti
Author-X-Name-Last: Petajisto
Title: Author Response to “Deactivating Active Share”
Abstract: 
 This material comments on “Deactivating Active Share”. (March/April
          2016).
Journal: Financial Analysts Journal
Pages: 11-12
Issue: 4
Volume: 72
Year: 2016
Month: 7
X-DOI: 10.2469/faj.v72.n4.2
File-URL: http://hdl.handle.net/10.2469/faj.v72.n4.2
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# input file: UFAJ_A_12048335_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Claude B. Erb
Author-X-Name-First: Claude B.
Author-X-Name-Last: Erb
Author-Name: Campbell R. Harvey
Author-X-Name-First: Campbell R.
Author-X-Name-Last: Harvey
Title: Conquering Misperceptions about Commodity Futures Investing
Abstract: 
 Long-only commodity futures returns have been very disappointing over the last decade,
          leading some to wonder whether investing in commodities was a mistake. The poor
          performance is largely the result of poor “income returns,” a return building
          block similar to a stock’s dividend yield or a bond’s yield. Three
          misperceptions have contributed to this disappointment: (1) Commodities are a play on
          commodity prices, (2) commodity prices provide an inflation hedge, and (3) commodity
          markets, which are smaller than Facebook’s market capitalization, can absorb
          abundant capital. Learning from mistakes and conquering misperceptions are key to becoming
          a better investor.Editor’s note: This article was reviewed and accepted by Executive Editor Stephen J.
            Brown
Journal: Financial Analysts Journal
Pages: 26-35
Issue: 4
Volume: 72
Year: 2016
Month: 7
X-DOI: 10.2469/faj.v72.n4.3
File-URL: http://hdl.handle.net/10.2469/faj.v72.n4.3
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Author-Name: Stephen J. Brown
Author-X-Name-First: Stephen J.
Author-X-Name-Last: Brown
Title: In Memoriam: Jack Treynor
Journal: Financial Analysts Journal
Pages: 5-6
Issue: 4
Volume: 72
Year: 2016
Month: 7
X-DOI: 10.2469/faj.v72.n4.4
File-URL: http://hdl.handle.net/10.2469/faj.v72.n4.4
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Author-Name: Martin Leibowitz
Author-X-Name-First: Martin
Author-X-Name-Last: Leibowitz
Author-Name: Andrew W. Lo
Author-X-Name-First: Andrew W.
Author-X-Name-Last: Lo
Author-Name: Robert C. Merton
Author-X-Name-First: Robert C.
Author-X-Name-Last: Merton
Author-Name: Stephen A. Ross
Author-X-Name-First: Stephen A.
Author-X-Name-Last: Ross
Author-Name: Jeremy Siegel
Author-X-Name-First: Jeremy
Author-X-Name-Last: Siegel
Title: Q Group Panel Discussion: Looking to the Future
Abstract: 
 At the Q Group (the Institute for Quantitative Research in Finance) Spring Seminar, held
          17–20 April 2016, Martin Leibowitz moderated a discussion of the important issues in
          finance by panelists Andrew W. Lo, Robert C. Merton, Stephen A. Ross, and Jeremy
          Siegel.Editor’s note: We wish to thank the Q Group for allowing us to
            publish an edited version of this panel discussion, held 19 April 2016, and thus making
            the panelists’ comments available to a wide audience.
Journal: Financial Analysts Journal
Pages: 17-25
Issue: 4
Volume: 72
Year: 2016
Month: 7
X-DOI: 10.2469/faj.v72.n4.5
File-URL: http://hdl.handle.net/10.2469/faj.v72.n4.5
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Author-Name: Jennifer Conrad
Author-X-Name-First: Jennifer
Author-X-Name-Last: Conrad
Author-Name: Jonathan Karpoff
Author-X-Name-First: Jonathan
Author-X-Name-Last: Karpoff
Author-Name: Craig Lewis
Author-X-Name-First: Craig
Author-X-Name-Last: Lewis
Author-Name: Jay R. Ritter
Author-X-Name-First: Jay R.
Author-X-Name-Last: Ritter
Title: Statement of the Financial Economists Roundtable: Crowdfunding
Abstract: 
 The Financial Economists Roundtable, a group of distinguished senior financial
          economists, discusses current issues and future developments in the crowdfunding market
          and offers suggestions regarding the regulation of the industry.Editor’s note: This article was reviewed and accepted by Executive Editor
              Stephen J. Brown.Authors’ note: This statement is an outcome of the Financial Economists
              Roundtable discussion at its annual meeting on 18–20 July 2015 in
            Vancouver, British Columbia, Canada. It reflects a consensus of more than
              two-thirds of the attending members. Although the statement provides suggestions to
              the US Securities and Exchange Commission (SEC) for how to improve crowdfunding, the
              issues involved affect crowdfunding throughout the world. If adopted, these
              suggestions would improve crowdfunding globally.
Journal: Financial Analysts Journal
Pages: 14-16
Issue: 4
Volume: 72
Year: 2016
Month: 7
X-DOI: 10.2469/faj.v72.n4.6
File-URL: http://hdl.handle.net/10.2469/faj.v72.n4.6
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Author-Name: Jack L. Treynor
Author-X-Name-First: Jack L.
Author-X-Name-Last: Treynor
Title: Long-Term Investing
Abstract: 
 We are reprinting this article by Jack Treynor, which first appeared in the May/June 1976 issue, as a companion to Stephen
      J. Brown’s Editor’s Corner about Treynor’s legacy. Treynor
     distinguishes between ideas whose implications are obvious and consequently travel quickly and
     ideas that require reflection, judgment, and special expertise for their evaluation and
     consequently travel slowly. According to Treynor, the second kind of idea is the only
     meaningful basis for “long-term investing.”Reprinted from Financial Analysts Journal, vol. 32, no. 3 (May/June
       1976): 56–59. 
Journal: Financial Analysts Journal
Pages: 7-10
Issue: 4
Volume: 72
Year: 2016
Month: 7
X-DOI: 10.2469/faj.v72.n4.7
File-URL: http://hdl.handle.net/10.2469/faj.v72.n4.7
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Author-Name: Mila Getmansky
Author-X-Name-First: Mila
Author-X-Name-Last: Getmansky
Author-Name: Giulio Girardi
Author-X-Name-First: Giulio
Author-X-Name-Last: Girardi
Author-Name: Craig Lewis
Author-X-Name-First: Craig
Author-X-Name-Last: Lewis
Title: Interconnectedness in the CDS Market
Abstract: 
 Concentrated risks in the market for credit default swaps (CDSs) are widely considered to
     have contributed significantly to the 2007–08 financial crisis. We examine the structure
     of the CDS market using a network-based approach that allows us to capture the
     interconnectedness between dealers and nondealers of CDS contracts. We find a high degree of
     interconnectivity among major market participants. Our work helps assess the stability of the
     CDS market and the potential contagion among market participants. Our findings are of practical
     importance because even after central clearing becomes mandatory, counterparty risk will remain
     a relevant systemic consideration owing to the long-term nature of CDS contracts.Editor’s note: This article was reviewed and accepted by Robert Litterman,
       executive editor at the time the article was submitted.Authors’ note: All three authors worked at the US Securities and Exchange
       Commission when they wrote this article. As a matter of policy, the SEC disclaims
       responsibility for any private publication or statement of any of its employees. The views
       expressed herein are those of the authors and do not necessarily reflect the views of the SEC
       or of the authors’ colleagues on the staff of the SEC.
Journal: Financial Analysts Journal
Pages: 62-82
Issue: 4
Volume: 72
Year: 2016
Month: 7
X-DOI: 10.2469/faj.v72.n4.8
File-URL: http://hdl.handle.net/10.2469/faj.v72.n4.8
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Author-Name: Eitan Goldman
Author-X-Name-First: Eitan
Author-X-Name-Last: Goldman
Author-Name: Zhenzhen Sun
Author-X-Name-First: Zhenzhen
Author-X-Name-Last: Sun
Author-Name: Xiyu (Thomas)  Zhou
Author-X-Name-First: Xiyu (Thomas)
Author-X-Name-Last:  Zhou
Title: The Effect of Management Design on the Portfolio Concentration and Performance of Mutual Funds
Abstract: 
 We show that the performance of actively managed equity mutual funds increases when
     portfolios are concentrated in the top one or two stocks within each industry sector. Funds
     managed by a single manager have much more concentrated portfolios, tend to perform better, and
     have higher expense ratios than funds managed by multiple managers. We observe that when a
     fund’s management design is changed from single manager to multiple managers, the
     portfolio’s within- and cross-sector concentration, performance, and expense ratios
     decrease.Editor’s note: This article was reviewed and accepted by Robert
      Litterman, executive editor at the time the article was submitted.Editor’s note: This article was reviewed via our double-blind peer review
       process. When the article was accepted for publication, the authors thanked the reviewers in
       their acknowledgments, and the reviewers were asked whether they agreed to be identified in
       the authors’ acknowledgments. Robin Braun and Joseph Chen were the reviewers for this
       article.
Journal: Financial Analysts Journal
Pages: 49-61
Issue: 4
Volume: 72
Year: 2016
Month: 7
X-DOI: 10.2469/faj.v72.n4.9
File-URL: http://hdl.handle.net/10.2469/faj.v72.n4.9
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Author-Name: Christopher C. Geczy
Author-X-Name-First: Christopher C.
Author-X-Name-Last: Geczy
Author-Name: Mikhail Samonov
Author-X-Name-First: Mikhail
Author-X-Name-Last: Samonov
Title: Two Centuries of Price-Return Momentum
Abstract: 
 Having created a monthly dataset of US security prices between 1801 and 1926, we conduct
     out-of-sample tests of price-return momentum strategies that have been implemented in the
     post-1925 datasets. The additional time-series data strengthen the evidence that price momentum
     is dynamically exposed to market risk, conditional on the sign and duration of the trailing
     market state. On average, in the beginning of positive market states, momentum’s equity
     beta is opposite to the new market direction, which generates a negative contribution to
     momentum profits around market turning points. A dynamically hedged momentum strategy
     significantly outperforms the unhedged strategy.Editor’s note: This article was reviewed and accepted by Executive Editor
       Stephen J. Brown.Authors’ note: We make frequent use of factor models that include momentum
       (the topic of this article) in our asset management, consulting, and other activities at
       Forefront Analytics and GKFO.
Journal: Financial Analysts Journal
Pages: 32-56
Issue: 5
Volume: 72
Year: 2016
Month: 9
X-DOI: 10.2469/faj.v72.n5.1
File-URL: http://hdl.handle.net/10.2469/faj.v72.n5.1
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Author-Name: Joanne M. Hill
Author-X-Name-First: Joanne M.
Author-X-Name-Last: Hill
Title: The Evolution and Success of Index Strategies in ETFs
Abstract: 
 Taking issue with John Bogle’s description of how investors use index strategies
          that are based on exchange-traded funds (ETFs), I explain why and how ETFs are a
          significant innovation propelling further growth in indexing with respect to both tactical
          and strategic investment strategies for institutional and retail investors.
Journal: Financial Analysts Journal
Pages: 8-13
Issue: 5
Volume: 72
Year: 2016
Month: 9
X-DOI: 10.2469/faj.v72.n5.2
File-URL: http://hdl.handle.net/10.2469/faj.v72.n5.2
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Author-Name: Ivo Welch
Author-X-Name-First: Ivo
Author-X-Name-Last: Welch
Title: The (Time-Varying) Importance of Disaster Risk
Abstract: 
 How much of the historical 7% per year equity risk premium could have been risk compensation
     for disasters that just happened not to have occurred? The answer can be found in
     below-the-money put prices, which would have protected against such disasters. Using the cost
     of rolling over one-month index put options, I show that the maximum possible premium for crash
     risk could not have accounted for more than about 2% per year, thus leaving about 5%
     per year for reasons other than sudden disasters. I also provide a novel “conservative
     diffuse prior” approach for dealing with black swan risk.Editor’s note: This article was reviewed and accepted by Robert
      Litterman, executive editor at the time the article was submitted. 
Journal: Financial Analysts Journal
Pages: 14-30
Issue: 5
Volume: 72
Year: 2016
Month: 9
X-DOI: 10.2469/faj.v72.n5.3
File-URL: http://hdl.handle.net/10.2469/faj.v72.n5.3
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Author-Name: Bob Greer
Author-X-Name-First: Bob
Author-X-Name-Last: Greer
Title: “Conquering Misperceptions about Commodity Futures Investing”: A Comment
Abstract: 
 This material comments on “Conquering Misperceptions about Commodity Futures Investing”
        (July/August).
Journal: Financial Analysts Journal
Pages: 5-5
Issue: 5
Volume: 72
Year: 2016
Month: 9
X-DOI: 10.2469/faj.v72.n5.4
File-URL: http://hdl.handle.net/10.2469/faj.v72.n5.4
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Author-Name: Claude B. Erb
Author-X-Name-First: Claude B.
Author-X-Name-Last: Erb
Author-Name: Campbell R. Harvey
Author-X-Name-First: Campbell R.
Author-X-Name-Last: Harvey
Title: “Conquering Misperceptions about Commodity Futures Investing”: Author Response
Abstract: 
 This material comments on This material comments on “Conquering Misperceptions about Commodity Futures Investing”
          (July/August).
Journal: Financial Analysts Journal
Pages: 5-6
Issue: 5
Volume: 72
Year: 2016
Month: 9
X-DOI: 10.2469/faj.v72.n5.5
File-URL: http://hdl.handle.net/10.2469/faj.v72.n5.5
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Author-Name: Noah Beck
Author-X-Name-First: Noah
Author-X-Name-Last: Beck
Author-Name: Jason Hsu
Author-X-Name-First: Jason
Author-X-Name-Last: Hsu
Author-Name: Vitali Kalesnik
Author-X-Name-First: Vitali
Author-X-Name-Last: Kalesnik
Author-Name: Helge Kostka
Author-X-Name-First: Helge
Author-X-Name-Last: Kostka
Title: Will Your Factor Deliver? An Examination of Factor Robustness and Implementation Costs
Abstract: 
 The multifactor investing framework has become very popular in the indexing community. Both
     academic and practitioner researchers have documented hundreds of equity factors. But which of
     these factors are likely to profit investors once implemented? We find that many of the
     documented factors lack robustness. Size and quality, two of the more prominent factors, show
     weak robustness, whereas value, momentum, illiquidity, and low beta are more robust. Further
     examining implementation characteristics, we find that liquidity-demanding factors, such as
     illiquidity and momentum, are associated with significantly higher trading costs than are other
     factors. Investors may be better off accessing these factors through active management rather
     than indexation. Editor’s note: This article was reviewed and accepted by Executive
      Editor Stephen J. Brown.
Journal: Financial Analysts Journal
Pages: 58-82
Issue: 5
Volume: 72
Year: 2016
Month: 9
X-DOI: 10.2469/faj.v72.n5.6
File-URL: http://hdl.handle.net/10.2469/faj.v72.n5.6
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Author-Name: Cameron Truong
Author-X-Name-First: Cameron
Author-X-Name-Last: Truong
Author-Name: Philip B. Shane
Author-X-Name-First: Philip B.
Author-X-Name-Last: Shane
Author-Name: Qiuhong Zhao
Author-X-Name-First: Qiuhong
Author-X-Name-Last: Zhao
Title: Information in the Tails of the Distribution of Analysts’ Quarterly Earnings Forecasts
Abstract: 
 Investors generally measure earnings announcement news on the basis of the difference between
     actual earnings and two salient benchmarks: earnings in the same quarter the previous year and
     a consensus drawn from a distribution of forecasts by financial analysts. We evaluate the
     implications of a third salient benchmark: the most optimistic forecast when actual earnings
     exceed the consensus and the most pessimistic forecast when the consensus exceeds actual
     earnings. We find that considering the information in these tails of the distribution of
     analysts’ earnings forecasts enhances the profitability of post–earnings
     announcement drift strategies.Editor’s note: This article was reviewed and accepted by Robert
      Litterman, executive editor at the time the article was submitted.
Journal: Financial Analysts Journal
Pages: 84-99
Issue: 5
Volume: 72
Year: 2016
Month: 9
X-DOI: 10.2469/faj.v72.n5.7
File-URL: http://hdl.handle.net/10.2469/faj.v72.n5.7
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Author-Name: C. Mitchell Conover
Author-X-Name-First: C. Mitchell
Author-X-Name-Last: Conover
Author-Name: Gerald R. Jensen
Author-X-Name-First: Gerald R.
Author-X-Name-Last: Jensen
Author-Name: Marc W. Simpson
Author-X-Name-First: Marc W.
Author-X-Name-Last: Simpson
Title: What Difference Do Dividends Make?
Abstract: 
 We evaluate the investment benefits of dividend-paying stocks and identify three major
          findings. First, high-dividend payers have the least risk yet return over 1.5% more per
          year than do nondividend payers. Second, the benefit of targeting dividend payers is
          conditional on investment style. Surprisingly, the benefit is largest for growth and
          small-cap stocks, the stocks of companies usually thought to benefit the most from
          reinvesting their cash flows. Third, long–short managers exploiting the value
          premium should focus on non-dividend-paying stocks as non-dividend-paying small-cap value
          stocks return 1% more per month than do non-dividend-paying small-cap growth stocks.Editor’s note: This article was reviewed and accepted by Robert
              Litterman, executive editor at the time the article was submitted.
Journal: Financial Analysts Journal
Pages: 28-40
Issue: 6
Volume: 72
Year: 2016
Month: 11
X-DOI: 10.2469/faj.v72.n6.1
File-URL: http://hdl.handle.net/10.2469/faj.v72.n6.1
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Author-Name: Te-Feng Chen
Author-X-Name-First: Te-Feng
Author-X-Name-Last: Chen
Author-Name: San-Lin Chung
Author-X-Name-First: San-Lin
Author-X-Name-Last: Chung
Author-Name: Wei-Che Tsai
Author-X-Name-First: Wei-Che
Author-X-Name-Last: Tsai
Title: Option-Implied Equity Risk and the Cross Section of Stock Returns
Abstract: 
 In our study, we take advantage of the forward-looking nature of information in option prices
     to estimate systematic equity risk while controlling for the effect of idiosyncratic skewness.
     Empirical results show a significantly positive relationship between the option-implied beta
     estimate and subsequent stock returns. A long–short portfolio based on our beta estimate
     earned an average monthly return of 0.96%. We also find that the option-implied beta predicts
     future realized betas and that the risk premium on the option-implied beta is positively
     associated with future market returns and contains information about future macroeconomic
     variables.Editor’s note: This article was reviewed and accepted by Robert Litterman,
       executive editor at the time the article was submitted.
Journal: Financial Analysts Journal
Pages: 42-55
Issue: 6
Volume: 72
Year: 2016
Month: 11
X-DOI: 10.2469/faj.v72.n6.2
File-URL: http://hdl.handle.net/10.2469/faj.v72.n6.2
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Author-Name: Roger Clarke
Author-X-Name-First: Roger
Author-X-Name-Last: Clarke
Author-Name: Harindra de Silva
Author-X-Name-First: Harindra
Author-X-Name-Last: de Silva
Author-Name: Steven Thorley
Author-X-Name-First: Steven
Author-X-Name-Last: Thorley
Title: Fundamentals of Efficient Factor Investing (corrected May 2017)
Abstract: 
 Combining long-only-constrained factor subportfolios is generally not a
     mean–variance-efficient way to capture expected factor returns. For example, a
     combination of four fully invested factor subportfolios—low beta, small size, value, and
     momentum—captures less than half (e.g., 40%) of the potential improvement over the market
     portfolio’s Sharpe ratio. In contrast, a long-only portfolio of individual securities,
     using the same risk model and return forecasts, captures most (e.g., 80%) of the potential
     improvement. We adapt traditional portfolio theory to more recently popularized factor-based
     investing and simulate optimal combinations of factor and security portfolios, using the
     largest 1,000 common stocks in the US equity market from 1968 to 2015. Editor’s note: This article was reviewed and accepted by Executive Editor
       Stephen J. Brown.Editor’s note: Steven Thorley, CFA, became co-editor of the
      Financial Analysts Journal after the article was submitted but before it was accepted
       for publication. He was recused from the peer review and acceptance processes. All the
       necessary measures were taken to prevent Dr. Thorley from accessing any information related
       to the submission, including the identity of the reviewers. The reviewers were also unaware
       of his and his co-authors’ identities. For information about the current
       conflict-of-interest policies, see www.cfapubs.org/page/faj/policies.
Journal: Financial Analysts Journal
Pages: 9-26
Issue: 6
Volume: 72
Year: 2016
Month: 11
X-DOI: 10.2469/faj.v72.n6.3
File-URL: http://hdl.handle.net/10.2469/faj.v72.n6.3
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Author-Name: J. Benson Durham
Author-X-Name-First: J. Benson
Author-X-Name-Last: Durham
Title: Betting against Beta with Bonds: Worry or Love the Steepener?
Abstract: 
 Although “betting against beta” with government bonds (BABgov) seems profitable,
     questions remain. First, to what extent are BABgov profits an anomaly? Previous studies do not
     address routine valuation frameworks, such as term-structure models or principal components
     analysis. Second, “low” in low-risk investing refers to the second, not third,
     moment of returns, and prior research does not address coskew preferences. To consider the
     third question—breadth—I examine 20 non-US markets. On balance, BABgov is found to
     produce alpha, but primarily for the United States and with substantial systematic risk.
     Investors should follow BABgov cautiously.Author’s note: The views in this article reflect those of the author
      and not any other person at Brevan Howard US Investment Management LP. The information has
      been obtained or derived from sources believed by the author to be reliable. However, the
      author does not make any representation or warranty, express or implied, as to the
      information’s accuracy or completeness, nor does the author recommend that the
      information serve as the basis of any investment decision. This article does not constitute an
      offer or solicitation of an offer, or any advice or recommendation, to purchase any securities
      or other financial instruments and may not be construed as such.Editor’s note: Executive Editor Stephen J. Brown recused himself
      from the peer-review and acceptance processes because of a potential conflict of interest.
      Laura T. Starks, who served as Pro Tem Executive Editor, reviewed and accepted this
      article.
Journal: Financial Analysts Journal
Pages: 57-85
Issue: 6
Volume: 72
Year: 2016
Month: 11
X-DOI: 10.2469/faj.v72.n6.5
File-URL: http://hdl.handle.net/10.2469/faj.v72.n6.5
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Author-Name: Stephen J. Brown
Author-X-Name-First: Stephen J.
Author-X-Name-Last: Brown
Title: Why Hedge Funds?
Abstract: 
 Institutional investors are fleeing hedge funds, which provided neither the high
        returns nor the protection from downside risk that were promised to investors before the
        financial crisis. Diversified hedge fund strategies have a place in a well-diversified asset
        portfolio, but diversification is not enough to satisfy the fiduciary responsibilities of
        institutional investors. The problem is that operational due diligence is expensive—and
        without appropriate due diligence, hedge fund diversification can be dangerous.
Journal: Financial Analysts Journal
Pages: 5-7
Issue: 6
Volume: 72
Year: 2016
Month: 11
X-DOI: 10.2469/faj.v72.n6.6
File-URL: http://hdl.handle.net/10.2469/faj.v72.n6.6
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Author-Name: David R. Gallagher
Author-X-Name-First: David R.
Author-X-Name-Last: Gallagher
Author-Name: Graham Harman
Author-X-Name-First: Graham
Author-X-Name-Last: Harman
Author-Name: Camille H. Schmidt
Author-X-Name-First: Camille H.
Author-X-Name-Last: Schmidt
Author-Name: Geoffrey J. Warren
Author-X-Name-First: Geoffrey J.
Author-X-Name-Last: Warren
Title: Global Equity Fund Performance: An Attribution Approach
Abstract: 
 Using data on portfolio holdings, we examine the performance of 143 global equity funds
          over 2002–2012. We find that the average global equity manager outperforms the
          benchmark by 1.2%–1.4% a year before fees. Attribution analysis reveals that the
          prime source of excess return is selecting stocks that beat their local markets. Modest
          contributions come from country selection, most notably in emerging markets, whereas
          currency effects are mixed. Our findings support considering active management in global
          equity markets, at least for institutional accounts that pay annual fees of less than
          1%.Editor’s note: Executive Editor Stephen J. Brown recused
            himself from the peer-review and acceptance processes because of a potential conflict of
            interest. Laura T. Starks, served as Pro Tem Executive Editor.Submitted 28 September 2015Accepted 27 June 2016 by Laura T. Starks
Journal: Financial Analysts Journal
Pages: 56-71
Issue: 1
Volume: 73
Year: 2017
Month: 1
X-DOI: 10.2469/faj.v73.n1.1
File-URL: http://hdl.handle.net/10.2469/faj.v73.n1.1
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Author-Name: Stephen Foerster
Author-X-Name-First: Stephen
Author-X-Name-Last: Foerster
Author-Name: John Tsagarelis
Author-X-Name-First: John
Author-X-Name-Last: Tsagarelis
Author-Name: Grant Wang
Author-X-Name-First: Grant
Author-X-Name-Last: Wang
Title: Are Cash Flows Better Stock Return Predictors Than Profits?
Abstract: 
 Although various income statement–based measures predict the cross section of stock
     returns, direct method cash flow measures have even stronger predictive power. We transform
     indirect method cash flow statements into disaggregated and more direct estimates of cash flows
     from operations and other sources and form portfolios on the basis of these measures. Stocks in
     the highest-cash-flow decile outperform those in the lowest by over 10% annually (risk
     adjusted). Our results are robust to investment horizons and across risk factors and sector
     controls. We also show that, in addition to operating cash flow information, cash taxes and
     capital expenditures provide incremental predictive power. Disclosures:John Tsagarelis and Grant Wang are employed by Highstreet
       Asset Management, an investment management firm that uses empirically based research and the
       combination of quantitative and fundamental analysis to capture alpha drivers—growth,
       value, and quality. Proprietary models are based on numerous factors, only a small portion of
       which are related to the cash flow measure variables and findings in this
      article.Editor’s note:This article was externally reviewed using our double-blind peer-review process. When the article was accepted for publication, the authors thanked the reviewers in their acknowledgments. Andrew L. Berkin and Heiko Jacobs were the reviewers for this article.Submitted 2 October 2015Accepted 31 May 2016 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 73-99
Issue: 1
Volume: 73
Year: 2017
Month: 1
X-DOI: 10.2469/faj.v73.n1.2
File-URL: http://hdl.handle.net/10.2469/faj.v73.n1.2
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Author-Name: Lidia Bolla
Author-X-Name-First: Lidia
Author-X-Name-Last: Bolla
Title: Fundamental Indexing in Global Bond Markets: The Risk Exposure Explains It All
Abstract: 
 To investigate the fundamental indexing methodology, I apply it to global government bond
     markets and examine its exposure to several newly introduced risk factors. I find that the
     fundamental indexing approach outperforms a market-value-weighted index. However, my results
     show statistically significant and economically relevant exposures of fundamentally weighted
     indexes to the risk factors term and duration risk, default risk, convexity risk, liquidity
     risk, and carry trade risk. The increased risk exposure explains the outperformance of the
     fundamental indexing methodology in government bond markets.Editor’s notes:Submitted 7 August 2015Accepted 7 July 2016 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 101-120
Issue: 1
Volume: 73
Year: 2017
Month: 1
X-DOI: 10.2469/faj.v73.n1.3
File-URL: http://hdl.handle.net/10.2469/faj.v73.n1.3
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Author-Name: Michael Melvin
Author-X-Name-First: Michael
Author-X-Name-Last: Melvin
Author-Name: Duncan Shand
Author-X-Name-First: Duncan
Author-X-Name-Last: Shand
Title: When Carry Goes Bad: The Magnitude, Causes, and Duration of Currency Carry Unwinds
Abstract: 
 We analyze the worst episodes of currency carry loss in recent decades, including causes,
     attribution by currency, timing, and duration of carry drawdowns. To explore the determinants
     of the length of carry losses, we estimate a model of carry drawdown duration. We find evidence
     that drawdown duration varies systematically with (1) expected return on the carry trade at the
     onset of the drawdown, (2) financial stress indicators, and (3) the magnitude of deviations
     from a fundamental value portfolio of the carry-related portfolio holdings. In an out-of-sample
     test, we show that these determinants can be used to control carry-related losses and improve
     investment performance.Editor’s note:This article was externally reviewed using our double-blind
      peer-review process. When the article was accepted for
      publication, the authors thanked the reviewers in their
      acknowledgments. Denis Chaves was one of the reviewers
      for this article.Submitted 27 October 2015Accepted 17 August 2016 by Stephen Brown
Journal: Financial Analysts Journal
Pages: 121-144
Issue: 1
Volume: 73
Year: 2017
Month: 1
X-DOI: 10.2469/faj.v73.n1.4
File-URL: http://hdl.handle.net/10.2469/faj.v73.n1.4
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Author-Name: Barbara S. Petitt
Author-X-Name-First: Barbara S.
Author-X-Name-Last: Petitt
Title: From the Editor
Abstract: 
 Managing Editor Barbara S. Petitt, CFA, explains the vision, goals, and changes for the
          Financial Analysts Journal to remain the flagship publication of CFA Institute and the
          leading practitioner-oriented journal in the investment management community.
Journal: Financial Analysts Journal
Pages: 5-9
Issue: 1
Volume: 73
Year: 2017
Month: 1
X-DOI: 10.2469/faj.v73.n1.5
File-URL: http://hdl.handle.net/10.2469/faj.v73.n1.5
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Author-Name: The Editors
Title: “In Memoriam: Jack Treynor”: A Comment
Abstract: 
 This material comments on “In Memoriam: Jack Treynor” (July/August).
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 1
Volume: 73
Year: 2017
Month: 1
X-DOI: 10.2469/faj.v73.n1.6
File-URL: http://hdl.handle.net/10.2469/faj.v73.n1.6
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Author-Name: Antti Petajisto
Author-X-Name-First: Antti
Author-X-Name-Last: Petajisto
Title: Inefficiencies in the Pricing of Exchange-Traded Funds
Abstract: 
 The prices of exchange-traded funds (ETFs) can deviate significantly from their net asset
     values (NAVs), in spite of the arbitrage mechanism that allows authorized participants to
     create and redeem shares for the underlying portfolios. The deviations, typically within a band
     of about 200 bps, are larger in funds holding international or illiquid securities. To control
     for stale pricing of the underlying assets, I introduce a novel approach that uses the cross
     section of prices on a group of similar ETFs. The average pricing band remains economically
     significant at about 100 bps, with even larger mispricings in some asset classes. Active
     trading strategies exploiting such inefficiencies produce substantial abnormal returns before
     transaction costs, providing further proof of short-term mean reversion in ETF prices.Disclosure:The first draft of this article was written when the author was a
       finance professor at the NYU Stern School of Business.Editor's Note: 
      Submitted 25 September 2013Accepted 6 October 2016 by Robert Litterman
Journal: Financial Analysts Journal
Pages: 24-54
Issue: 1
Volume: 73
Year: 2017
Month: 1
X-DOI: 10.2469/faj.v73.n1.7
File-URL: http://hdl.handle.net/10.2469/faj.v73.n1.7
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Author-Name: Patrick Houweling
Author-X-Name-First: Patrick
Author-X-Name-Last: Houweling
Author-Name: Jeroen van Zundert
Author-X-Name-First: Jeroen
Author-X-Name-Last: van Zundert
Title: Factor Investing in the Corporate Bond Market
Abstract: 
 We offer empirical evidence that size, low-risk, value, and momentum factor portfolios
     generate economically meaningful and statistically significant alphas in the corporate bond
     market. Because the correlations between the single-factor portfolios are low, a combined
     multi-factor portfolio benefits from diversification among the factors: It has a lower tracking
     error and a higher information ratio than the individual factors. Our results are robust to
     transaction costs, alternative factor definitions, alternative portfolio construction settings,
     and constructing factor portfolios on a subsample of liquid bonds. Finally, allocating to
     corporate bond factors provides added value beyond allocating to equity factors in a
     multi-asset context.A practitioner's perspective on this article is provided in the In Practice piece "Corporate Bonds: Time for Factors?" by Phil Davis, online 13 February 2017.Disclosure:The views expressed in this article are the authors’ and do not
      necessarily reflect the views of Robeco Institutional Asset Management B.V.
      (“Robeco”). Editor’s Note:Submitted 11 December 2015Accepted 30 September 2016 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 100-115
Issue: 2
Volume: 73
Year: 2017
Month: 4
X-DOI: 10.2469/faj.v73.n2.1
File-URL: http://hdl.handle.net/10.2469/faj.v73.n2.1
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Author-Name: The Editors
Title: Our Thanks to Reviewers
Abstract: 
 We thank the 174 reviewers who took part during 2016 in the double-blind peer-review
          process that guarantees the quality of the Financial Analysts
          Journal.
Journal: Financial Analysts Journal
Pages: 12-12
Issue: 2
Volume: 73
Year: 2017
Month: 4
X-DOI: 10.2469/faj.v73.n2.10
File-URL: http://hdl.handle.net/10.2469/faj.v73.n2.10
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Author-Name: U-Wen Kok
Author-X-Name-First: U-Wen
Author-X-Name-Last: Kok
Author-Name: Jason Ribando
Author-X-Name-First: Jason
Author-X-Name-Last: Ribando
Author-Name: Richard Sloan
Author-X-Name-First: Richard
Author-X-Name-Last: Sloan
Title: Facts about Formulaic Value Investing
Abstract: 
 The term “value investing” is increasingly being adopted by quantitative
     investment strategies that use ratios of common fundamental metrics (e.g., book value,
     earnings) to market price. A hallmark of such strategies is that they do not involve a
     comprehensive effort to determine the intrinsic value of the underlying securities. We document
     two facts about such strategies. First, there is little compelling evidence that these
     strategies deliver superior investment performance for US equities. Second, instead of
     identifying undervalued securities, these strategies systematically identify companies with
     temporarily inflated accounting numbers. We argue that these strategies should not be confused
     with value strategies that use a comprehensive approach in determining the intrinsic value of
     the underlying securities.A practitioner's perspective on this article is provided in the In Practice piece "Value Investing: Do Quant Strategies Measure Up?" by Phil Davis, online 6 March 2017.
      Disclosure:The views and opinions expressed herein are those of the authors and do not
       necessarily reflect the views of Victory Capital Management, Arch Mortgage Insurance Company,
       or their affiliates or employees.U-Wen Kok is an employee of RS Investments, an investment franchise of Victory Capital
       Management. Jason Ribando was an employee of RS Investments during the research and writing
       phases of this article. Richard Sloan has served as a paid consultant for RS Investments. RS
       Investments provided access to resources used to conduct this research.Editor’s note:This article was reviewed via our double-blind peer-review
       process. When the article was accepted for publication, the authors thanked the reviewers in
       their acknowledgments. Tim Loughran, CFA, and Allen Michel were the reviewers for this
       article.Submitted 17 May 2016Accepted 19 October 2016 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 81-99
Issue: 2
Volume: 73
Year: 2017
Month: 4
X-DOI: 10.2469/faj.v73.n2.2
File-URL: http://hdl.handle.net/10.2469/faj.v73.n2.2
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Author-Name: Cormac Mullen
Author-X-Name-First: Cormac
Author-X-Name-Last: Mullen
Author-Name: Jenny Berrill
Author-X-Name-First: Jenny
Author-X-Name-Last: Berrill
Title: Mononationals: The Diversification Benefits of Investing in Companies with No Foreign Sales
Abstract: 
 Few papers have focused on the diversification benefits of companies with domestic sales
     only, or mononationals. We compare the international diversification benefits of equity
     portfolios of various multinational classifications. We find that multinationality has a
     significant impact on diversification benefits, with foreign “domestic” stocks
     offering the most benefits and foreign “global” stocks the least, and that
     investing in stocks with low sales in the investor’s home region leads to higher
     benefits. For portfolio managers, we suggest that a portfolio of mononationals offers the
     potential for greater benefits than a portfolio of multinationals. Our results are strongest
     for US, eurozone, UK, and Japanese investors.A practitioner's perspective on this article is provided in the In Practice piece "Rediscovering Diversification in International Equities" by Phil Davis, online 17 April 2017.
      Disclosure:The authors report no conflict of interest.
      Editor’s Notes:
      This article was externally reviewed using our double-blind peer-review process. When
       the article was accepted for publication, the authors thanked the reviewers in their
       acknowledgments. Patrick Savaria, CFA, was one of the reviewers for this article.
     Submitted 17 February 2016
     Accepted 24 November 2016 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 116-132
Issue: 2
Volume: 73
Year: 2017
Month: 4
X-DOI: 10.2469/faj.v73.n2.3
File-URL: http://hdl.handle.net/10.2469/faj.v73.n2.3
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Author-Name: Martijn Cremers
Author-X-Name-First: Martijn
Author-X-Name-Last: Cremers
Title: Active Share and the Three Pillars of Active Management: Skill, Conviction, and Opportunity
Abstract: 
 This article relates Active Share to the fund manager’s individual stock-picking
     skill, conviction, and opportunity. I propose a new formula for Active Share that emphasizes
     that a fund’s Active Share is reduced only through overlapping holdings with its
     benchmark. I show why and how to adjust the expense ratio for the level of Active Share and the
     cost of investing in the benchmark. I conclude that Active Share matters for the performance of
     actively managed funds. Investors should not pay (too) much for low–Active Share funds,
     which generally underperform. But there is no evidence that high–Active Share funds as a
     group have underperformed, and patient managers with high Active Share have been quite
     successful. A practitioner's perspective on this article is provided in the In Practice piece "Why Should We Care about Active Share?" by Phil Davis, online 20 March 2017.
      Disclosure: The data on Active Share and fund holding duration used in this study are available
       at http://activeshare.nd.edu for academic purposes. Active Share and Active Fee information (as well as other
       related holdings-based information) for US equity funds is available at http://activeshare.info. I consult with investment firms that offer high–Active Share
       investments.
      Editor’s Notes:This article was externally reviewed using our double-blind peer-review process. When
       the article was accepted for publication, the authors thanked the reviewers in their
       acknowledgments. David Blitz was one of the reviewers for this article.Submitted 10 August 2016
     Accepted 28 December 2016 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 61-79
Issue: 2
Volume: 73
Year: 2017
Month: 4
X-DOI: 10.2469/faj.v73.n2.4
File-URL: http://hdl.handle.net/10.2469/faj.v73.n2.4
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Author-Name: Jack T. Ciesielski
Author-X-Name-First: Jack T.
Author-X-Name-Last: Ciesielski
Author-Name: Elaine Henry
Author-X-Name-First: Elaine
Author-X-Name-Last: Henry
Title: Accounting’s Tower of Babel: Key Considerations in Assessing Non-GAAP Earnings
Abstract: 
 The increasingly pervasive reporting of non-GAAP earnings poses fundamental challenges
          for investors and analysts. Non-GAAP earnings lack comparability, and related disclosures
          lack sufficient transparency to add comparability. In addition, non-GAAP earnings
          disclosures may raise potentially troubling questions about management’s motivation.
          We incorporate relevant research in our discussion and conclude with key prescriptions in
          assessing non-GAAP earnings.
            Disclosure:
          One of the authors is the publisher of The Analyst’s Accounting
              Observer, and we refer to certain data from that publication, as indicated
            where appropriate.
            Editor’s Notes: 
          This article was externally reviewed using our double-blind peer-review process. When
            the article was accepted for publication, the authors thanked the reviewers in their
            acknowledgments. Alok Kumar Agarwal, CFA, and Stephen R. Foerster, CFA, were two of the
            reviewers for this article. 
            Submitted 1 December 2015
            Accepted 21 November 2016 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 34-50
Issue: 2
Volume: 73
Year: 2017
Month: 4
X-DOI: 10.2469/faj.v73.n2.5
File-URL: http://hdl.handle.net/10.2469/faj.v73.n2.5
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# input file: UFAJ_A_12048371_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jonathan B. Berk
Author-X-Name-First: Jonathan B.
Author-X-Name-Last: Berk
Author-Name: Jules H. van Binsbergen
Author-X-Name-First: Jules H.
Author-X-Name-Last: van Binsbergen
Title: How Do Investors Compute the Discount Rate? They Use the CAPM (Corrected June 2017)
Abstract: 
 We provide guidance to corporate managers and investors on how to select the discount rate
     when evaluating investment opportunities. When making corporate investment decisions on behalf
     of the equity investors in a firm, an obvious choice is to use the method that equity investors
     use in making their own investment decisions. We infer how investors compute the discount rate
     by looking at mutual fund investors’ capital allocation decisions. We find that
     investors adjust for risk by using the beta of the capital asset pricing model (CAPM).
     Extensions to the CAPM perform poorly, implying that investors do not use these models to
     compute discount rates. 
      Disclosure:
      The authors report no conflicts of interest. This article is an updated version of the
       version that was posted on 26 September 2016.
      Editor’s Note:
      The original version had a production error in Table 2, which has been corrected in this version.Submitted 3 November 2015Accepted 31 May 2016 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 25-32
Issue: 2
Volume: 73
Year: 2017
Month: 4
X-DOI: 10.2469/faj.v73.n2.6
File-URL: http://hdl.handle.net/10.2469/faj.v73.n2.6
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Author-Name: Stephen J. Brown
Author-X-Name-First: Stephen J.
Author-X-Name-Last: Brown
Author-Name: Barbara S. Petitt
Author-X-Name-First: Barbara S.
Author-X-Name-Last: Petitt
Title: 2016 Report to Readers
Abstract: 
 2016 Report to Readers
Journal: Financial Analysts Journal
Pages: 6-10
Issue: 2
Volume: 73
Year: 2017
Month: 4
X-DOI: 10.2469/faj.v73.n2.7
File-URL: http://hdl.handle.net/10.2469/faj.v73.n2.7
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Author-Name: John C. Bogle
Author-X-Name-First: John C.
Author-X-Name-Last: Bogle
Title: Balancing Professional Values and Business Values
Abstract: 
 In this incisive and timely essay on balancing professional values and business values in
          the world of investing and finance, John C. Bogle, founder of both The Vanguard Group and
          the first index mutual fund, offers concise and useful guidance to practitioners seeking
          ways to cope with the extraordinary changes in society, technology, and market forces of
          the past few decades. Drawing on lessons learned over his distinguished 65-year career,
          Mr. Bogle bases his sage and prudent advice on not only his own vast experience but also
          the time-tested wisdom of both Adam Smith, the 18th-century Scottish
          economist-philosopher, and Benjamin Graham, a legendary pioneer in our profession.Editor’s NoteJohn C. Bogle is the founder of both The Vanguard Group
              and the first index mutual fund. He served as chief executive of Vanguard from 1974 to
              1996 and is the author of 10 books, including Common Sense on Mutual Funds:
            New Imperatives for the Intelligent Investor; The Battle for the Soul
            of Capitalism; Enough: True Measures of Money, Business, and
            Life; and The Clash of the Cultures: Investment vs.
              Speculation.
Journal: Financial Analysts Journal
Pages: 14-23
Issue: 2
Volume: 73
Year: 2017
Month: 4
X-DOI: 10.2469/faj.v73.n2.8
File-URL: http://hdl.handle.net/10.2469/faj.v73.n2.8
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# input file: UFAJ_A_12048374_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “Fundamentals of Efficient
            Factor Investing,” by Roger Clarke, Harindra de Silva, CFA, and Steven
          Thorley, CFA, in the November/December 2016 issue of the Financial Analysts
            Journal.
Journal: Financial Analysts Journal
Issue: 2
Volume: 73
Year: 2017
Month: 4
X-DOI: 10.2469/faj.v73.n2.9
File-URL: http://hdl.handle.net/10.2469/faj.v73.n2.9
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Author-Name: Ramzi Ben-Abdallah
Author-X-Name-First: Ramzi
Author-X-Name-Last: Ben-Abdallah
Author-Name: Michèle Breton
Author-X-Name-First: Michèle
Author-X-Name-Last: Breton
Title: History Is Repeating Itself: Get Ready for a Long Dry Spell
Abstract: 
 The recent disappearance of a five-year maturity gap from the set of bonds deliverable to the
     Chicago Board of Trade Treasury bond futures has resulted in a distinctive configuration,
     whereby a single T-bond will have the shortest remaining maturity in the delivery basket of
     bonds for a five-year period. This situation would be inconsequential were three other
     conditions not simultaneously present, ensuring that this single bond will probably be the
     cheapest-to-deliver bond over the next five years. We show that a similar alignment of
     conditions happened in 1994–1999, during the “long dry spell of the
     11¼%.” We recall the detrimental repercussions of that dry spell on the bond
     markets and suggest possible steps to remedy the current situation. 
      Disclosure:
     The authors report no conflicts of interest.
      Editor’s Note
     Submitted 7 January 2016 Accepted 28 December 2016 by Stephen J. Brown 
Journal: Financial Analysts Journal
Pages: 106-130
Issue: 3
Volume: 73
Year: 2017
Month: 7
X-DOI: 10.2469/faj.v73.n3.1
File-URL: http://hdl.handle.net/10.2469/faj.v73.n3.1
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Author-Name: Marie Brière
Author-X-Name-First: Marie
Author-X-Name-Last: Brière
Author-Name: Jonathan Peillex
Author-X-Name-First: Jonathan
Author-X-Name-Last: Peillex
Author-Name: Loredana Ureche-Rangau
Author-X-Name-First: Loredana
Author-X-Name-Last: Ureche-Rangau
Title: Do Social Responsibility Screens Matter When Assessing Mutual Fund Performance?
Abstract: 
 Regarding the contribution of socially responsible (SR) screening to mutual fund performance,
     we propose a new decomposition of the variability of SR mutual fund returns that isolates the
     contribution of SR screening, allowing it to be compared with other, traditional sources of
     performance. Our results, based on a sample of SR equity mutual funds, show that SR screening
     does contribute to the variability of mutual fund performance, together with asset allocation
     decisions and active management. This contribution is, on average, between 4% and 10%, roughly
     two times lower than the contribution made by active portfolio choices. 
      Disclosure:The authors report no conflicts of interest.
      Editor’s NoteThis article was externally reviewed using our double-blind peer-review process. When
       the article was accepted for publication, the authors thanked the reviewers in their
       acknowledgments. Denys Glushkov and Jenke ter Horst were the reviewers for this
       article.Submitted 10 April 2015
     Accepted 28 December 2016 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 53-66
Issue: 3
Volume: 73
Year: 2017
Month: 7
X-DOI: 10.2469/faj.v73.n3.2
File-URL: http://hdl.handle.net/10.2469/faj.v73.n3.2
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Author-Name: Steven L. Heston
Author-X-Name-First: Steven L.
Author-X-Name-Last: Heston
Author-Name: Nitish Ranjan Sinha
Author-X-Name-First: Nitish Ranjan
Author-X-Name-Last: Sinha
Title: News vs. Sentiment: Predicting Stock Returns from News Stories
Abstract: 
 The authors used a dataset of more than 900,000 news stories to test whether news can
          predict stock returns. They measured sentiment with a proprietary Thomson Reuters neural
          network and found that daily news predicts stock returns for only one to two days,
          confirming previous research. Weekly news, however, predicts stock returns for one
          quarter. Positive news stories increase stock returns quickly, but negative stories
          receive a long-delayed reaction. Much of the delayed response to news occurs around the
          subsequent earnings announcement.
            Disclosure:
            The authors report no conflicts of interest.
            Editor’s Note
          Submitted 10 November 2015
          Accepted 28 December 2016 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 67-83
Issue: 3
Volume: 73
Year: 2017
Month: 7
X-DOI: 10.2469/faj.v73.n3.3
File-URL: http://hdl.handle.net/10.2469/faj.v73.n3.3
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Author-Name: Philip U. Straehl
Author-X-Name-First: Philip U.
Author-X-Name-Last: Straehl
Author-Name: Roger G. Ibbotson
Author-X-Name-First: Roger G.
Author-X-Name-Last: Ibbotson
Title: The Long-Run Drivers of Stock Returns: Total Payouts and the Real Economy
Abstract: 
 We provide theoretical and empirical evidence over 1871–2014 that total payouts
     (dividends plus buybacks) are the key drivers of long-run stock market returns. We show that
     total payouts per share (adjusted for the share decrease from buybacks) grew
     in line with economic productivity, whereas aggregate total payouts grew in
     line with GDP. We also show that a dividend discount model (DDM) based on current yields and
     historical growth rates underestimates expected returns relative to the total payout model.
     Finally, we demonstrate that the cyclically adjusted total yield (CATY) predicts changes in
     expected returns at least as well as the cyclically adjusted price-to-earnings ratio
     (CAPE).
      Disclosure:
     Morningstar Investment Management LLC uses a version of the methodology outlined in this
      article to manage multi-asset portfolios.
      Editor’s Note 
     Submitted 29 June 2016Accepted 28 December 2016 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 32-52
Issue: 3
Volume: 73
Year: 2017
Month: 7
X-DOI: 10.2469/faj.v73.n3.4
File-URL: http://hdl.handle.net/10.2469/faj.v73.n3.4
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Author-Name: Jens Overgaard Knudsen
Author-X-Name-First: Jens Overgaard
Author-X-Name-Last: Knudsen
Author-Name: Simon Kold
Author-X-Name-First: Simon
Author-X-Name-Last: Kold
Author-Name: Thomas Plenborg
Author-X-Name-First: Thomas
Author-X-Name-Last: Plenborg
Title: Stick to the Fundamentals and Discover Your Peers
Abstract: 
 The use of industry as a criterion for selecting peers for multiples-based valuation rests on
     the notion that companies operating in the same industry are more likely to share fundamental
     value drivers (i.e., profitability, growth, and risk). However, such companies may not have
     similar characteristics in terms of these drivers and thus should not be traded at the same
     multiple. We analyze this issue by developing the sum of absolute rank differences (SARD)
     approach. The SARD approach can account for an infinite number of proxies for profitability,
     growth, and risk while remaining independent of industry classifications. Our results indicate
     that the SARD approach yields significantly more accurate valuation estimates than the industry
     classification approach.Disclosure:The authors indicate no conflicts of interest. Editor’s NoteThis article was externally reviewed using our double-blind
      peer-review process. When the article was accepted for publication, the authors thanked the
      reviewers in their acknowledgments. Alok Kumar Agarwal, CFA, and Michael Fuerst were the
      reviewers for this article.Submitted 6 March 2016Accepted 28 December 2016 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 85-105
Issue: 3
Volume: 73
Year: 2017
Month: 7
X-DOI: 10.2469/faj.v73.n3.5
File-URL: http://hdl.handle.net/10.2469/faj.v73.n3.5
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# input file: UFAJ_A_12048381_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Stephen J. Brown
Author-X-Name-First: Stephen J.
Author-X-Name-Last: Brown
Title: In Memoriam: Stephen A. Ross
Journal: Financial Analysts Journal
Pages: 5-7
Issue: 3
Volume: 73
Year: 2017
Month: 7
X-DOI: 10.2469/faj.v73.n3.6
File-URL: http://hdl.handle.net/10.2469/faj.v73.n3.6
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# input file: UFAJ_A_12048382_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin L. Leibowitz
Author-X-Name-First: Martin L.
Author-X-Name-Last: Leibowitz
Author-Name: Stanley Kogelman
Author-X-Name-First: Stanley
Author-X-Name-Last: Kogelman
Author-Name: Anthony Bova
Author-X-Name-First: Anthony
Author-X-Name-Last: Bova
Title: Funding Ratio Peaks and Stalls
Abstract: 
 Virtually all investment plans share the ultimate goal of providing financial support for
     some class of beneficiaries. A plan’s long-term financial health is typically measured
     by its funding ratio—the market value of assets divided by the present value of
     liability. Although this funding ratio is intuitively appealing, it may be misleading because
     it represents only a momentary snapshot of plan sustainability. Even with a high initial value
     and reasonable return assumption, the funding ratio’s time-path (orbit) often shifts
     from a rise to a “stall” to a precipitous decline. In this article, we focus on
     how funding ratios evolve over time, using the concept of “fulfillment return” to
     clarify the limitations of the single-point funding ratio measure.
      Disclosure:The authors report no conflicts of interest.
      Editor’s NoteSubmitted 9 December 2016
     Accepted 9 March 2017 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 8-20
Issue: 3
Volume: 73
Year: 2017
Month: 7
X-DOI: 10.2469/faj.v73.n3.7
File-URL: http://hdl.handle.net/10.2469/faj.v73.n3.7
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Author-Name: The Editors
Title: Errata
Abstract: 
 This material provides a correction to “How Do Investors Compute the
      Discount Rate? They Use the CAPM,” by Jonathan B. Berk and Jules H. van
     Binsbergen, in the Second Quarter 2017 issue of the Financial Analysts
     Journal. 
Journal: Financial Analysts Journal
Issue: 3
Volume: 73
Year: 2017
Month: 7
X-DOI: 10.2469/faj.v73.n3.8
File-URL: http://hdl.handle.net/10.2469/faj.v73.n3.8
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# input file: UFAJ_A_12048385_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Malcolm Baker
Author-X-Name-First: Malcolm
Author-X-Name-Last: Baker
Author-Name: Ryan Taliaferro
Author-X-Name-First: Ryan
Author-X-Name-Last: Taliaferro
Author-Name: Terence Burnham
Author-X-Name-First: Terence
Author-X-Name-Last: Burnham
Title: Optimal Tilts: Combining Persistent Characteristic Portfolios
Abstract: 
 We examine the optimal weighting of four tilts in US equity markets over 1968–2014.
          We define a “tilt” as a characteristics-based portfolio strategy that
          requires relatively low annual turnover. This definition forms a continuum, with small
          size, a very persistent characteristic, at one end of the spectrum and high-frequency
          reversal at the other. Unlike with low-turnover tilts, a full history of transaction costs
          is essential for determining the expected return of, and thus the optimal allocation to,
          less persistent, more turnover-intensive characteristics. The mean–variance-optimal
          tilts toward value, size, and profitability are roughly equal to each other and to the
          optimal low-beta tilt. Notably, the low-beta tilt is not subsumed by the other three.
            Disclosure:Ryan Taliaferro is a senior vice president at Acadian Asset Management. Malcolm
              Baker serves as a consultant to Acadian Asset Management and also acknowledges support
              from the Division of Research at Harvard Business School. The views expressed herein
              are those of the authors and do not necessarily reflect the views of the National
              Bureau of Economic Research or Acadian Asset Management. The views expressed herein
              should not be considered investment advice and do not constitute or form part of any
              offer to issue or sell, or any solicitation of any offer to subscribe or to purchase,
              shares, units, or other interest in any particular investments.Editor’s Note 
          Submitted 2 May 2016
          Accepted 14 March 2017 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 75-89
Issue: 4
Volume: 73
Year: 2017
Month: 10
X-DOI: 10.2469/faj.v73.n4.1
File-URL: http://hdl.handle.net/10.2469/faj.v73.n4.1
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Author-Name: Daniel Giamouridis
Author-X-Name-First: Daniel
Author-X-Name-Last: Giamouridis
Title: Systematic Investment Strategies
Abstract: 
 Systematic, rules-based investment strategies are where academia and practice are
          currently interacting strongly. My objective in this editorial is to offer some thoughts
          on research on systematic investing, including three articles in this issue, that can
          provide significant practical benefits for academics, practitioners, and investors
          alike.Author’s note:The views expressed in this editorial are my own and
            do not necessarily reflect the views of Bank of America Merrill Lynch.
Journal: Financial Analysts Journal
Pages: 10-14
Issue: 4
Volume: 73
Year: 2017
Month: 10
X-DOI: 10.2469/faj.v73.n4.10
File-URL: http://hdl.handle.net/10.2469/faj.v73.n4.10
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Author-Name: Mark Kritzman
Author-X-Name-First: Mark
Author-X-Name-Last: Kritzman
Author-Name: Harry M. Markowitz
Author-X-Name-First: Harry M.
Author-X-Name-Last: Markowitz
Title: An Interview with Nobel Laureate Harry M. Markowitz
Abstract: 
 On 8 November and 6 December 2016, Mark Kritzman, CFA, interviewed Harry M. Markowitz to
          discuss his background at the University of Chicago, the Cowles Commission, and the RAND
          Corporation; his many contributions not only to modern portfolio theory but also to other
          fields; and his views on the 2008 global financial crisis.
Journal: Financial Analysts Journal
Pages: 16-21
Issue: 4
Volume: 73
Year: 2017
Month: 10
X-DOI: 10.2469/faj.v73.n4.3
File-URL: http://hdl.handle.net/10.2469/faj.v73.n4.3
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Author-Name: Feng Gu
Author-X-Name-First: Feng
Author-X-Name-Last: Gu
Author-Name: Baruch Lev
Author-X-Name-First: Baruch
Author-X-Name-Last: Lev
Title: Time to Change Your Investment Model
Abstract: 
 We demonstrate empirically that the gains from predicting corporate earnings, or
          consensus hits and misses—an activity at the core of most investment
          methodologies—have been shrinking fast over the past 30 years. We identify the main
          reasons for this loss of earnings relevance and propose an improved alternative to current
          investment methodologies, one that focuses on the “strategic assets” of the
          enterprise and their contribution to maintaining the company’s competitive edge. We
          demonstrate this investment methodology using subscription-based companies.
            Disclosure:The authors report no conflicts of interest.
            Editor’s NoteSubmitted 24 November 2016Accepted 26 April 2017 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 23-33
Issue: 4
Volume: 73
Year: 2017
Month: 10
X-DOI: 10.2469/faj.v73.n4.4
File-URL: http://hdl.handle.net/10.2469/faj.v73.n4.4
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Author-Name: Andrew Clare
Author-X-Name-First: Andrew
Author-X-Name-Last: Clare
Author-Name: James Seaton
Author-X-Name-First: James
Author-X-Name-Last: Seaton
Author-Name: Peter N. Smith
Author-X-Name-First: Peter N.
Author-X-Name-Last: Smith
Author-Name: Stephen Thomas
Author-X-Name-First: Stephen
Author-X-Name-Last: Thomas
Title: Reducing Sequence Risk Using Trend Following and the CAPE Ratio
Abstract: 
 The risk of experiencing bad investment outcomes at the wrong time, or sequence
      risk, is a poorly understood but crucial aspect of the risk investors
     face—particularly those in the decumulation phase of their savings journey, typically
     over the period of retirement financed by a defined contribution pension scheme. Using US
     equity return data for 1872–2014, we show how this risk can be significantly reduced by
     applying trend-following investment strategies. We also show that knowing a valuation ratio,
     such as the cyclically adjusted price-to-earnings (CAPE) ratio, at the beginning of a
     decumulation period is useful for enhancing sustainable investment income.
      Disclosure:
      The authors report no conflicts of interest.
      Editor’s Note
     Submitted 8 September 2016
     Accepted 28 April 2017 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 91-103
Issue: 4
Volume: 73
Year: 2017
Month: 10
X-DOI: 10.2469/faj.v73.n4.5
File-URL: http://hdl.handle.net/10.2469/faj.v73.n4.5
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# input file: UFAJ_A_12048390_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Andrew Ang
Author-X-Name-First: Andrew
Author-X-Name-Last: Ang
Author-Name: Ananth Madhavan
Author-X-Name-First: Ananth
Author-X-Name-Last: Madhavan
Author-Name: Aleksander Sobczyk
Author-X-Name-First: Aleksander
Author-X-Name-Last: Sobczyk
Title: Estimating Time-Varying Factor Exposures (Corrected October 2017)
Abstract: 
 We develop a methodology to estimate dynamic factor loadings using cross-sectional risk
     characteristics. Applying it to a dataset of US-domiciled mutual funds, we distinguish the
     components of active returns attributable to (1) constant factor exposures (e.g., a tilt to
     value stocks), (2) time-varying factor exposures, and (3) security selection. We find that
     large-cap growth funds tend to be concentrated in two factors (momentum and quality) whereas
     large-cap blend funds have the most factor diversity. We also find that common measures to
     gauge manager skill may be misleading.
      Disclosure:
      The views expressed in this article are those of the authors and do not necessarily
      reflect the views of BlackRock, Inc.
      Editor’s Note
      The original version had an error in Equation 5 and Note 5, which have been corrected in this version.This article was externally reviewed using our double-blind peer-review process. When
       the article was accepted for publication, the authors thanked the reviewers in their
       acknowledgments. Jason Hsu and Timothy Loughran, CFA, were the reviewers for this
       article.
     Submitted 2 December 2016
     Accepted 28 April 2017 by Stephen J. Brown
     Disclaimer:This material is not intended to be relied upon as a forecast,
      research, or investment advice and is not a recommendation, offer, or solicitation to buy or
      sell any securities or to adopt any investment strategy. The opinions expressed are those of
      the authors and may change as subsequent conditions vary. Individual portfolio managers for
      BlackRock may have opinions and/or make investment decisions that, in certain respects, may
      not be consistent with the information contained in this document. Past performance is no
      guarantee of future results. Indexes are unmanaged and one cannot invest directly in an index.
Journal: Financial Analysts Journal
Pages: 41-54
Issue: 4
Volume: 73
Year: 2017
Month: 10
X-DOI: 10.2469/faj.v73.n4.6
File-URL: http://hdl.handle.net/10.2469/faj.v73.n4.6
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Author-Name: Timotheos Angelidis
Author-X-Name-First: Timotheos
Author-X-Name-Last: Angelidis
Author-Name: Nikolaos Tessaromatis
Author-X-Name-First: Nikolaos
Author-X-Name-Last: Tessaromatis
Title: Global Equity Country Allocation: An Application of Factor Investing
Abstract: 
 Under the paradigm of factor investing, we create a global factor allocation strategy using
     country indexes and portfolio construction methodologies that are robust to estimation error.
     Implementable through exchange-traded funds or index futures, a portfolio based on country
     indexes with favorable factor exposures significantly outperforms, both economically and
     statistically, the world market capitalization portfolio. The outperformance remains
     significant after taking into account transaction costs, alternative portfolio construction
     methodologies, and tracking error constraints. From a practical investment perspective,
     country-based factor portfolios offer a viable alternative implementation of factor investing
     in a world of illiquidity, transaction costs, and capacity constraints.
      Disclosure:
      The authors report no conflicts of interest.
      Editor’s Note
     This article was externally reviewed using our double-blind peer-review process. When
       the article was accepted for publication, the authors thanked the reviewers in their
       acknowledgments. Ronnie Shah, CFA, was one of the reviewers for this article.
     Submitted 20 August 2016
     Accepted 26 May 2017 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 55-73
Issue: 4
Volume: 73
Year: 2017
Month: 10
X-DOI: 10.2469/faj.v73.n4.7
File-URL: http://hdl.handle.net/10.2469/faj.v73.n4.7
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Author-Name: The Editors
Title: Letter to the Editor
Abstract: 
 This material comments on "Diversification Returns and Asset Contributions" by David G.
          Booth and Eugene F. Fama (May/June 1992) and "Migration" by Eugene F. Fama and Kenneth R.
          French (May/June 2007).
Journal: Financial Analysts Journal
Pages: 8-8
Issue: 4
Volume: 73
Year: 2017
Month: 10
X-DOI: 10.2469/faj.v73.n4.8
File-URL: http://hdl.handle.net/10.2469/faj.v73.n4.8
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Author-Name: Gary Baker
Author-X-Name-First: Gary
Author-X-Name-Last: Baker
Title: Help Us Embrace Sustainability by Forgoing Print
Abstract: 
 We currently print and ship over 100 metric tons of paper a year to members worldwide in
          the form of hard copies of the Financial Analysts Journal, which goes against the formal
          sustainability mission of CFA Institute to use resources responsibly and achieve its
          objectives ethically. What can you do to help? If possible, go digital and forgo print!
Journal: Financial Analysts Journal
Pages: 6-7
Issue: 4
Volume: 73
Year: 2017
Month: 10
X-DOI: 10.2469/faj.v73.n4.9
File-URL: http://hdl.handle.net/10.2469/faj.v73.n4.9
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Author-Name: Clemens Sialm
Author-X-Name-First: Clemens
Author-X-Name-Last: Sialm
Author-Name: Nathan Sosner
Author-X-Name-First: Nathan
Author-X-Name-Last: Sosner
Title: Taxes, Shorting, and Active Management
Abstract: 
 We examine the consequences of short selling in the context of quantitative investment
     strategies held by individual investors in taxable accounts. Short positions not only allow
     investors to benefit from the anticipated underperformance of securities but also create tax
     benefits because they enhance opportunities to time capital gains realizations. Relaxing
     short-selling constraints results in tax benefits because a portfolio’s long positions
     tend to realize net long-term capital gains taxed at relatively low rates, whereas short
     positions tend to realize net short-term capital losses, which can offset short-term capital
     gains from other strategies in the investor’s portfolio. Our results show that investment
     strategies that take advantage of short selling can generate superior after-tax performance by
     significantly reducing the tax burden. 
      Disclosures: The views expressed in this article are those of the authors and do not necessarily reflect
      the views of AQR Capital Management, LLC. Further information can be found at the end of this
      article. 
      Editor’s Note
     Submitted 27 January 2017 Accepted 27 March 2017 by Stephen J. Brown Disclaimer: The views and opinions expressed are those of the authors; do not necessarily
      reflect the views of AQR Capital Management, its affiliates, or its employees; and do not
      constitute an offer, solicitation of an offer, or any advice or recommendation, to purchase
      any securities or other financial instruments, and may not be construed as such. Nothing
      contained herein constitutes investment, legal, tax, or other advice, nor is it to be relied
      on in making an investment or other decision.
Journal: Financial Analysts Journal
Pages: 88-107
Issue: 1
Volume: 74
Year: 2018
Month: 2
X-DOI: 10.2469/faj.v74.n1.1
File-URL: http://hdl.handle.net/10.2469/faj.v74.n1.1
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Author-Name: Mark P. Kritzman
Author-X-Name-First: Mark P.
Author-X-Name-Last: Kritzman
Author-Name: Robert C. Merton
Author-X-Name-First: Robert C.
Author-X-Name-Last: Merton
Title: An Interview with Nobel Laureate Robert C. Merton
Abstract: 
 On 7 August 2017, Mark P. Kritzman, CFA, interviewed Robert C. Merton, winner of the 1997
          Alfred Nobel Memorial Prize in Economic Sciences, to discuss his student days at Columbia
          University, Caltech, and MIT; his development of the continuous-time theory of optimal
          lifetime consumption and portfolio choice as well as his contribution to the development
          of the option-pricing formula; and his collaboration with Paul Samuelson.
Journal: Financial Analysts Journal
Pages: 12-20
Issue: 1
Volume: 74
Year: 2018
Month: 2
X-DOI: 10.2469/faj.v74.n1.10
File-URL: http://hdl.handle.net/10.2469/faj.v74.n1.10
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Author-Name: The Editors
Title: Errata
Journal: Financial Analysts Journal
Issue: 1
Volume: 74
Year: 2018
Month: 2
X-DOI: 10.2469/faj.v74.n1.11
File-URL: http://hdl.handle.net/10.2469/faj.v74.n1.11
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# input file: UFAJ_A_12043515_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Shawn McKay
Author-X-Name-First: Shawn
Author-X-Name-Last: McKay
Author-Name: Robert Shapiro
Author-X-Name-First: Robert
Author-X-Name-Last: Shapiro
Author-Name: Ric Thomas
Author-X-Name-First: Ric
Author-X-Name-Last: Thomas
Title: What Free Lunch? The Costs of Overdiversification
Abstract: 
 Institutional investors, charged with outperforming a policy benchmark, often allocate to
     external active managers in order to hit their return objective. The challenge is to do so
     without overdiversifying the plan. Hiring too many managers can significantly reduce active
     risk, leaving the plan with high fees and limited ability to outperform a policy benchmark. We
     review the number of external investment strategies held by the largest US public and corporate
     pension funds. Our analysis shows that most large pension funds are overdiversified, allowing
     us to suggest a simpler framework for moving forward.Disclosure: The authors report no conflicts of interest.Editor’s Note This article was externally reviewed using our double-blind
      peer-review process. When the article was accepted for publication, the authors thanked the
      reviewers in their acknowledgments. Rajna Gibson Brandon and Maria Vassalou were the reviewers
      for this article. Submitted 20 October 2016Accepted 1 June 2017 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 44-58
Issue: 1
Volume: 74
Year: 2018
Month: 2
X-DOI: 10.2469/faj.v74.n1.2
File-URL: http://hdl.handle.net/10.2469/faj.v74.n1.2
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Author-Name: Ted Carey
Author-X-Name-First: Ted
Author-X-Name-Last: Carey
Title: “History Is Repeating Itself”: A Comment
Abstract: 
 This material comments on “History Is Repeating Itself: Get Ready for a Long Dry Spell” (Third
          Quarter 2017).
Journal: Financial Analysts Journal
Issue: 1
Volume: 74
Year: 2018
Month: 2
X-DOI: 10.2469/faj.v74.n1.3
File-URL: http://hdl.handle.net/10.2469/faj.v74.n1.3
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Author-Name: Lasse Heje Pedersen
Author-X-Name-First: Lasse Heje
Author-X-Name-Last: Pedersen
Title: Sharpening the Arithmetic of Active Management
Abstract: 
 I challenge William F. Sharpe’s famous equality that “before costs, the return on
     the average actively managed dollar will equal the return on the average passively managed
     dollar.” This equality is based on the implicit assumption that the market portfolio
     never changes, which does not hold in the real world because new shares are issued, others are
     repurchased, and indexes are reconstituted—so even “passive” investors must
     regularly trade. Therefore, active managers can be worth positive fees in aggregate, allowing
     them to play an important economic role: helping allocate resources efficiently. Passive
     investing also plays a useful economic role: creating low-cost access to markets.
      Disclosure: The author is a principal at AQR Capital Management, a global investment management firm,
      which may or may not apply similar investment techniques or methods of analysis as described
      herein. The views expressed here are those of the author and not necessarily those of AQR.
      Editor’s Note
     Submitted 10 January 2017Accepted 4 July 2017 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 21-36
Issue: 1
Volume: 74
Year: 2018
Month: 2
X-DOI: 10.2469/faj.v74.n1.4
File-URL: http://hdl.handle.net/10.2469/faj.v74.n1.4
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Author-Name: Gerald R. Jensen
Author-X-Name-First: Gerald R.
Author-X-Name-Last: Jensen
Author-Name: Robert R. Johnson
Author-X-Name-First: Robert R.
Author-X-Name-Last: Johnson
Author-Name: Kenneth M. Washer
Author-X-Name-First: Kenneth M.
Author-X-Name-Last: Washer
Title: All That’s Gold Does Not Glitter
Abstract: 
 Spurred by economic uncertainty, interest in precious metals has increased dramatically.
          Investors target precious-metal funds for two primary reasons: (1) to capture an expected
          appreciation in precious-metal prices and (2) as a form of portfolio insurance. The
          authors compare the advantages and disadvantages of traditional funds with those of newer
          types of funds, including bullion, synthetics, and equity. They find tremendous variation
          in both fund returns and efficacy in serving the two primary investor motivations. Their
          findings imply that the success of a commodity investment hinges on the type of fund
          selected.Disclosure: The authors report no conflicts of interest.Editor’s NoteThis article was externally reviewed using our double-blind peer-review process. When
            the article was accepted for publication, the authors thanked the reviewers in their
            acknowledgments. Dirk Baur and Claude Erb, CFA, were the reviewers for this article.Submitted 31 January 2017Accepted 14 August 2017 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 59-76
Issue: 1
Volume: 74
Year: 2018
Month: 2
X-DOI: 10.2469/faj.v74.n1.5
File-URL: http://hdl.handle.net/10.2469/faj.v74.n1.5
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Author-Name: William J. Bernstein
Author-X-Name-First: William J.
Author-X-Name-Last: Bernstein
Title: “The Long-Run Drivers of Stock Returns: Total Payouts and the Real Economy”: A Comment
Abstract: 
 This material comments on “The Long-Run Drivers of Stock Returns: Total Payouts and
          the Real Economy” (Third Quarter 2017).
Journal: Financial Analysts Journal
Issue: 1
Volume: 74
Year: 2018
Month: 2
X-DOI: 10.2469/faj.v74.n1.6
File-URL: http://hdl.handle.net/10.2469/faj.v74.n1.6
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Author-Name: Ramzi Ben-Abdallah
Author-X-Name-First: Ramzi
Author-X-Name-Last: Ben-Abdallah
Author-Name: Michèle Breton
Author-X-Name-First: Michèle
Author-X-Name-Last: Breton
Title: “History Is Repeating Itself”: Author Response
Abstract: 
 This piece addresses “History Is Repeating Itself’: A
          Comment”.
Journal: Financial Analysts Journal
Issue: 1
Volume: 74
Year: 2018
Month: 2
X-DOI: 10.2469/faj.v74.n1.7
File-URL: http://hdl.handle.net/10.2469/faj.v74.n1.7
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Author-Name: Terence C. Burnham
Author-X-Name-First: Terence C.
Author-X-Name-Last: Burnham
Author-Name: Harry Gakidis
Author-X-Name-First: Harry
Author-X-Name-Last: Gakidis
Author-Name: Jeffrey Wurgler
Author-X-Name-First: Jeffrey
Author-X-Name-Last: Wurgler
Title: Investing in the Presence of Massive Flows: The Case of MSCI Country Reclassifications
Abstract: 
 Almost $10 trillion is benchmarked to MSCI’s developed, emerging, frontier, and
          standalone market indexes. Reclassifications from one index to another require thousands
          of investors to decide how to react. We study a comprehensive sample of past
          reclassifications to inform this decision. On average, reclassified markets’ prices
          substantially overshoot between the announcement date and the effective date—prices
          fall when a market moves from an index with more benchmarked ownership to one with less
          (such as from emerging to frontier) and vice versa—but largely revert within a year.
          We identify alpha-maximizing responses to reclassifications for both benchmarked and more
          flexible investors.
            Disclosure: The views expressed herein are those of the authors and do not necessarily reflect the
            views of the National Bureau of Economic Research or Acadian Asset Management. The views
            expressed herein should not be considered investment advice and do not constitute or
            form part of any offer to issue or sell, or any solicitation of an offer to subscribe or
            to purchase, shares, units, or other interests in any particular investments.
            Editor’s Note 
          This article was externally reviewed using our double-blind peer-review process. When
            the article was accepted for publication, the authors thanked the reviewers in their
            acknowledgments. Andrew L. Berkin and Joanne M. Hill were the reviewers for this
            article. Submitted 17 January 2017 Accepted 20 August 2017 by Stephen J. Brown 
Journal: Financial Analysts Journal
Pages: 77-87
Issue: 1
Volume: 74
Year: 2018
Month: 2
X-DOI: 10.2469/faj.v74.n1.8
File-URL: http://hdl.handle.net/10.2469/faj.v74.n1.8
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Author-Name: Philip U. Straehl
Author-X-Name-First: Philip U.
Author-X-Name-Last: Straehl
Author-Name: Roger G. Ibbotson
Author-X-Name-First: Roger G.
Author-X-Name-Last: Ibbotson
Title: “The Long-Run Drivers of Stock Returns: Total Payouts and the Real Economy”: Author Response
Abstract: 
 This piece addresses ‘The Long-Run Drivers of Stock Returns: Total Payouts
          and the Real Economy”: A Comment’
Journal: Financial Analysts Journal
Issue: 1
Volume: 74
Year: 2018
Month: 2
X-DOI: 10.2469/faj.v74.n1.9
File-URL: http://hdl.handle.net/10.2469/faj.v74.n1.9
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Author-Name: Albert J. Menkveld
Author-X-Name-First: Albert J.
Author-X-Name-Last: Menkveld
Title: High-Frequency Trading as Viewed through an Electron Microscope
Abstract: 
 The electron microscope improved our vision by a factor of 1 million, enabling us to see
     atoms. In this study, I aim for a similar leap by examining trades executed in nanoseconds, a
     million times more precise than the oft-used milliseconds. This approach allows us to observe
     asset reallocations among rapid-fire “tradebots,” including those used by
     high-frequency traders (HFTs). Some 20% of trades occur in submillisecond clusters, which seem
     to have no price instability. Although submillisecond trade bursts are costly to non-HFTs in terms of adverse
     selection, these costs can be avoided.
      Disclosure: The author reports no conflicts of interest.
      Editor’s Note
     Submitted 13 January 2017Accepted 16 May 2017 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 24-31
Issue: 2
Volume: 74
Year: 2018
Month: 4
X-DOI: 10.2469/faj.v74.n2.1
File-URL: http://hdl.handle.net/10.2469/faj.v74.n2.1
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Author-Name: Qiang Kang
Author-X-Name-First: Qiang
Author-X-Name-Last: Kang
Author-Name: Xi Li
Author-X-Name-First: Xi
Author-X-Name-Last: Li
Author-Name: Tie Su
Author-X-Name-First: Tie
Author-X-Name-Last: Su
Title: Sell-Side Financial Analysts and the CFA® Program
Abstract: 
 We examine the effects the Chartered Financial Analyst® (CFA) designation
     program has on recommendation performance and career outcomes of the analysts who complete the
     CFA Program and become CFA charterholders. For these analysts, both their recommendation
     performance and their chances of making Institutional Investor’s
     All-America Research Team increased during the 1993–2015 period. These effects are
     attributable to the CFA Program curriculum. The results remain largely stable over the pre- and
     post-2000 subperiods, and they survive an array of robustness checks.Disclosure: The authors report no conflicts of interest.
      Editor’s Note
     Submitted 21 November 2015 Accepted 19 September 2017 by Stephen J. Brown 
Journal: Financial Analysts Journal
Pages: 70-83
Issue: 2
Volume: 74
Year: 2018
Month: 4
X-DOI: 10.2469/faj.v74.n2.2
File-URL: http://hdl.handle.net/10.2469/faj.v74.n2.2
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Author-Name: Renée B. Adams
Author-X-Name-First: Renée B.
Author-X-Name-Last: Adams
Author-Name: Brad M. Barber
Author-X-Name-First: Brad M.
Author-X-Name-Last: Barber
Author-Name: Terrance Odean
Author-X-Name-First: Terrance
Author-X-Name-Last: Odean
Title: STEM Parents and Women in Finance
Abstract: 
 “STEM parents” refers to parents who work in a science, technology,
          engineering, or mathematics field. Using survey data from CFA Institute members, we show
          that parental careers differentially affect the future career choices of girls and boys.
          Among CFA Institute members, women are more likely to have a STEM parent (particularly a
          STEM mother) than men. Relative to the base rates at which girls and boys become CFA
          Institute members, STEM mothers increase the girls’ rate by 48% more than the
          boys’ rate; STEM fathers increase the girls’ rate 29% more than the
          boys’ rate. Our findings are consistent with the hypothesis that early role models,
          particularly female role models, influence women’s choice of a finance career.Disclosure: The authors report no conflicts of interest.
            Editor's Note
          Submitted 17 July 2017Accepted 5 December 2017 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 84-97
Issue: 2
Volume: 74
Year: 2018
Month: 4
X-DOI: 10.2469/faj.v74.n2.3
File-URL: http://hdl.handle.net/10.2469/faj.v74.n2.3
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Author-Name: Ari Levine
Author-X-Name-First: Ari
Author-X-Name-Last: Levine
Author-Name: Yao Hua Ooi
Author-X-Name-First: Yao Hua
Author-X-Name-Last: Ooi
Author-Name: Matthew Richardson
Author-X-Name-First: Matthew
Author-X-Name-Last: Richardson
Author-Name: Caroline Sasseville
Author-X-Name-First: Caroline
Author-X-Name-Last: Sasseville
Title: Commodities for the Long Run
Abstract: 
 Using a novel dataset consisting of daily futures prices going back to 1877, we find that
          returns of commodity futures indices have, on average, been positive over the long run.
          Although return premiums are associated with both carry and spot returns, commodity
          returns in different economic states (inflation up/down, expansion/recession) vary mostly
          as a result of moves in the underlying spot price. These economic states are important
          drivers of commodity returns, even after conditioning on whether commodity markets are in
          backwardation or contango. The evidence supports commodities as a potentially attractive
          asset class in portfolios of stocks and bonds.Disclosure: Three of the authors are employed at AQR
            Capital Management, a global investment management firm, which may or may not apply
            similar investment techniques or methods of analysis as described herein. The views
            expressed here are those of the authors and not necessarily those of AQR.
            Editor’s Note
          This article was externally reviewed using our double-blind peer-review process. When
            the article was accepted for publication, the authors thanked the reviewers in their
            acknowledgments. William Fung was one of the reviewers for this article.Submitted 27 October 2016Accepted 20 December 2017 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 55-68
Issue: 2
Volume: 74
Year: 2018
Month: 4
X-DOI: 10.2469/faj.v74.n2.4
File-URL: http://hdl.handle.net/10.2469/faj.v74.n2.4
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Author-Name: Hendrik Bessembinder
Author-X-Name-First: Hendrik
Author-X-Name-Last: Bessembinder
Title: The “Roll Yield” Myth
Abstract: 
 Futures investors are frequently said to periodically pay or receive the difference in
          futures prices across contracts with different delivery dates. But this “roll
          yield” is mythical: No such cash flow occurs—at the time of roll trades or on
          any other date. However, although the term is a misnomer, the roll yield does contain
          useful information. It explains when futures gains exceed or fall short of spot-price
          changes, and for storable assets, it provides information regarding benefits to the
          marginal holder of a spot position. This article clarifies the actual role of the roll
          yield.Disclosure: The author reports no conflicts of interest.
            Editor’s Note
          This article was externally reviewed using our double-blind peer-review process. When
            the article was accepted for publication, the author thanked the reviewers in the
            acknowledgments. Hilary Till was one of the reviewers for this article. Submitted 21 September 2017Accepted 6 February 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 41-53
Issue: 2
Volume: 74
Year: 2018
Month: 4
X-DOI: 10.2469/faj.v74.n2.5
File-URL: http://hdl.handle.net/10.2469/faj.v74.n2.5
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Author-Name: Vineer Bhansali
Author-X-Name-First: Vineer
Author-X-Name-Last: Bhansali
Author-Name: Larry Harris
Author-X-Name-First: Larry
Author-X-Name-Last: Harris
Title: Everybody’s Doing It: Short Volatility Strategies and Shadow Financial Insurers
Abstract: 
 The extraordinary growth of short volatility strategies creates risks that may trigger a
          serious market crash. A low-yield, low-volatility environment has drawn various market
          participants into essentially similar short volatility-contingent strategies with a common
          nonlinear risk factor. We discuss these strategies, their commonalities, and the generally
          unrecognized risks that they would pose if everyone were to unwind simultaneously.
          Volatility-selling investors essentially provide “shadow financial insurance.”
          Investors and regulators would benefit from preparing for large, self-reinforcing
          technical unwinds that may occur when/if central banks change policy or macro or political
          events affect investor confidence. We also discuss potential mechanisms that might provide
          stabilization against largely adverse financial outcomes.
            Disclosure: The views expressed in this article are those of the authors
            and do not necessarily reflect the views of LongTail Alpha, LLC; the USC Marshall School
            of Business; or Interactive Brokers. Further information appears at the end of this
            article. 
            Editor’s Note
          Submitted 15 November 2017 Accepted 14 February 2018 by Stephen J. Brown LongTail Alpha, LLC, is an SEC-registered investment adviser and a Commodity Futures
            Trading Commission registered commodity trading adviser and commodity pool operator. The reader
            should not treat any opinion expressed by Dr. Bhansali as investment advice or as a
            recommendation to make an investment in any particular investment strategy or product.
            Many of Interactive Brokers’ brokerage clients actively trade volatility products.
            Professor Harris undertook this project independently of his relationship with
            Interactive Brokers. He received no compensation for his participation from any entity.
Journal: Financial Analysts Journal
Pages: 12-23
Issue: 2
Volume: 74
Year: 2018
Month: 4
X-DOI: 10.2469/faj.v74.n2.6
File-URL: http://hdl.handle.net/10.2469/faj.v74.n2.6
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Author-Name: Stephen J. Brown
Author-X-Name-First: Stephen J.
Author-X-Name-Last: Brown
Title: 2017 Report to Readers
Abstract: 
 In 2017, we published 22 peer-reviewed articles, including 18 research articles and four
          Perspectives pieces, on a broad range of topics related to the practice of investment
          management. We also published one Viewpoint, one Editor’s Corner, and an interview with
          Nobel Prize winner Harry Markowitz. This variety of content continues to provide unique
          opportunities for readers to advance their knowledge and understanding of the practice of
          investment management and to keep abreast of new research and ideas.
Journal: Financial Analysts Journal
Pages: 5-8
Issue: 2
Volume: 74
Year: 2018
Month: 4
X-DOI: 10.2469/faj.v74.n2.7
File-URL: http://hdl.handle.net/10.2469/faj.v74.n2.7
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Author-Name: The Editors
Title: Our Thanks to Reviewers
Abstract: 
 We thank the 124 reviewers who took part during 2017 in the double-blind peer-review
          process that guarantees the quality of the Financial Analysts
          Journal.
Journal: Financial Analysts Journal
Pages: 10-10
Issue: 2
Volume: 74
Year: 2018
Month: 4
X-DOI: 10.2469/faj.v74.n2.8
File-URL: http://hdl.handle.net/10.2469/faj.v74.n2.8
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Author-Name: John C. Bogle
Author-X-Name-First: John C.
Author-X-Name-Last: Bogle
Title: The Modern Corporation and the Public Interest
Abstract: 
 Video abstractIn this essay, I discuss the problems associated with the rise of institutional investors
          and the concentration of stock ownership. I seek to answer the question, What
							is the public interest that the modern corporation should serve? I
          provide solutions for achieving a modern capitalism that place fiduciary duty and the
          public interest first. 
							Disclosure: The views expressed in this essay are solely those of the author
            and do not necessarily represent the opinions of Vanguard’s present
            management.Read the transcript
Journal: Financial Analysts Journal
Pages: 8-17
Issue: 3
Volume: 74
Year: 2018
Month: 7
X-DOI: 10.2469/faj.v74.n3.1
File-URL: http://hdl.handle.net/10.2469/faj.v74.n3.1
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Author-Name: Amir Amel-Zadeh
Author-X-Name-First: Amir
Author-X-Name-Last: Amel-Zadeh
Author-Name: George Serafeim
Author-X-Name-First: George
Author-X-Name-Last: Serafeim
Title: Why and How Investors Use ESG Information: Evidence from a Global Survey
Abstract: 
 Using survey data from mainstream investment organizations, we provide insights into why
          and how investors use reported environmental, social, and governance (ESG) information.
          Relevance to investment performance is the most frequent motivation, followed by client
          demand, product strategy, and then, ethical considerations. An important impediment to the
          use of ESG information is the lack of reporting standards. Among the various ESG
          investment styles, negative screening is perceived to be the least beneficial to
          investments and is driven by product and ethical considerations. Full integration and
          engagement are considered more beneficial and are driven by relevance to investment
          performance.A practitioner's perspective on this article is provided in the In Practice piece "ESG Investing Moves to the Mainstream" by Keyur Patel, online 18 June 2018.
            Disclosure: Professor Serafeim serves on the advisory board of investment
            organizations that practice various environmental, social, and governance styles.
            Professor Amel-Zadeh received a research grant from Bank of New York Mellon supporting
            this research. He also received speaker honoraria from the same organization. 
            Editor’s Note 
          Submitted 19 October 2017 Accepted 23 February 2018 by Stephen J. Brown This article was externally reviewed using our double-blind peer-review process. When
            the article was accepted for publication, the authors thanked the reviewers in the
            acknowledgments. John Christopher Hughen, CFA, CIPM, was one of the reviewers for this
            article. 
Journal: Financial Analysts Journal
Pages: 87-103
Issue: 3
Volume: 74
Year: 2018
Month: 7
X-DOI: 10.2469/faj.v74.n3.2
File-URL: http://hdl.handle.net/10.2469/faj.v74.n3.2
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Author-Name: Sébastien Page
Author-X-Name-First: Sébastien
Author-X-Name-Last: Page
Author-Name: Robert A. Panariello
Author-X-Name-First: Robert A.
Author-X-Name-Last: Panariello
Title: When Diversification Fails
Abstract: 
 One of the most vexing problems in investment management is that diversification seems to
     disappear when investors need it the most. We surmise that many investors still do not fully
     appreciate the impact of extreme correlations on portfolio efficiency—in particular, on
     exposure to loss. We take an in-depth look at what drives the stock-to-credit,
     stock-to–hedge fund, stock-to–private asset, stock-to–risk factors, and
     stock-to-bond correlations during tail events. We introduce a data-augmentation technique to
     improve the robustness of tail correlation estimates. Finally, we discuss implications for
     multi-asset investing.Disclosure: The views expressed in this article are those of the authors and do
      not necessarily reflect the views of T. Rowe Price. Details can be found at the end of this
      article.
      Editor’s Note
     Submitted 7 November 2017Accepted 23 February 2018 by Stephen J. BrownViews expressed by the authors', are subject to change without notice, and may differ from
      those of other T. Rowe Price associates. Information and opinions are derived from sources
      deemed reliable; their accuracy is not guaranteed. This material does not constitute a
      distribution, offer, invitation, recommendation, or solicitation to sell or buy any
      securities; it does not constitute investment advice and should not be relied upon as such.
      Investors should seek independent legal and financial advice before making investment
      decisions. Past performance cannot guarantee future results. All investments involve risk. The
      charts and tables are shown for illustrative purposes only.
Journal: Financial Analysts Journal
Pages: 19-32
Issue: 3
Volume: 74
Year: 2018
Month: 7
X-DOI: 10.2469/faj.v74.n3.3
File-URL: http://hdl.handle.net/10.2469/faj.v74.n3.3
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Author-Name: Charles Cao
Author-X-Name-First: Charles
Author-X-Name-Last: Cao
Author-Name: Yong Chen
Author-X-Name-First: Yong
Author-X-Name-Last: Chen
Author-Name: William N. Goetzmann
Author-X-Name-First: William N.
Author-X-Name-Last: Goetzmann
Author-Name: Bing Liang
Author-X-Name-First: Bing
Author-X-Name-Last: Liang
Title: Hedge Funds and Stock Price Formation
Abstract: 
 Using comprehensive quarterly data on hedge fund stock holdings, we study the role of hedge
     funds in the process of stock price formation. We find that hedge funds tend to hold
     undervalued stocks and that both hedge fund ownership and trading by hedge funds are positively related
     to the degree of stock mispricing. A portfolio of undervalued stocks with high hedge fund
     ownership generated a risk-adjusted return of 0.40% per month (4.8% annually), and the profit
     remained even after transaction costs. Hedge fund ownership and trades also precede the
     dissipation of stock mispricing. These patterns are either nonexistent or much weaker for other
     institutional investors. Our results suggest that hedge funds exploit and help correct
     mispricing but the process is not instantaneous.A practitioner's perspective on this article is provided in the In Practice piece "Hedge Funds' Influence on Stocks" by Phil Davis, online 9 July 2018.
      Disclosure: William N. Goetzmann is on the scientific advisory board of a small hedge fund, Zebra
       Asset Management. 
      Editor’s Note
     Submitted 16 June 2017
     Accepted 23 February 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 54-68
Issue: 3
Volume: 74
Year: 2018
Month: 7
X-DOI: 10.2469/faj.v74.n3.4
File-URL: http://hdl.handle.net/10.2469/faj.v74.n3.4
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Author-Name: Khalid Ghayur
Author-X-Name-First: Khalid
Author-X-Name-Last: Ghayur
Author-Name: Ronan Heaney
Author-X-Name-First: Ronan
Author-X-Name-Last: Heaney
Author-Name: Stephen Platt
Author-X-Name-First: Stephen
Author-X-Name-Last: Platt
Title: Constructing Long-Only Multifactor Strategies: Portfolio Blending vs. Signal Blending
Abstract: 
 Long-only multifactor strategies may be constructed by combining individual-factor portfolios
     (portfolio blending) or by combining individual-factor signals into a composite signal to
     construct the portfolio (signal blending). To compare these two approaches, we present a
     framework for building exposure-matched portfolios. In empirical tests on global equity
     markets, we find that, generally, portfolio blending generates higher information ratios for
     low-to-moderate levels of tracking error. At high levels of tracking error, signal blending
     delivers better risk-adjusted performance. These results generally hold for various factor
     combinations, and they have important practical implications for investors considering the
     implementation of multifactor smart-beta strategies.A practitioner's perspective on this article is provided in the In Practice piece "Comparing Portfolio Blending and Signal Blending
      when Constructing Multifactor Portfolios" by Keyur Patel, online 23 July 2018.
      Disclosure:  The authors work at Goldman Sachs Asset Management, which offers
      strategies that use both the portfolio-blending and signal-blending approaches to factor
      investing. Additional disclosures can be found at the end of this article. 
      Editor’s Note
     Submitted 30 March 2017Accepted 16 March 2018 by Stephen J. BrownThis article was externally reviewed using our double-blind peer-review process. When the
      article was accepted for publication, the authors thanked the reviewers in the
      acknowledgments. Markus Leippold was one of the reviewers for this article. Disclosure: The views and opinions expressed herein are those of the authors.
      The backtests and analysis described are provided for educational purposes in reliance on past
      market data with the benefit of hindsight and do not reflect actual results. If any
      assumptions used do not prove to be true, results may vary substantially. Our research does
      not take into account specific investment objectives or investor guidelines or restrictions.
      Investors must also consider suitability, liquidity needs, and investment objectives when
      determining appropriate asset allocation.
Journal: Financial Analysts Journal
Pages: 70-85
Issue: 3
Volume: 74
Year: 2018
Month: 7
X-DOI: 10.2469/faj.v74.n3.5
File-URL: http://hdl.handle.net/10.2469/faj.v74.n3.5
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Author-Name: Eugene F. Fama
Author-X-Name-First: Eugene F.
Author-X-Name-Last: Fama
Author-Name: Kenneth R. French
Author-X-Name-First: Kenneth R.
Author-X-Name-Last: French
Title: Volatility Lessons
Abstract: 
 The average monthly premium of the Market return over the one-month T-bill return is
          substantial, as are average premiums of value and small stocks over Market. As the return
          horizon increases, premium distributions become more disperse, but they move to the right
          (toward higher values) faster than they become more disperse. There is, however, some bad
          news. Even if future expected premiums match high past averages, high volatility means
          that for the 3- and 5-year periods commonly used to evaluate asset allocations, the
          probabilities of negative realized premiums are substantial, and the probabilities are
          nontrivial for 10- and 20-year periods.A practitioner's perspective on this article is provided in the In Practice piece "Volatility: It's Worse Than You Thought " by Phil Davis, online 6 August 2018.
            Disclosure: The authors are consultants to, board members of, and shareholders in
              Dimensional Fund Advisors.
            Editor’s Note
          This article was externally reviewed using our double-blind peer-review process.
              When the article was accepted for publication, the authors thanked the reviewers in
              their acknowledgments. Lisa Goldberg was one of the reviewers for this
              article.
          Submitted 30 November 2017 
          Accepted 25 April 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 42-53
Issue: 3
Volume: 74
Year: 2018
Month: 7
X-DOI: 10.2469/faj.v74.n3.6
File-URL: http://hdl.handle.net/10.2469/faj.v74.n3.6
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Author-Name: Gary Baker
Author-X-Name-First: Gary
Author-X-Name-Last: Baker
Title: The Financial Analysts Journal Welcomes Its New Managing Editor
Abstract: 
          The Financial Analysts Journal welcomes Dr. Heidi Raubenheimer,
            CFA, as its managing editor and Head of Journal Publications at CFA Institute.
Journal: Financial Analysts Journal
Pages: 6-6
Issue: 3
Volume: 74
Year: 2018
Month: 7
X-DOI: 10.2469/faj.v74.n3.7
File-URL: http://hdl.handle.net/10.2469/faj.v74.n3.7
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Author-Name: Peng Wang
Author-X-Name-First: Peng
Author-X-Name-Last: Wang
Author-Name: Laura Chapman
Author-X-Name-First: Laura
Author-X-Name-Last: Chapman
Author-Name: Steven Peterson
Author-X-Name-First: Steven
Author-X-Name-Last: Peterson
Author-Name: Jon Spinney
Author-X-Name-First: Jon
Author-X-Name-Last: Spinney
Title: Evaluating Spending Policies in a Low-Return Environment
Abstract: 
 For an endowment seeking to minimize payout variability while preserving the long-run
          health of the institution, appropriate spending policy is a crucial choice. We study two
          competing methods for setting spending policy—the “moving-average”
          method and the “snake-in-the-tunnel” (SIT) approach. We show that the SIT
          approach may significantly decrease the possibility of spending reductions in the short
          run. Additionally, the SIT approach with 3%–7% bands allows for a smooth evolution
          of payouts over time, which enhances spending predictability while preserving the
          endowment’s real (inflation-adjusted) long-run purchasing power.
            Disclosure:  The authors report no conflicts of interest. 
            Editor’s Note 
          Submitted 13 October 2017 Accepted 12 April 2018 by Stephen J. Brown 
Journal: Financial Analysts Journal
Pages: 11-23
Issue: 4
Volume: 74
Year: 2018
Month: 9
X-DOI: 10.2469/faj.v74.n4.1
File-URL: http://hdl.handle.net/10.2469/faj.v74.n4.1
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Author-Name: Charles D. Ellis
Author-X-Name-First: Charles D.
Author-X-Name-Last: Ellis
Title: Our #1 Challenge: Retirement Insecurity
Abstract: 
 One of the consequences of the shift in corporate retirement plans from defined benefit
          to defined contribution is widespread retirement insecurity. Although most people in the
          top one-third of economic affluence will be fine, for the other two-thirds—particularly
          the bottom one-third—the problem is a serious threat. We can prevent this painful
          future if we act sensibly and soon by raising the alarm with our corporate and government
          leaders.
Journal: Financial Analysts Journal
Pages: 6-9
Issue: 4
Volume: 74
Year: 2018
Month: 9
X-DOI: 10.2469/faj.v74.n4.2
File-URL: http://hdl.handle.net/10.2469/faj.v74.n4.2
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Author-Name: Andrea Frazzini
Author-X-Name-First: Andrea
Author-X-Name-Last: Frazzini
Author-Name: David Kabiller
Author-X-Name-First: David
Author-X-Name-Last: Kabiller
Author-Name: Lasse Heje Pedersen
Author-X-Name-First: Lasse Heje
Author-X-Name-Last: Pedersen
Title: Buffett’s Alpha
Abstract: 
 Warren Buffett’s Berkshire Hathaway has realized a Sharpe ratio of 0.79 with
     significant alpha to traditional risk factors. The alpha became insignificant, however, when we
     controlled for exposure to the factors “betting against beta” and “quality
     minus junk.” Furthermore, we estimate that Buffett’s leverage is about 1.7 to 1,
     on average. Therefore, Buffett’s returns appear to be neither luck nor magic but,
     rather, a reward for leveraging cheap, safe, high-quality stocks. Decomposing
     Berkshire’s portfolio into publicly traded stocks and wholly owned private companies, we
     found that the public stocks have performed the best, which suggests that Buffett’s
     returns are more the result of stock selection than of his effect on management.A practitioner's perspective on this article is provided in the In Practice piece "Demystifying Buffett’s Investment Success" by Keyur Patel.
      Disclosure: The authors are principals at AQR Capital Management, a global investment management
      firm, which may or may not apply investment techniques or methods of analysis similar to those
      described in this article. The views expressed here are those of the authors and not
      necessarily those of AQR.
      Editor’s Note 
     Submitted 24 April 2018
     Accepted 15 June 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 35-55
Issue: 4
Volume: 74
Year: 2018
Month: 9
X-DOI: 10.2469/faj.v74.n4.3
File-URL: http://hdl.handle.net/10.2469/faj.v74.n4.3
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# input file: UFAJ_A_12048398_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jean-François L’Her
Author-X-Name-First: Jean-François
Author-X-Name-Last: L’Her
Author-Name: Tarek Masmoudi
Author-X-Name-First: Tarek
Author-X-Name-Last: Masmoudi
Author-Name: Ram Karthik Krishnamoorthy
Author-X-Name-First: Ram Karthik
Author-X-Name-Last: Krishnamoorthy
Title: Net Buybacks and the Seven Dwarfs
Abstract: 
 During the last two decades, the relationship between economic growth and equity returns has
     been weak across global stock markets. Economic growth has not been a good proxy for
     dividend-per-share growth. In the majority of the stock markets, issuance has exceeded buybacks
     and has resulted in a dilution effect. In several markets, however, buybacks have exceeded
     issuance, resulting in an accretion effect. The main finding of our study is that, whether
     investors use a dividend model or a total payout model to decompose equity returns, net
     buybacks explain more than 80% of the cross-sectional dispersion of stock market returns.A practitioner's perspective on this article is provided in the In Practice piece "Economic Growth = High Returns? Don't Bet on It" by Phil Davis.Disclosure: The views expressed in this article are those of the authors in their
      personal capacity and do not necessarily reflect the views of the Abu Dhabi Investment
      Authority (ADIA). Although the authors have taken care to ensure that the information herein
      is accurate at the time of publication, neither the authors nor ADIA make any representation
      or warranty with respect to the accuracy of this article.Editor’s NoteThis article was externally reviewed using our double-blind peer-review process. When
       the article was accepted for publication, the authors thanked the reviewers in their
       acknowledgments. Roger Ibbotson was one of the reviewers for this article.
     Submitted 11 September 2017
     Accepted 21 June 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 57-85
Issue: 4
Volume: 74
Year: 2018
Month: 9
X-DOI: 10.2469/faj.v74.n4.4
File-URL: http://hdl.handle.net/10.2469/faj.v74.n4.4
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Handle: RePEc:taf:ufajxx:v:74:y:2018:i:4:p:57-85




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Author-Name: Chansog (Francis) Kim
Author-X-Name-First: Chansog (Francis)
Author-X-Name-Last: Kim
Author-Name: Incheol Kim
Author-X-Name-First: Incheol
Author-X-Name-Last: Kim
Author-Name: Christos Pantzalis
Author-X-Name-First: Christos
Author-X-Name-Last: Pantzalis
Author-Name: Jung Chul Park
Author-X-Name-First: Jung Chul
Author-X-Name-Last: Park
Title: Corporate Political Strategies and Return Predictability
Abstract: 
 We assess whether observable corporate political strategies can serve as channels of
     value-relevant political information flow into stock prices and form the basis for profitable
     return predictability strategies. We document that returns of politically connected
     firms’ stocks lead those of their non-connected peers, suggesting that information shocks
     associated with new policies and other political developments become evident first in the stock
     prices of firms that pursue political strategies and then, with delay, in those of similar,
     non-connected firms.It's often said that money and power go hand in hand. Now there is hard evidence that
     investors can achieve outperformance by analyzing the political connectedness of companies.A practitioner's perspective on this article is provided in the In Practice piece "The Predictive Power of Politics" by Phil Davis.
      Disclosure: The authors report no conflicts of interest. 
      Editor’s Note
     Submitted 29 September 2017 Accepted 23 July 2018 by Stephen J. Brown This article was externally reviewed using our double-blind peer-review process. When the
      article was accepted for publication, the authors thanked the reviewers in the
      acknowledgments. Heiko Bailer and Claude B. Erb, CFA, were the reviewers for this article.
Journal: Financial Analysts Journal
Pages: 87-101
Issue: 4
Volume: 74
Year: 2018
Month: 9
X-DOI: 10.2469/faj.v74.n4.5
File-URL: http://hdl.handle.net/10.2469/faj.v74.n4.5
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Author-Name: Stephen Penman
Author-X-Name-First: Stephen
Author-X-Name-Last: Penman
Author-Name: Francesco Reggiani
Author-X-Name-First: Francesco
Author-X-Name-Last: Reggiani
Title: Fundamentals of Value versus Growth Investing and an Explanation for the Value Trap
Abstract: 
 Value stocks earn higher returns than growth stocks on average, but a “value”
     position can turn against the investor. Fundamental analysis can explain this so-called value
     trap: The investor may be buying earnings growth that is risky. Both the earnings-to-price
     ratio (E/P) and the book-to-price ratio (B/P) come into play. E/P indicates expected earnings
     growth, but price in that ratio also discounts for the risk to that growth; B/P indicates that
     risk. A striking finding emerges: For a given E/P, a high B/P (“value”) indicates
     higher expected earnings growth—but growth that is risky. This finding contrasts with the
     standard convention that considers a low B/P to be “growth” with lower risk.A practitioner's perspective on this article is provided in the In Practice piece "Explaining Value vs. Growth Investing through Accounting
       Fundamentals" by Keyur Patel.Disclosure: The authors report no conflicts of interest.Editor’s NoteThis article was externally reviewed using our double-blind peer-review process. When
       the article was accepted for publication, the authors thanked the reviewers in their
       acknowledgments. Clifford S. Asness was one of the reviewers for this article.
     Submitted 12 December 2017
     Accepted 23 July 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 103-119
Issue: 4
Volume: 74
Year: 2018
Month: 9
X-DOI: 10.2469/faj.v74.n4.6
File-URL: http://hdl.handle.net/10.2469/faj.v74.n4.6
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Handle: RePEc:taf:ufajxx:v:74:y:2018:i:4:p:103-119




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# input file: UFAJ_A_1547049_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Douglas Cumming
Author-X-Name-First: Douglas
Author-X-Name-Last: Cumming
Author-Name: Grant Fleming
Author-X-Name-First: Grant
Author-X-Name-Last: Fleming
Author-Name: Zhangxin (Frank) Liu
Author-X-Name-First: Zhangxin (Frank)
Author-X-Name-Last: Liu
Title: The Returns to Private Debt: Primary Issuances vs. Secondary Acquisitions
Abstract: 
 Private debt fund managers invest in debt positions of private companies through (1) new
          issuances or (2) secondary acquisition of loans. In the study reported here, we used data
          from more than 400 investments into private companies in 13 Asia-Pacific markets between
          2001 and 2015 to examine which strategy performs best. Conditional on market and industry
          factors, trading private debt delivers higher returns than buying and holding a primary
          issuance. So, institutional investors should permit fund managers investment flexibility
          to trade. Furthermore, a portfolio of private debt investments delivers excess returns to
          public markets over time, with excess returns affected by volatility, funding liquidity,
          and the global financial crisis. An investment in Asia-Pacific private debt should improve
          risk-adjusted returns for a global or emerging market fixed-income portfolio.Disclosure: The authors report no conflicts of interest.
            Editor’s Note
          Submitted 15 September 2017Accepted 9 August 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 48-62
Issue: 1
Volume: 75
Year: 2019
Month: 2
X-DOI: 10.1080/0015198X.2018.1547049
File-URL: http://hdl.handle.net/10.1080/0015198X.2018.1547049
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# input file: UFAJ_A_1547051_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Alexander N. Bogin
Author-X-Name-First: Alexander N.
Author-X-Name-Last: Bogin
Author-Name: William M. Doerner
Author-X-Name-First: William M.
Author-X-Name-Last: Doerner
Author-Name: William D. Larson
Author-X-Name-First: William D.
Author-X-Name-Last: Larson
Title: Missing the Mark: Mortgage Valuation Accuracy and Credit Modeling
Abstract: 
 In 2008, the US mortgage market collapsed under a lack of transparency, incorrect pricing,
     and underestimated risk. Price indexes, however, could help investment managers monitor assets
     that are heterogeneous or infrequently traded. Responding to needs for better valuation
     approaches, we created new localized house price indexes and evaluated their ability to predict
     transaction prices and mortgage performance. We show where and when valuation errors occur and
     how to avoid them. Our work has a broader application than mortgage valuation for analysts or
     investors valuing alternative assets—namely, using the most granular indexes yields
     positive but diminishing modeling gains when submarket trends exist.
     Disclosure: The authors report no conflicts of interest.
     Editor’s Note
    This article was externally reviewed using our double-blind peer-review process. When the
      article was accepted for publication, the authors thanked the reviewers in their
      acknowledgments. Jonatan Groba and Dan Scholz, CFA, were the reviewers for this article. Submitted 25 November 2017 Accepted 26 July 2018 by Stephen J. Brown 
Journal: Financial Analysts Journal
Pages: 32-47
Issue: 1
Volume: 75
Year: 2019
Month: 2
X-DOI: 10.1080/0015198X.2018.1547051
File-URL: http://hdl.handle.net/10.1080/0015198X.2018.1547051
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# input file: UFAJ_A_1547052_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Gert Elaut
Author-X-Name-First: Gert
Author-X-Name-Last: Elaut
Author-Name: Péter Erdős
Author-X-Name-First: Péter
Author-X-Name-Last: Erdős
Title: Trends’ Signal Strength and the Performance of CTAs
Abstract: 
 We propose a new asset-based factor that relies on aggregating momentum signals over
     different horizons. Aggregating signals this way captures assets’ trend signal strength,
     thereby addressing a limitation in existing time series momentum strategies. Our factor mimics
     a trend-following manager that increases exposure to markets where trends develop and decreases
     exposure to markets where trends fade. Taking into account a number of practical implementation
     issues, we found that our proposed factor performs better at replicating the stylized facts of
     Commodity Trading Advisors’ returns than previous methods and allows a more meaningful
     assessment of fund alpha.Editor's Note: The original version had a typographical error in Equation
	5, which has been corrected in this version.Disclosure: The authors report no conflicts of interest.
      Editor’s Note
     Submitted 9 November 2017Accepted 31 August 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 64-83
Issue: 1
Volume: 75
Year: 2019
Month: 2
X-DOI: 10.1080/0015198X.2018.1547052
File-URL: http://hdl.handle.net/10.1080/0015198X.2018.1547052
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# input file: UFAJ_A_1547053_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Arun Muralidhar
Author-X-Name-First: Arun
Author-X-Name-Last: Muralidhar
Title: Can (Financial) Ignorance Be Bliss?
Abstract: 
 Financial illiteracy is widespread and leads to bad financial decisions. Individuals
          cannot answer basic questions about inflation, compounding, and diversification. This
          article argues that financial literacy programs should be complemented with a new class of
          financial instruments that embed goal-specific compounding and inflation protection. These
          income-only real bonds, with a forward start date, would pay investors for the period
          required for the respective goal. Further, there is ample potential supply from natural
          issuers. This innovation trivializes the investment problem to just simple multiplication
          or division, thereby addressing the challenge of financial illiteracy with financial
          innovation across a range of saving/investment goals.Disclosure: The author reports no conflicts of interest.
            Editor’s Note
          This article was externally reviewed using our double-blind peer-review process. When
            the article was accepted for publication, the author thanked the reviewers in his
            acknowledgments. David Chambers and Raul Leote de Carvalho were the reviewers for this
            article. Submitted 18 March 2018Accepted 5 October 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 8-15
Issue: 1
Volume: 75
Year: 2019
Month: 2
X-DOI: 10.1080/0015198X.2018.1547053
File-URL: http://hdl.handle.net/10.1080/0015198X.2018.1547053
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# input file: UFAJ_A_1547056_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jacob Boudoukh
Author-X-Name-First: Jacob
Author-X-Name-Last: Boudoukh
Author-Name: Ronen Israel
Author-X-Name-First: Ronen
Author-X-Name-Last: Israel
Author-Name: Matthew Richardson
Author-X-Name-First: Matthew
Author-X-Name-Last: Richardson
Title: Long-Horizon Predictability: A Cautionary Tale
Abstract: 
 Long-horizon return regressions effectively have small sample sizes. Using overlapping
          long-horizon returns provides only marginal benefit. Adjustments for overlapping
          observations have greatly overstated t-statistics. The evidence from
          regressions at multiple horizons is often misinterpreted. As a result, much less
          statistical evidence of long-horizon return predictability exists than is implied by
          research, which casts doubt on claims about forecasts based on stock market valuations and
          factor timing.Disclosure: AQR Capital Management is a global investment management firm that may or may
          not apply investment techniques or methods of analysis similar to those described
          herein. The views expressed here are those of the authors and not necessarily those of
          AQR.Editor’s NoteSubmitted 2 April 2018Accepted 1 August 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 17-30
Issue: 1
Volume: 75
Year: 2019
Month: 2
X-DOI: 10.1080/0015198X.2018.1547056
File-URL: http://hdl.handle.net/10.1080/0015198X.2018.1547056
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Author-Name: Robert Novy-Marx
Author-X-Name-First: Robert
Author-X-Name-Last: Novy-Marx
Author-Name: Mihail Velikov
Author-X-Name-First: Mihail
Author-X-Name-Last: Velikov
Title: Comparing Cost-Mitigation Techniques
Abstract: 
 This article compares the efficacy of three common transaction-cost-mitigation
          techniques: limiting a strategy to cheap-to-trade securities, rebalancing a strategy less
          frequently, and “banding,” which imposes a higher hurdle for actively trading
          into a position than for maintaining an established position. All three strategies
          significantly reduce transaction costs, but the techniques that reduce turnover have a
          less negative impact on strategy gross performance than limiting trade to low-cost
          securities has. Banding is more effective than simply reducing rebalancing frequencies,
          because banding yields similar trading-cost reductions while maintaining a better exposure
          to the underlying signal used to select stocks.Disclaimer: The views expressed in this article are those of the authors
            and do not necessarily reflect the position of the Federal Reserve Bank of Richmond or
            the Federal Reserve System. We thank Barbara Petitt, CFA, Stephen Brown, and Milena
            Novy-Marx for discussions and comments. Robert Novy-Marx provides consulting services to
            Dimensional Fund Advisors, an investment firm headquartered in Austin, Texas, with
            strong ties to the academic community. The thoughts and opinions expressed in this
            article are those of the authors alone, and no other person or institution has any
            control over its content.
            Editor’s Note
          Submitted 28 June 2018Accepted 27 September 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 85-102
Issue: 1
Volume: 75
Year: 2019
Month: 2
X-DOI: 10.1080/0015198X.2018.1547057
File-URL: http://hdl.handle.net/10.1080/0015198X.2018.1547057
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Author-Name: The Editors
Title: Correction
Journal: Financial Analysts Journal
Pages: 2-3
Issue: 1
Volume: 75
Year: 2019
Month: 2
X-DOI: 10.1080/0015198X.2019.1569444
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1569444
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# input file: UFAJ_A_1567190_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Feifei Li
Author-X-Name-First: Feifei
Author-X-Name-Last: Li
Author-Name: Tzee-Man Chow
Author-X-Name-First: Tzee-Man
Author-X-Name-Last: Chow
Author-Name: Alex Pickard
Author-X-Name-First: Alex
Author-X-Name-Last: Pickard
Author-Name: Yadwinder Garg
Author-X-Name-First: Yadwinder
Author-X-Name-Last: Garg
Title: Transaction Costs of Factor-Investing Strategies
Abstract: 
 Although hidden, the implicit market impact costs of factor investing may substantially erode
     a strategy’s expected excess returns. The rebalancing data of a suite of large and
     long-standing factor-investing indexes are used in this study to model these market impact
     costs. A framework to assess the costs of rebalancing activities is introduced. These costs are
     then attributed to characteristics that intuitively describe the strategies’ demands on
     liquidity, such as rate of turnover and the concentration of turnover. A number of popular
     factor-investing implementations are identified, and the authors discuss how their index
     construction methods, when thoughtfully designed, can reduce market impact costs.Disclosure: The authors report no conflicts of interest. Editor’s NoteSubmitted 10 May 2018Accepted 12 December 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 62-78
Issue: 2
Volume: 75
Year: 2019
Month: 4
X-DOI: 10.1080/0015198X.2019.1567190
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1567190
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# input file: UFAJ_A_1567191_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Lisa R. Goldberg
Author-X-Name-First: Lisa R.
Author-X-Name-Last: Goldberg
Author-Name: Pete Hand
Author-X-Name-First: Pete
Author-X-Name-Last: Hand
Author-Name: Taotao Cai
Author-X-Name-First: Taotao
Author-X-Name-Last: Cai
Title: Tax-Managed Factor Strategies
Abstract: 
 We examine the tax efficiency of an indexing strategy and six factor tilts. Between June 1995
     and March 2018, average value added by tax management exceeded 1.50% per year at a 10-year
     horizon for all the strategies we considered. Tax-managed factor tilts that are beta 1 to the
     market generated average tax alpha between 1.59% and 1.89% per year, while average tax alpha
     for the tax-managed indexing strategy was 2.26% per year. These remarkable results depend on
     the availability of short-term capital gains to offset. To a great extent, they can be
     attributed to loss harvesting and the tax rate differential.Disclosure: Aperio Group manages equity for taxable investors.Editor’s NoteSubmitted 22 March 2018Accepted 13 November 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 79-90
Issue: 2
Volume: 75
Year: 2019
Month: 4
X-DOI: 10.1080/0015198X.2019.1567191
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1567191
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# input file: UFAJ_A_1567194_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jason Hsu
Author-X-Name-First: Jason
Author-X-Name-Last: Hsu
Author-Name: Vitali Kalesnik
Author-X-Name-First: Vitali
Author-X-Name-Last: Kalesnik
Author-Name: Engin Kose
Author-X-Name-First: Engin
Author-X-Name-Last: Kose
Title: What Is Quality?
Abstract: 
 Unlike standard factors, such as value, momentum, and size, “quality” lacks a
          commonly accepted definition. Practitioners, however, are increasingly gravitating to this
          style factor. They define quality to be various signals or combinations of
          signals—some that have been thoroughly explored in the academic literature and
          others that have received limited attention. Among a comprehensive group of the quality
          categories used by practitioners, we find that profitability, accounting quality,
          payout/dilution, and investment tend to be associated with a return premium whereas
          capital structure, earnings stability, and growth in profitability show little evidence of
          a premium. Profitability and investment-related characteristics tend to capture most of
          the quality return premium.Disclosure: The authors report no conflicts of interest.
          Editor’s Note
        Submitted 11 July 2018Accepted 25 October 2018 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 44-61
Issue: 2
Volume: 75
Year: 2019
Month: 4
X-DOI: 10.1080/0015198X.2019.1567194
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1567194
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# input file: UFAJ_A_1572358_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hailey Lynch
Author-X-Name-First: Hailey
Author-X-Name-Last: Lynch
Author-Name: Sébastien Page
Author-X-Name-First: Sébastien
Author-X-Name-Last: Page
Author-Name: Robert A. Panariello
Author-X-Name-First: Robert A.
Author-X-Name-Last: Panariello
Author-Name: James A. Tzitzouris
Author-X-Name-First: James A.
Author-X-Name-Last: Tzitzouris
Author-Name: David Giroux
Author-X-Name-First: David
Author-X-Name-Last: Giroux
Title: The Revenge of the Stock Pickers
Abstract: 
 When an exchange-traded fund (ETF) trades heavily around a theme, correlations among its
          constituents increase significantly. Even some securities that have little or negative
          exposure to the theme itself begin to trade in lockstep with other ETF constituents. In
          other words, because ETF investors are agnostic to security-level information, they often
          “throw the baby out with the bathwater.” As the prices of individual stocks
          get dragged up or down with ETFs, these mispricings can become significant, and the
          profits realized by taking advantage of them may present an opportunity for stock
          pickers.
          Disclosure: The authors work for an active investment manager involved in stock picking. The
            views expressed in this article are those of the authors and do not necessarily
            reflect the views of T. Rowe Price. Further information can be found at the end of
            this paper.
          Editor’s note
        Submitted 10 September 2018Accepted 7 January 2019 by Stephen J. BrownThe views expressed are those of the authors, are subject to change without notice, and may
            differ from those of other T. Rowe Price associates. Information and opinions are derived
            from proprietary and nonproprietary sources deemed to be reliable; the accuracy of those
            sources is not guaranteed. This material does not constitute a distribution, offer,
            invitation, recommendation, or solicitation to sell or buy any securities; it does not
            constitute investment advice and should not be relied upon as such. Investors should seek
            independent legal and financial advice, including advice as to tax consequences, before
            making any investment decision. Past performance is not a reliable indicator of future
              performance. All investments involve risk. The charts and tables are shown for
            illustrative purposes only.
Journal: Financial Analysts Journal
Pages: 34-43
Issue: 2
Volume: 75
Year: 2019
Month: 4
X-DOI: 10.1080/0015198X.2019.1572358
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1572358
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Handle: RePEc:taf:ufajxx:v:75:y:2019:i:2:p:34-43




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# input file: UFAJ_A_1575160_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Neil Hartnett
Author-X-Name-First: Neil
Author-X-Name-Last: Hartnett
Author-Name: Paul Gerrans
Author-X-Name-First: Paul
Author-X-Name-Last: Gerrans
Author-Name: Robert Faff
Author-X-Name-First: Robert
Author-X-Name-Last: Faff
Title: Trusting Clients’ Financial Risk Tolerance Survey Scores
Abstract: 
 We examine whether and to what extent financial advisers can trust financial risk
          tolerance scores derived from client survey responses. We propose using the standard
          deviation of standardized survey responses as a simple, practical measure for determining
          the reliability of client risk tolerance measures. Our findings suggest that advisers will
          better discharge their fiduciary responsibilities by reexamining a client’s survey
          results if there is substantial variation in that client’s standardized survey
          responses and resurveying such clients to better gauge their risk tolerance scores.
          Dislosure: The authors report no conflicts of interest.
          Editor’s Note
        Submitted 26 December 2017Accepted 15 January 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 91-104
Issue: 2
Volume: 75
Year: 2019
Month: 4
X-DOI: 10.1080/0015198X.2019.1575160
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1575160
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Handle: RePEc:taf:ufajxx:v:75:y:2019:i:2:p:91-104




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# input file: UFAJ_A_1581549_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: James Yaworski
Author-X-Name-First: James
Author-X-Name-Last: Yaworski
Title: Spending Policy Customization for Institutional Preferences
Abstract: 
 Many research papers have demonstrated the shortcomings of popular spending
          rules—specifically, the tendency for rules to cause a loss of purchasing power over
          time. This study identifies the negative correlation between portfolio purchasing power
          and recommended spending rates as the primary cause of these shortcomings and the source
          of considerable fiduciary risk. Using this research, I outline a new spending rule, the
          “purchasing power rule,” which is designed to sustain portfolio value in a
          reliable manner. I present a framework based on the purchasing power rule for customizing
          spending rules to match organizational preferences and goals.
          Disclosure: The author reports no conflicts of interest.
          Editor’s note
        This article was externally reviewed using our double-blind peer-review process.
              When the article was accepted for publication, the author thanked the reviewers in his
              acknowledgments. Mike Sebastian was one of the reviewers for this article.
          Submitted 12 June 2018Accepted 6 February 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 20-33
Issue: 2
Volume: 75
Year: 2019
Month: 4
X-DOI: 10.1080/0015198X.2019.1581549
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1581549
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Handle: RePEc:taf:ufajxx:v:75:y:2019:i:2:p:20-33




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# input file: UFAJ_A_1587429_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Stephen J. Brown
Author-X-Name-First: Stephen J.
Author-X-Name-Last: Brown
Title: In Memoriam: John C. Bogle
Abstract: 
 Stephen J. Brown, executive editor of the Financial Analysts Journal,
          reflects on the life and work of industry leader John C. Bogle.
Journal: Financial Analysts Journal
Pages: 11-13
Issue: 2
Volume: 75
Year: 2019
Month: 4
X-DOI: 10.1080/0015198X.2019.1587429
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1587429
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# input file: UFAJ_A_1587431_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: Our Thanks to Reviewers
Abstract: 
 We thank the 164 reviewers who took part during 2018 in the double-blind peer-review
          process that guarantees the quality of the Financial Analysts
          Journal.
Journal: Financial Analysts Journal
Pages: 8-9
Issue: 2
Volume: 75
Year: 2019
Month: 4
X-DOI: 10.1080/0015198X.2019.1587431
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1587431
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# input file: UFAJ_A_1587433_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Heidi Raubenheimer
Author-X-Name-First: Heidi
Author-X-Name-Last: Raubenheimer
Title: 2018 Report to Readers
Abstract: 
 Report to Readers for 2018.
Journal: Financial Analysts Journal
Pages: 5-7
Issue: 2
Volume: 75
Year: 2019
Month: 4
X-DOI: 10.1080/0015198X.2019.1587433
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1587433
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Handle: RePEc:taf:ufajxx:v:75:y:2019:i:2:p:5-7




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# input file: UFAJ_A_1593766_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Franklin R. Edwards
Author-X-Name-First: Franklin R.
Author-X-Name-Last: Edwards
Author-Name: Kathleen Hanley
Author-X-Name-First: Kathleen
Author-X-Name-Last: Hanley
Author-Name: Robert Litan
Author-X-Name-First: Robert
Author-X-Name-Last: Litan
Author-Name: Roman L. Weil
Author-X-Name-First: Roman L.
Author-X-Name-Last: Weil
Title: Crypto Assets Require Better Regulation: Statement of the Financial Economists Roundtable on Crypto Assets
Abstract: 
 The exponential rise and volatility in the price of Bitcoin has heightened investor
          interest in cryptocurrencies and crypto assets. These assets have attracted a growing
          number of investors but also have been used to facilitate a wide range of illicit
          activities. In some cases, legitimate participants in crypto asset markets have incurred
          substantial losses. In response, the Financial Economists Roundtable discussed the
          potential benefits and risks associated with crypto asset markets and agreed that
          financial regulators need to be more proactive in addressing abusive activities. Viewpoint is an occasional feature of the Financial Analysts Journal.
            This piece was not subjected to the peer-review process. It reflects the views of the
            authors and does not represent the official views of the Financial Analysts
              Journal or CFA Institute.
Journal: Financial Analysts Journal
Pages: 14-19
Issue: 2
Volume: 75
Year: 2019
Month: 4
X-DOI: 10.1080/0015198X.2019.1593766
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1593766
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# input file: UFAJ_A_1572377_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Steven S. Crawford
Author-X-Name-First: Steven S.
Author-X-Name-Last: Crawford
Author-Name: Pietro Perotti
Author-X-Name-First: Pietro
Author-X-Name-Last: Perotti
Author-Name: Richard A. Price
Author-X-Name-First: Richard A.
Author-X-Name-Last: Price
Author-Name: Christopher J. Skousen
Author-X-Name-First: Christopher J.
Author-X-Name-Last: Skousen
Title: Financial Statement Anomalies in the Bond Market
Abstract: 
 We investigate the association between bond returns and 32 financial statement variables. Our
     findings show that 17 of the 32 financial statement measures we examined are significantly
     related to future bond returns. Evidence of inefficiency is more pronounced when institutional
     investors are less active and when there is more uncertainty about the creditworthiness of the
     issuer. We contribute to the literature by significantly expanding the number of anomalies
     analyzed and by providing practitioners with actionable guidance on which trading strategies
     may be profitable in the bond market.Disclosure: The authors report no conflicts of interest.Authors’ NoteThe data used in this study are available from public sources
      identified in the article.Editor’s NoteSubmitted 16 April 2018Accepted 15 January 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 105-124
Issue: 3
Volume: 75
Year: 2019
Month: 7
X-DOI: 10.1080/0015198X.2019.1572377
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1572377
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# input file: UFAJ_A_1596678_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Keywan Christian Rasekhschaffe
Author-X-Name-First: Keywan Christian
Author-X-Name-Last: Rasekhschaffe
Author-Name: Robert C. Jones
Author-X-Name-First: Robert C.
Author-X-Name-Last: Jones
Title: Machine Learning for Stock Selection
Abstract: 
 Machine learning is an increasingly important and controversial topic in quantitative
          finance. A lively debate persists as to whether machine learning techniques can be
          practical investment tools. Although machine learning algorithms can uncover subtle,
          contextual, and nonlinear relationships, overfitting poses a major challenge when one is
          trying to extract signals from noisy historical data. We describe some of the basic
          concepts of machine learning and provide a simple example of how investors can use machine
          learning techniques to forecast the cross-section of stock returns while limiting the risk
          of overfitting.
          Disclosure: The authors report no conflicts of interest.
          Editor’s Note
        Submitted 19 July 2018Accepted 30 January 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 70-88
Issue: 3
Volume: 75
Year: 2019
Month: 7
X-DOI: 10.1080/0015198X.2019.1596678
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1596678
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# input file: UFAJ_A_1600955_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Nick Baltas
Author-X-Name-First: Nick
Author-X-Name-Last: Baltas
Title: The Impact of Crowding in Alternative Risk Premia Investing
Abstract: 
 Crowding is a major concern for investors in alternative risk premia. By focusing on the
          distinct mechanics of various systematic strategies, this study introduces a framework
          that provides insights into the implications of crowding for subsequent strategy
          performance. Understanding such implications is key for strategy design, portfolio
          construction, and performance assessment. The analysis shows that divergence premia, such
          as momentum, are more likely to underperform following crowded periods. Conversely,
          convergence premia, such as value, show signs of outperformance as they transition into
          phases of larger investor flows.Editor’s NoteSubmitted 19 September 2018Accepted 20 March 2019 by Stephen J. BrownDisclosure: The opinions and statements expressed in this paper are those of
              the author and may be different to views or opinions otherwise held or expressed by or
              within Goldman Sachs. The content of this paper is for information purposes only and
              is not investment advice or advice of any other kind. None of the author, Goldman
              Sachs, or its affiliates, officers, employees, or representatives accepts any
              liability whatsoever in connection with any of the content of this paper or for any
              action or inaction of any person taken in reliance upon such content or any part
              thereof. An earlier version of this paper was previously published by Goldman Sachs
              under the title “The Impact of Crowding in Systematic ARP Investing” (7
              June 2018).This article was externally reviewed using our double-blind peer-review process. When
            the article was accepted for publication, the author thanked the reviewers in his
            acknowledgments. Robert Faff was one of the reviewers for this article.
Journal: Financial Analysts Journal
Pages: 89-104
Issue: 3
Volume: 75
Year: 2019
Month: 7
X-DOI: 10.1080/0015198X.2019.1600955
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1600955
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# input file: UFAJ_A_1600957_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Patrick A. Lach
Author-X-Name-First: Patrick A.
Author-X-Name-Last: Lach
Author-Name: Leisa Reinecke Flynn
Author-X-Name-First: Leisa Reinecke
Author-X-Name-Last: Flynn
Author-Name: G. Wayne Kelly
Author-X-Name-First: G. Wayne
Author-X-Name-Last: Kelly
Title: Brokers or Investment Advisers? The US Public Perception
Abstract: 
 We find that individuals are confused by the titles used by investment professionals and
          cannot distinguish between investment advisers and brokers. This confusion persists even
          among those with investment industry experience, a college degree, or a high level of
          perceived knowledge (one’s self-assessment or feeling of knowing the information).
          Surveyed individuals better identified the brokerage responsibilities of “an
          investment sales representative” (an alternate title for broker) than the more
          ambiguous titles brokers often use, such as “financial advisor.”
          Disclosure: One of the authors, Patrick Lach, owns and operates an independent investment
            advisory firm.Editor’s NoteSubmitted 17 January 2019Accepted 13 March 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 125-131
Issue: 3
Volume: 75
Year: 2019
Month: 7
X-DOI: 10.1080/0015198X.2019.1600957
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1600957
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# input file: UFAJ_A_1600958_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David Allen
Author-X-Name-First: David
Author-X-Name-Last: Allen
Author-Name: Colin Lizieri
Author-X-Name-First: Colin
Author-X-Name-Last: Lizieri
Author-Name: Stephen Satchell
Author-X-Name-First: Stephen
Author-X-Name-Last: Satchell
Title: In Defense of Portfolio Optimization: What If We Can Forecast?
Abstract: 
 We challenge the academic consensus that estimation error makes mean–variance
          portfolio strategies inferior to passive equal-weighted approaches. We demonstrate
          analytically, via simulation, and empirically that investors endowed with modest
          forecasting ability benefit substantially from a mean–variance approach. An investor
          with some forecasting ability improves expected utility by increasing the number of assets
          considered. We frame our study realistically using budget constraints, transaction costs,
          and out-of-sample testing for a wide range of investments. We derive practical decision
          rules to choose between passive and mean–variance optimization and generate results
          consistent with much financial market practice and the original Markowitz formulation.Disclosure: The authors report no conflicts of interest.
          Editor’s Note:This article was externally reviewed using our double-blind peer-review process. When
            the article was accepted for publication, the authors thanked the reviewers in their
            acknowledgments. Nick Baltas was one of the reviewers for this article.Submitted 8 June 2018Accepted 20 March 2019 by Stephen J. Brown.
Journal: Financial Analysts Journal
Pages: 20-38
Issue: 3
Volume: 75
Year: 2019
Month: 7
X-DOI: 10.1080/0015198X.2019.1600958
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1600958
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# input file: UFAJ_A_1618097_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Edwin J. Elton
Author-X-Name-First: Edwin J.
Author-X-Name-Last: Elton
Author-Name: Martin J. Gruber
Author-X-Name-First: Martin J.
Author-X-Name-Last: Gruber
Author-Name: Andre de Souza
Author-X-Name-First: Andre
Author-X-Name-Last: de Souza
Title: Are Passive Funds Really Superior Investments? An Investor Perspective
Abstract: 
 A number of papers have demonstrated that over historical periods, a specified set of
          factors has outperformed actively managed funds. In almost all cases, however, the factors
          used or the procedures followed are not replicable by tradable passive investments. In
          addition, tradable passive investments have expense ratios that almost always cause them
          to underperform indexes. The purposes of this article are to identify a small set of
          exchange-traded funds that captures most of the variation in the population of potential
          indexes and to determine whether a combination of exchange-traded funds from this small
          set can be identified that outperforms active mutual funds in future periods.Disclosure: The authors report no conflicts of interest.
          Editor’s NoteSubmitted 30 October 2018Accepted 8 April 2019 by Stephen J. Brown.This article was externally reviewed using our double-blind peer-review process. When
            the article was accepted for publication, the authors thanked the reviewers in their
            acknowledgments. Claude Erb was one of the reviewers for this article.
Journal: Financial Analysts Journal
Pages: 7-19
Issue: 3
Volume: 75
Year: 2019
Month: 7
X-DOI: 10.1080/0015198X.2019.1618097
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1618097
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# input file: UFAJ_A_1618109_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Geoffrey J. Warren
Author-X-Name-First: Geoffrey J.
Author-X-Name-Last: Warren
Title: Choosing and Using Utility Functions in Forming Portfolios
Abstract: 
 Utility functions offer a means to encode objectives and preferences in investor
          portfolios. The functions allow one to place a score on outcomes and then identify optimal
          portfolios by maximizing utility. The central theme of this article is that utility
          functions should be tailored to the investor. I discuss how an appropriate function might
          be chosen and demonstrate concepts for power utility and reference-dependent utility. A
          modeling approach is presented that may be applied without resorting to dynamic
          optimization. The selection of utility functions is illustrated for four investor
          types.Disclosure: The author reports no conflict of interest.
          Editor’s Note The original version had a
            typographical error in Figure 4B, which has been corrected in this
            version.
          Submitted 1 October 2018Accepted 20 March 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 39-69
Issue: 3
Volume: 75
Year: 2019
Month: 7
X-DOI: 10.1080/0015198X.2019.1618109
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1618109
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# input file: UFAJ_A_1626632_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: Correction
Journal: Financial Analysts Journal
Pages: 4-
Issue: 3
Volume: 75
Year: 2019
Month: 7
X-DOI: 10.1080/0015198X.2019.1626632
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1626632
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# input file: UFAJ_A_1625617_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Eric C. Engstrom
Author-X-Name-First: Eric C.
Author-X-Name-Last: Engstrom
Author-Name: Steven A. Sharpe
Author-X-Name-First: Steven A.
Author-X-Name-Last: Sharpe
Title: The Near-Term Forward Yield Spread as a Leading Indicator: A Less Distorted Mirror
Abstract: 
 The spread between the yields on a 10-year US T-note and a 2-year T-note is commonly used
          as a harbinger of US recessions. We show that such “long-term spreads” are
          statistically dominated in forecasting models by an economically intuitive alternative, a
          “near-term forward spread.” This spread can be interpreted as a measure of
          market expectations for near-term conventional monetary policy rates. Its predictive power
          suggests that when market participants have expected—and priced in—a monetary
          policy easing over the subsequent year and a half, a recession was likely to follow. The
          near-term spread also has predicted four-quarter GDP growth with greater accuracy than
          survey consensus forecasts, and it has substantial predictive power for stock returns.
          Once a near-term spread is included in forecasting equations, yields on longer-term bonds
          maturing beyond six to eight quarters have no added value for forecasting recessions, GDP
          growth, or stock returns.
          Disclosure: The views herein are those of the authors and do not
            necessarily reflect those of the Board of Governors of the Federal Reserve System or its
            staff.
          Editor’s note
        Submitted 16 July 2018Accepted 24 April 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 37-49
Issue: 4
Volume: 75
Year: 2019
Month: 10
X-DOI: 10.1080/0015198X.2019.1625617
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1625617
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# input file: UFAJ_A_1628552_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin Martens
Author-X-Name-First: Martin
Author-X-Name-Last: Martens
Author-Name: Paul Beekhuizen
Author-X-Name-First: Paul
Author-X-Name-Last: Beekhuizen
Author-Name: Johan Duyvesteyn
Author-X-Name-First: Johan
Author-X-Name-Last: Duyvesteyn
Author-Name: Casper Zomerdijk
Author-X-Name-First: Casper
Author-X-Name-Last: Zomerdijk
Title: Carry Investing on the Yield Curve
Abstract: 
 Bond carry is the expected return on a bond when the yield curve does not change. The
          curve carry strategy within each country constructs buckets based on bond maturities on a
          monthly basis and buys the government bond buckets with high carry while selling those
          with low carry. Combining these curve carry strategies for 13 countries, we found a global
          curve carry factor with an information ratio of 1.0. Returns to a global curve carry
          factor cannot be explained by value or momentum, and the strategy subsumes the
          betting-against-beta factor.
          Editor’s note
        Submitted 19 December 2018Accepted 16 May 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 51-63
Issue: 4
Volume: 75
Year: 2019
Month: 10
X-DOI: 10.1080/0015198X.2019.1628552
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1628552
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# input file: UFAJ_A_1628555_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: K.J. Martijn Cremers
Author-X-Name-First: K.J. Martijn
Author-X-Name-Last: Cremers
Author-Name: Jon A. Fulkerson
Author-X-Name-First: Jon A.
Author-X-Name-Last: Fulkerson
Author-Name: Timothy B. Riley
Author-X-Name-First: Timothy B.
Author-X-Name-Last: Riley
Title: Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds
Abstract: 
 Just over 20 years have passed since the publication of Mark Carhart’s landmark
          1997 study on mutual funds. Its conclusion—that the data did “not support the
          existence of skilled or informed mutual fund portfolio managers”—was the
          capstone of an academic literature, which began with Michael Jensen in 1968, that formed
          the conventional wisdom that active management does not create value for investors. We
          review the literature on active mutual fund management since the publication of
          Carhart’s work to assess the extent to which current research still supports the
          conventional wisdom. Our review of the most recent literature suggests that the
          conventional wisdom is too negative on the value of active management.Disclosure: This research was supported by the Investment Adviser
            Association’s Active Managers Council. Martijn Cremers currently serves as an
            independent director at Ariel Investments and a consultant to Touchstone Investments and
            State Street Associates.
          Editor’s note
        Submitted 27 January 2019Accepted 23 May 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 8-35
Issue: 4
Volume: 75
Year: 2019
Month: 10
X-DOI: 10.1080/0015198X.2019.1628555
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1628555
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Handle: RePEc:taf:ufajxx:v:75:y:2019:i:4:p:8-35




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# input file: UFAJ_A_1628556_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jacob Boudoukh
Author-X-Name-First: Jacob
Author-X-Name-Last: Boudoukh
Author-Name: Matthew Richardson
Author-X-Name-First: Matthew
Author-X-Name-Last: Richardson
Author-Name: Ashwin Thapar
Author-X-Name-First: Ashwin
Author-X-Name-Last: Thapar
Author-Name: Franklin Wang
Author-X-Name-First: Franklin
Author-X-Name-Last: Wang
Title: Optimal Currency Hedging for International Equity Portfolios
Abstract: 
 This study explores optimal currency exposures in international equity portfolios through
          the lens of a modified mean–variance optimization framework. We decomposed the
          optimal currency portfolio into a “hedge portfolio” that uses a dynamic risk
          model to minimize equity volatility and an “alpha-seeking portfolio” based on
          the well-documented currency styles of value, momentum, fundamental momentum, and carry.
          This method is an integrated and economically intuitive approach to currency management
          that simultaneously provides lower risk and higher returns than either hedged or unhedged
          benchmarks. Crucially, the solution is practical, with realistic and implementable
          leverage, turnover, and tail-risk characteristics.Disclaimer: AQR Capital Management is a global investment management firm
            that may or may not apply similar investment techniques or methods of analysis as
            described herein. The views expressed here are those of the authors and not necessarily
            those of AQR.Editor’s noteSubmitted 3 October 2018Accepted 20 May 2019 by Stephen J. Brown.This article was externally reviewed using our double-blind peer-review process. When
            the article was accepted for publication, the authors thanked the reviewers in their
            acknowledgments. David Gallagher was one of the reviewers for this article.
Journal: Financial Analysts Journal
Pages: 65-83
Issue: 4
Volume: 75
Year: 2019
Month: 10
X-DOI: 10.1080/0015198X.2019.1628556
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1628556
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Handle: RePEc:taf:ufajxx:v:75:y:2019:i:4:p:65-83




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# input file: UFAJ_A_1645478_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hubert Dichtl
Author-X-Name-First: Hubert
Author-X-Name-Last: Dichtl
Author-Name: Wolfgang Drobetz
Author-X-Name-First: Wolfgang
Author-X-Name-Last: Drobetz
Author-Name: Harald Lohre
Author-X-Name-First: Harald
Author-X-Name-Last: Lohre
Author-Name: Carsten Rother
Author-X-Name-First: Carsten
Author-X-Name-Last: Rother
Author-Name: Patrick Vosskamp
Author-X-Name-First: Patrick
Author-X-Name-Last: Vosskamp
Title: Optimal Timing and Tilting of Equity Factors
Abstract: 
 Aiming to optimally harvest global equity factor premiums, we investigated the benefits
          of parametric portfolio policies for timing factors conditioned on
          time-series predictors and tilting factors based on cross-sectional
          factor characteristics. We discovered that equity factors are predictably related to
          fundamental and technical time-series indicators and to such characteristics as factor
          momentum and crowding. We found that such predictability is hard to benefit from after
          transaction costs. Advancing the timing and tilting policies to smooth factor allocation
          turnover slightly improved the evidence for factor timing but not for factor tilting,
          which renders our analysis a cautionary tale on dynamic factor allocation.Disclosure: Two of the authors are at Invesco, one is at Allianz Global
            Investors. The authors follow an evidence-based investment process, including
            multi-factor equity propositions. Therefore, Invesco and Allianz Global Investors have a
            commercial interest in the subject matter (optimal equity factor allocation).
          Editor’s note
        Submitted 23 November 2018Accepted 28 June 2019 by Stephen J. BrownThis article was externally reviewed using our double-blind peer-review process. When
            the article was accepted for publication, the authors thanked the reviewers in their
            acknowledgments. David Blitz and Mike Sebastian were the reviewers for this article.
Journal: Financial Analysts Journal
Pages: 84-102
Issue: 4
Volume: 75
Year: 2019
Month: 10
X-DOI: 10.1080/0015198X.2019.1645478
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1645478
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Handle: RePEc:taf:ufajxx:v:75:y:2019:i:4:p:84-102




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# input file: UFAJ_A_1651160_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David M. Blanchett
Author-X-Name-First: David M.
Author-X-Name-Last: Blanchett
Author-Name: Michael Guillemette
Author-X-Name-First: Michael
Author-X-Name-Last: Guillemette
Title: Do Investors Consider Nonfinancial Risks When Building Portfolios?
Abstract: 
 Households typically have significant wealth that is not in their investment portfolios,
          such as human capital and real estate. Basic economic theory indicates that the risk of
          these nonfinancial assets should affect the allocation of the household’s financial
          assets. Little empirical evidence has been gathered, however, to indicate whether such a
          risk assessment actually does (as opposed to merely should) occur. We
          used longitudinal data to explore this question in the portfolio decisions of 36,755
          participants proactively managing their portfolios in 268 defined-contribution plans. We
          found statistically significant differences in equity allocations among different
          industries and locations. We also found that investors with more aggressive (conservative)
          nonfinancial assets tend to have more conservative (aggressive) portfolios, which is
          consistent with economic theory.Disclosure: One of the author’s firms considers the risks associated
            with an investor’s total wealth when determining the appropriate portfolio for
            clients/investors.
          Editor’s note
        Submitted 1 November 2018Accepted 17 July 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 124-142
Issue: 4
Volume: 75
Year: 2019
Month: 10
X-DOI: 10.1080/0015198X.2019.1651160
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1651160
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# input file: UFAJ_A_1654299_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mozaffar Khan
Author-X-Name-First: Mozaffar
Author-X-Name-Last: Khan
Title: Corporate Governance, ESG, and Stock Returns around the World
Abstract: 
 Nonfinancial performance measures, such as environmental, social, and governance (ESG)
          measures, are potentially leading indicators of companies’ financial performance. In
          the study reported here, I drew on prior academic literature and the concept of ESG
          materiality to develop new corporate governance and ESG metrics. The new metrics predicted
          stock returns in a global investable universe over the tested period, which suggests
          potential investment value in the ESG signals.Disclaimer: The author is employed by an investment management firm that
            invests in public equities globally.Important Disclosures: These materials should not be relied on as research
            or investment advice regarding any stock. There is no guarantee that any forecasts made
            will come to pass. Causeway Capital Management LLC does not guarantee the accuracy,
            adequacy, or completeness of such information. Although the author’s information
            providers, including without limitation MSCI ESG Research LLC and its affiliates (the
            “ESG Parties”), obtain information from sources they consider reliable, none
            of the ESG Parties warrants or guarantees the originality, accuracy, and/or completeness
            of any data herein. None of the ESG Parties makes any express or implied warranties of
            any kind, and the ESG Parties hereby expressly disclaim all warranties of
            merchantability and fitness for a particular purpose, with respect to any data herein.
            None of the ESG Parties shall have any liability for any errors or omissions in
            connection with any data herein. Further, without limiting any of the foregoing, in no
            event shall any of the ESG Parties have any liability for any direct, indirect, special,
            punitive, consequential, or any other damages (including lost profits) even if notified
            of the possibility of such damages.
          Editor’s note
        Submitted 18 June 2019Accepted 30 July 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 103-123
Issue: 4
Volume: 75
Year: 2019
Month: 10
X-DOI: 10.1080/0015198X.2019.1654299
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1654299
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# input file: UFAJ_A_1661722_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: Our Thanks to Reviewers
Abstract: 
 We thank the 167 reviewers who took part during 2019 in the double-blind peer-review
	   process that guarantees the quality of the Financial Analysts
	   Journal.
Journal: Financial Analysts Journal
Pages: 5-6
Issue: 4
Volume: 75
Year: 2019
Month: 10
X-DOI: 10.1080/0015198X.2019.1661722
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1661722
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# input file: UFAJ_A_1675421_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Joseph Liberman
Author-X-Name-First: Joseph
Author-X-Name-Last: Liberman
Author-Name: Clemens Sialm
Author-X-Name-First: Clemens
Author-X-Name-Last: Sialm
Author-Name: Nathan Sosner
Author-X-Name-First: Nathan
Author-X-Name-Last: Sosner
Author-Name: Lixin Wang
Author-X-Name-First: Lixin
Author-X-Name-Last: Wang
Title: The Tax Benefits of Separating Alpha from Beta
Abstract: 
 Long-only active investment strategies have an inherent flaw: Investors pay capital gains taxes on market-related gains as well as on the alpha created. By separating alpha and beta, taxes can be reduced and returns enhanced. Using both simulated and historical data, we show that separating active returns (i.e., alpha) from market exposure (i.e., beta) may have significant tax benefits. We find that an investment strategy that invests separately in a passive index portfolio and an actively managed long–short portfolio is more tax efficient than a long-only actively managed strategy with similar risk and style exposures. The turnover of a traditional active strategy causes capital gain realizations in both the active and passive portfolio components. In contrast, the turnover of a strategy that separates alpha from beta is concentrated in the long–short component and enables the deferral of capital gain realizations in the passive market component. Separating alpha from beta is different from systematic tax management as described in the literature. Our approach provides a practical solution for taxable investors in a world dominated by tax-agnostic managers.Disclosure: AQR Capital Management is a global investment management firm that may or may not apply investment techniques or methods of analysis similar to those described herein. The views expressed here are those of the authors and not necessarily those of AQR. The reader should conduct his or her own analysis and consult with professional advisers prior to making any investment decisions. AQR is not a tax adviser. This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax adviser.Editor’s NotesSubmitted 22 March 2019Accepted 11 September 2019 by Stephen J. BrownThis article was externally reviewed using our double-blind peer-review process. When the article was accepted for publication, the authors thanked the reviewers in their acknowledgments. Benjamin Schneider, CFA, was one of the reviewers for this article.
Journal: Financial Analysts Journal
Pages: 38-61
Issue: 1
Volume: 76
Year: 2020
Month: 1
X-DOI: 10.1080/0015198X.2019.1675421
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1675421
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# input file: UFAJ_A_1702373_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Heidi Raubenheimer
Author-X-Name-First: Heidi
Author-X-Name-Last: Raubenheimer
Title: 2019 Report to Readers
Abstract: 
 The Financial Analysts Journal’s 2019 report to readers and authorsAt the close of every calendar year, we report to our readers, authors, and stakeholders on the behind-the-scenes activities of the Financial Analysts Journal. This report comes at the end of a particularly auspicious year, the 75th year of the Financial Analysts Journal’s existence and the completion of our 75th volume.
Journal: Financial Analysts Journal
Pages: 6-8
Issue: 1
Volume: 76
Year: 2020
Month: 1
X-DOI: 10.1080/0015198X.2019.1702373
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1702373
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# input file: UFAJ_A_1694356_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Travis Box
Author-X-Name-First: Travis
Author-X-Name-Last: Box
Author-Name: Ryan Davis
Author-X-Name-First: Ryan
Author-X-Name-Last: Davis
Author-Name: Kathleen Fuller
Author-X-Name-First: Kathleen
Author-X-Name-Last: Fuller
Title: The Dynamics of ETF Fees
Abstract: 
 Despite widely publicized fee reductions, average expense ratios of ETFs have remained relatively steady. Thousands of new funds have not led to lower fees. Investors should examine all available opportunities before choosing specific funds.Despite widely publicized fee reductions, average expense ratios of exchange-traded funds (ETFs) remained relatively steady between 2004 and 2018. Even though thousands of new funds entered the market during this period, the arrival of most ETF sponsors into a narrowly defined area has not generally led to lower fees for competing funds. Given the impact of fees on long-term investment returns, investors should carefully examine all available opportunities before choosing specific funds. Furthermore, as objectives for newer ETFs become increasingly specialized, investors must also consider whether the benefits of targeted strategies justify their higher prices.Disclosure: The authors report no conflicts of interest.Editor’s NotesSubmitted 5 September 2019Accepted 1 November 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 11-18
Issue: 1
Volume: 76
Year: 2020
Month: 1
X-DOI: 10.1080/0015198X.2019.1694356
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1694356
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# input file: UFAJ_A_1694362_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert Battalio
Author-X-Name-First: Robert
Author-X-Name-Last: Battalio
Author-Name: Stephen Figlewski
Author-X-Name-First: Stephen
Author-X-Name-Last: Figlewski
Author-Name: Robert Neal
Author-X-Name-First: Robert
Author-X-Name-Last: Neal
Title: Option Investor Rationality Revisited: The Role of Exercise Boundary Violations
Abstract: 
 The authors dispute the theory that American call options should not be exercised early. By looking at intraday pricing, they find that the best bid price available is often lower than the option’s intrinsic value and early exercise can be rational.Our empirical results overturn the well-known textbook theory that American options should not be exercised early except in very limited conditions. In the real world, the best bid available in the market is frequently below the option’s intrinsic value (e.g., nearly half of all quotes for in-the- money calls), which we call an “exercise boundary violation” (EBV). In an EBV, early exercise can be the right strategy and the “American” option characteristic has economic value. Some option holders do exercise, some sell at EBV bid prices, and our results suggest that actual exercise behavior is much less irrational than earlier studies concluded.Disclosure: The authors report no conflicts of interest.Editor’s NotesSubmitted 26 May 2019Accepted 4 November 2019 by Stephen J. Brown.This article was externally reviewed using our double-blind peer-review process. When the article was accepted for publication, the authors thanked the reviewers in their acknowledgments. Giuseppe Ballocchi, CFA, and William Fung were the reviewers for this article.
Journal: Financial Analysts Journal
Pages: 82-99
Issue: 1
Volume: 76
Year: 2020
Month: 1
X-DOI: 10.1080/0015198X.2019.1694362
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1694362
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Handle: RePEc:taf:ufajxx:v:76:y:2020:i:1:p:82-99




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# input file: UFAJ_A_1682426_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David M. Blanchett, CFA
Author-X-Name-First: David M.
Author-X-Name-Last: Blanchett, CFA
Author-Name: Michael S. Finke
Author-X-Name-First: Michael S.
Author-X-Name-Last: Finke
Author-Name: James A. Licato
Author-X-Name-First: James A.
Author-X-Name-Last: Licato
Title: Change Is a Good Thing
Abstract: 
 Do DC plan sponsors add value by monitoring and refreshing the menu of investments offered to participants? The authors find evidence that they do, particularly by successfully removing underperforming funds.Empirical research offers little evidence that monitoring defined-contribution menus adds value, despite the time, effort, and resources spent by plan sponsors on such activities. Using a unique longitudinal dataset of plan menus from January 2010 to November 2018 that included 4,215 fund replacements, we found that the replacement fund outperformed the replaced fund over future one-year and three-year periods. The outperformance remained even after we controlled for various fund characteristics and risk factors. It can be attributed primarily to the subsequent underperformance of replaced funds and to the lower expense ratios of the replacements.Disclaimer: Two of the authors’ companies offer menu services for defined-contribution plans.Editor’s noteSubmitted 12 June 2019Accepted 17 September 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 20-37
Issue: 1
Volume: 76
Year: 2020
Month: 1
X-DOI: 10.1080/0015198X.2019.1682426
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1682426
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# input file: UFAJ_A_1682427_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Shingo Goto
Author-X-Name-First: Shingo
Author-X-Name-Last: Goto
Author-Name: Zhao Wang
Author-X-Name-First: Zhao
Author-X-Name-Last: Wang
Author-Name: Shu Yan
Author-X-Name-First: Shu
Author-X-Name-Last: Yan
Title: Net Share Issuance and Asset Growth Effects: The Role of Managerial Incentives
Abstract: 
 By considering executives’ stock holdings (incentives) alongside their decisions over equity buybacks/issuance and asset growth, investors can discern companies likely to outperform.In the presence of asymmetric information, managerial equity incentives mitigate company managers’ empire-building motives while increasing their market-timing motives. If the market underreacts to these motives, the negative return predictability by net share issuance (NSI) and asset growth (AG) should be more pronounced among stocks with, respectively, larger managerial equity incentives and smaller managerial equity incentives. Our evidence supports this prediction. A hybrid strategy that exploited the NSI and AG effects in different groups of stocks screened by managerial equity incentives attained significant alphas after transaction costs, even after we controlled for the investment and profitability factors known to attenuate the two effects.Disclosure: The authors report no conflicts of interest.Editor’s NotesSubmitted 4 June 2019Accepted 17 September 2019 by Stephen J. Brown.
Journal: Financial Analysts Journal
Pages: 63-81
Issue: 1
Volume: 76
Year: 2020
Month: 1
X-DOI: 10.1080/0015198X.2019.1682427
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1682427
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# input file: UFAJ_A_1694363_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: Correction
Journal: Financial Analysts Journal
Pages: 4-4
Issue: 1
Volume: 76
Year: 2020
Month: 1
X-DOI: 10.1080/0015198X.2019.1694363
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1694363
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# input file: UFAJ_A_1734375_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Stephen J. Brown
Author-X-Name-First: Stephen J.
Author-X-Name-Last: Brown
Title: The Efficient Market Hypothesis, the Financial Analysts Journal, and the Professional Status of Investment Management
Abstract: 
 Prior to Eugene Fama’s 1965 contribution to the Financial Analysts
	     Journal, making money on Wall Street was considered to be easy. The practical
	  implication of the efficient market hypothesis (EMH) changed that presumption. Despite
	  challenges to the hypothesis, small investors—those who are not professionals and
	  have limited capital and limited access to special information—may as well assume
	  that the EMH is true. Persistent outperformance requires skill and a professional status
	  for security analysis—Benjamin Graham’s argument in 1945 for the establishment
	  of the Financial Analysts Journal. Not surprisingly, the
	  Journal has extensively covered discussions of the EMH and its practical
	  and intellectual implications.Disclosure: The author reports no conflicts of interest.
					Editor’s Note
				Submitted 3 February 2020Accepted 23 February 2020 by Heidi Raubenheimer, CFA, Luis Garcia-Feijóo, CFA,
		CIPM, Daniel Giamouridis, and Steven Thorley, CFA.
Journal: Financial Analysts Journal
Pages: 5-14
Issue: 2
Volume: 76
Year: 2020
Month: 4
X-DOI: 10.1080/0015198X.2020.1734375
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1734375
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# input file: UFAJ_A_1730655_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bradford Cornell
Author-X-Name-First: Bradford
Author-X-Name-Last: Cornell
Author-Name: Aswath Damodaran
Author-X-Name-First: Aswath
Author-X-Name-Last: Damodaran
Title: The Big Market Delusion: Valuation and Investment Implications
Abstract: 
 In entrepreneurs’ minds, big markets offer the promise of easily scalable
	     revenues that, coupled with profitability, can translate into large profits. This
	     article examines how the “big market promise” affects business formation
	     and financing, with a focus on the role of overconfidence on the part of both
	     entrepreneurs and their financiers (venture capitalists and public equity) in creating
	     a collective overpricing of companies in alleged big markets—and an inevitable
	     correction. Three case studies illustrate this thesis—one in which the process
	     has fully played out (1990s dot-com retail), one in which it has been unfolding for a
	     while (online advertising), and one in which it is just beginning (the cannabis market).
	     We suggest several lessons for investors, regulators, and businesses based on these
	     case studies.Viewpoint is an occasional feature of the Financial Analysts Journal.
		This piece was not subjected to the peer-review process. It reflects the views of the
		authors and does not represent the official views of the Financial Analysts
		   Journal or CFA Institute.
Journal: Financial Analysts Journal
Pages: 15-25
Issue: 2
Volume: 76
Year: 2020
Month: 4
X-DOI: 10.1080/0015198X.2020.1730655
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1730655
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# input file: UFAJ_A_1723390_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: George Serafeim
Author-X-Name-First: George
Author-X-Name-Last: Serafeim
Title: Public Sentiment and the Price of Corporate Sustainability
Abstract: 
 Combining environmental, social, and governance (ESG) data with “big data”
	     measuring public sentiment about corporate sustainability performance, I found that the
	     valuation premium for strong sustainability performance increases as a function of
	     positive momentum in public sentiment. An ESG factor  long (short) on companies with
	     superior (inferior) sustainability performance and negative (positive) ESG sentiment
	     momentum delivered significant positive alpha. In contrast, the high-sentiment ESG
	     factor delivered insignificant alpha and was negatively correlated with the value
	     factor. The evidence suggests that public sentiment influences investor views about the
	     value of sustainability activities and that big ESG data can be useful in identifying
	     “value” ESG stocks.Disclosure: The author is an academic partner at State Street Associates
		conducting research on ESG issues and sits on the advisory board of investment
		organizations that use ESG data.
					Editor’s Note:
				Submitted 29 Sep 2019accepted 23 Jan 2020 by Stephen J. Brown.
Journal: Financial Analysts Journal
Pages: 26-46
Issue: 2
Volume: 76
Year: 2020
Month: 4
X-DOI: 10.1080/0015198X.2020.1723390
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1723390
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# input file: UFAJ_A_1707592_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Marina Druz
Author-X-Name-First: Marina
Author-X-Name-Last: Druz
Author-Name: Ivan Petzev
Author-X-Name-First: Ivan
Author-X-Name-Last: Petzev
Author-Name: Alexander F. Wagner
Author-X-Name-First: Alexander F.
Author-X-Name-Last: Wagner
Author-Name: Richard J. Zeckhauser
Author-X-Name-First: Richard J.
Author-X-Name-Last: Zeckhauser
Title: When Managers Change Their Tone, Analysts and Investors Change Their Tune
Abstract: 
 The negativity of managerial word choice (managerial tone) in conference calls is a
	     telltale indicator of a company’s future. Specifically, increases in
	     negativity–what we term “bleak tone changes”–strongly predict
	     lower future earnings and increased uncertainty. Decreases in negativity, however, only
	     weakly predict the opposite. To isolate the explanatory power of managerial tone, we
	     controlled for negativity changes in the earnings press release and analysts’
	     questions. Analysts and investors underreact when they extract value-relevant information
	     from negativity changes. Consequently, a negativity-based trading strategy generates
	     abnormal returns.Disclosure: Marina Druz, Alexander Wagner, and Richard Zeckhauser declare
		that they have no relevant or material financial interests that relate to the research
		described in this article. Ivan Petzev works for an asset management firm that invests
		in equities globally.Authors’ Note: The views expressed in this article are those of the
		authors and do not necessarily reflect the views of Swiss Rock Asset Management.A previous version of this article was titled “Reading Managerial Tone: How
		Analysts and the Market Respond to Conference Calls”.
					Editor’s Note
				Submitted 23 May 2019Accepted 11 December 2019 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 47-69
Issue: 2
Volume: 76
Year: 2020
Month: 4
X-DOI: 10.1080/0015198X.2019.1707592
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1707592
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Handle: RePEc:taf:ufajxx:v:76:y:2020:i:2:p:47-69




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# input file: UFAJ_A_1712924_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David Turkington
Author-X-Name-First: David
Author-X-Name-Last: Turkington
Author-Name: Alireza Yazdani
Author-X-Name-First: Alireza
Author-X-Name-Last: Yazdani
Title: The Equity Differential Factor in Currency Markets
Abstract: 
 We show that the differential in trailing equity market performance across countries
	     strongly predicts the cross-section of currency returns. Specifically, exchange rates
	     tend to appreciate for countries with the strongest equity returns in the preceding
	     year. Portfolios formed on this factor have outperformed those formed on traditional
	     carry, trend, and valuation factors in currencies since 1990. The equity differential
	     factor cannot be explained by these traditional factors and produces a statistically
	     significant alpha in excess of them. Its performance is remarkably consistent and robust
	     to different formulations. We provide evidence that investor demand for outperforming
	     equity markets probably contributes to this effect.Disclosure: The authors report no conflicts of interest.
					Editor’s Note:
				Submitted 4 September 2019Accepted 30 December 2019 by Stephen J. Brown.
Journal: Financial Analysts Journal
Pages: 70-81
Issue: 2
Volume: 76
Year: 2020
Month: 4
X-DOI: 10.1080/0015198X.2020.1712924
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1712924
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# input file: UFAJ_A_1707593_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Diogo Palhares
Author-X-Name-First: Diogo
Author-X-Name-Last: Palhares
Author-Name: Scott Richardson
Author-X-Name-First: Scott
Author-X-Name-Last: Richardson
Title: Looking under the Hood of Active Credit Managers
Abstract: 
 Extensive research has explored the style exposures of actively managed equity funds.
	     We conducted an exhaustive set of return-based and holdings-based analyses to understand
	     actively managed credit funds. We found that credit long–short managers tend to
	     have high passive exposure to the credit risk premium. In contrast, we found that
	     long-only managers that focus on high-yield credits provide less exposure to the credit
	     risk premium than do their respective benchmarks. For both credit hedge funds and
	     long-only credit mutual funds, we found that neither has economically meaningful
	     exposures to well-compensated systematic factors.Disclosure: The views and opinions expressed here are those of the
		authors and do not necessarily reflect the views of AQR Capital Management, LLC,
		its affiliates, or its employees. This information does not constitute an offer
		or solicitation of an offer, or any advice or recommendation, by AQR, to purchase
		any securities or other financial instruments and may not be construed as such.
					Editor’s Note:
				Submitted 21 June 2019Accepted 11 December 2019 by Stephen J. BrownWe thank Editor Stephen Brown, Co-Editor Daniel Giamouridis, Antti Ilmanen, Ronen
		Israel, Oktay Kurbanov, Thom Maloney, Toby Moskowitz, Connor Stack, Dan Villalon,
		and two anonymous referees for helpful comments and thank Wenry Lu for excellent
		data analysis for this project.
Journal: Financial Analysts Journal
Pages: 82-102
Issue: 2
Volume: 76
Year: 2020
Month: 4
X-DOI: 10.1080/0015198X.2019.1707593
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1707593
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# input file: UFAJ_A_1701323_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Richard O. Michaud
Author-X-Name-First: Richard O.
Author-X-Name-Last: Michaud
Author-Name: David N. Esch
Author-X-Name-First: David N.
Author-X-Name-Last: Esch
Author-Name: Robert O. Michaud
Author-X-Name-First: Robert O.
Author-X-Name-Last: Michaud
Title: “In Defense of Portfolio Optimization: What If We Can Forecast?”: A Comment
Journal: Financial Analysts Journal
Pages: 104-105
Issue: 2
Volume: 76
Year: 2020
Month: 4
X-DOI: 10.1080/0015198X.2019.1701323
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1701323
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# input file: UFAJ_A_1703984_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David Allen
Author-X-Name-First: David
Author-X-Name-Last: Allen
Author-Name: Colin Lizieri
Author-X-Name-First: Colin
Author-X-Name-Last: Lizieri
Author-Name: Stephen Satchell
Author-X-Name-First: Stephen
Author-X-Name-Last: Satchell
Title: “In Defense of Portfolio Optimization: What If We Can Forecast?”: Author Response
Journal: Financial Analysts Journal
Pages: 106-107
Issue: 2
Volume: 76
Year: 2020
Month: 4
X-DOI: 10.1080/0015198X.2019.1703984
File-URL: http://hdl.handle.net/10.1080/0015198X.2019.1703984
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# input file: UFAJ_A_1733902_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Sinan Krückeberg
Author-X-Name-First: Sinan
Author-X-Name-Last: Krückeberg
Author-Name: Peter Scholz
Author-X-Name-First: Peter
Author-X-Name-Last: Scholz
Title: Decentralized Efficiency? Arbitrage in Bitcoin Markets
Abstract: 
 Using tick-level bitcoin data from February 2013 through April 2018, we show substantial
	     arbitrage spreads between global bitcoin markets. Spreads follow multiple consistent
	     patterns. Minimum and maximum prices show significant clustering. Spreads increase during
	     the early hours of a day (according to coordinated universal time), when new exchanges
	     enter markets, and following bitcoin heists and hacks. The full year 2017 and the first
	     quarter of 2018 each had exploitable net arbitrage profit opportunities of at least USD380
	     million that smart money failed to capture. Based on long-term analyses, we also found
	     that bitcoin market inefficiency has increased over time.Disclosure: The authors report no conflicts of interest.
					Editor’s Note
				This article was externally reviewed in our double-blind peer-review process. When the
		article was accepted for publication, the authors thanked the reviewers in their
		acknowledgments. Daniele Bianchi and Nicola Borri were the reviewers for this article.Submitted 12 September 2019Accepted 18 February 2020 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 135-152
Issue: 3
Volume: 76
Year: 2020
Month: 7
X-DOI: 10.1080/0015198X.2020.1733902
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1733902
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# input file: UFAJ_A_1738126_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Edwin J. Elton
Author-X-Name-First: Edwin J.
Author-X-Name-Last: Elton
Author-Name: Martin J. Gruber
Author-X-Name-First: Martin J.
Author-X-Name-Last: Gruber
Title: A Review of the Performance Measurement of Long-Term Mutual Funds
Abstract: 
 We review the major models of mutual fund performance: (1) using return data to evaluate equity
	     funds—from single to multi-index models, (2) measuring passive portfolio performance, (3)
	     using holdings-based performance measures, (4) measuring timing ability, and (5) measuring bond
	     fund performance. We conclude with a discussion of issues affecting performance measurement:
	     data sources and bias, missing factors, and improvements to benchmarks.Disclosure: The authors report no conflicts of interest.
Journal: Financial Analysts Journal
Pages: 22-37
Issue: 3
Volume: 76
Year: 2020
Month: 7
X-DOI: 10.1080/0015198X.2020.1738126
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1738126
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# input file: UFAJ_A_1744211_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jan Jaap Hazenberg
Author-X-Name-First: Jan Jaap
Author-X-Name-Last: Hazenberg
Title: A New Framework for Analyzing Market Share Dynamics among Fund Families
Abstract: 
 A simple framework decomposes changes in a fund family’s market share into four
          components. The components are highly relevant for understanding mutual fund market
          dynamics and evaluating the business performance of fund families. Two components are
          performance driven, and two are flow driven. Analysis of US market data shows that the
          “Excess Flows” component, which measures whether fund family flows exceed or
          lag those of competitors that operate in the same fund categories, has the biggest impact
          on fund-family market share changes. Major cross-sectional differences characterize how
          individual families score on each of the components. Fund families can use this framework
          to provide input for strategic decision making. 
          Disclosure: The author reports no conflicts of
	       interest.
          Editor’s Note
        This article was externally reviewed using our double-blind peer-review process. When
            the article was accepted for publication, the author thanked the reviewers in the
            acknowledgments for their comments and suggestions. Jian ZHANG and one anonymous
            reviewer were the reviewers for this article.Submitted 31 January 2019Accepted 9 March 2020 by Stephen J. BrownThis article has been corrected with minor changes. These changes do not impact the
	     academic content of the article.
Journal: Financial Analysts Journal
Pages: 110-133
Issue: 3
Volume: 76
Year: 2020
Month: 7
X-DOI: 10.1080/0015198X.2020.1744211
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1744211
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# input file: UFAJ_A_1756614_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Roger Clarke
Author-X-Name-First: Roger
Author-X-Name-Last: Clarke
Author-Name: Harindra de Silva
Author-X-Name-First: Harindra
Author-X-Name-Last: de Silva
Author-Name: Steven Thorley
Author-X-Name-First: Steven
Author-X-Name-Last: Thorley
Title: Risk Management and the Optimal Combination of Equity Market Factors
Abstract: 
 Managing the intertemporal risk of optimally constructed multifactor portfolios adds
	     to performance. The increases in Sharpe ratios are in addition to the utility that
	     investors gain from controlling how much active risk they are exposed to over time. We
	     derive a simple closed-form formula for security weights in optimal multifactor
	     portfolios with an active-risk target. We test the risk control of five well-known
	     factors—value, momentum, small size, low beta, and profitability—and the
	     optimal multifactor portfolio. Our empirical research was carried out on the
	     large-capitalization US equity market for 1966 through 2019. We conclude that for the
	     equity market, more active factors are better than fewer if each subportfolio is
	     “pure” as to factor, anchored to the benchmark, and combined on the basis
	     of forecastable risks. Our portfolio construction methodology allows for transparent
	     performance attribution and replication of the process in other markets and time
	     periods.Disclosure: The authors report no conflicts of interest.
					Editor’s Note
				This article was externally reviewed using our double-blind peer-review process.
		When the article was accepted for publication, the authors thanked the two anonymous
		reviewers in their acknowledgments.Submitted 18 November 2019Accepted 9 April 2020 by Stephen J. Brown.
Journal: Financial Analysts Journal
Pages: 57-79
Issue: 3
Volume: 76
Year: 2020
Month: 7
X-DOI: 10.1080/0015198X.2020.1756614
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1756614
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# input file: UFAJ_A_1758502_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jamil Baz
Author-X-Name-First: Jamil
Author-X-Name-Last: Baz
Author-Name: Josh Davis
Author-X-Name-First: Josh
Author-X-Name-Last: Davis
Author-Name: Steve Sapra
Author-X-Name-First: Steve
Author-X-Name-Last: Sapra
Author-Name: Normane Gillmann
Author-X-Name-First: Normane
Author-X-Name-Last: Gillmann
Author-Name: Jerry Tsai
Author-X-Name-First: Jerry
Author-X-Name-Last: Tsai
Title: A Framework for Constructing Equity-Risk-Mitigation Portfolios
Abstract: 
 The key trade-off among equity-risk-mitigation strategies is their expected return
	     versus their ability to diversify equity risk. In particular, the more reliable a
	     strategy’s equity-hedging properties, the lower its expected return, and vice
	     versa. This article proposes a framework for optimal equity-risk-mitigation portfolio
	     construction. In our model, the investor maximizes the portfolio’s unconditional
	     expected return, subject to a constraint on its conditional equity beta. We show that
	     the return to a risk-mitigation portfolio can be decomposed into hedging and return-
	     generating components. We then demonstrate that optimal risk-mitigation portfolios
	     exhibit better return-defensiveness properties relative to the underlying strategies.Disclosure: The authors report no conflicts of interest.
					Editor’s Note
				Submitted 17 June 2019Accepted 14 April 2020 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 81-98
Issue: 3
Volume: 76
Year: 2020
Month: 7
X-DOI: 10.1080/0015198X.2020.1758502
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1758502
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# input file: UFAJ_A_1758503_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Adam Kobor
Author-X-Name-First: Adam
Author-X-Name-Last: Kobor
Author-Name: Arun Muralidhar
Author-X-Name-First: Arun
Author-X-Name-Last: Muralidhar
Title: Targeting Retirement Security with a Dynamic Asset Allocation Strategy
Abstract: 
 The goal of investing for retirement is to secure a target level of income that
	     maintains the individual’s preretirement lifestyle. Current “safe
	     harbor” glide-path products shift investments from stocks to bonds on the basis
	     of the individual’s age. This approach is unlikely to secure a target retirement
	     income because the glide path is focused on the wrong goal. We tested a dynamic asset
	     allocation strategy that takes no view of future market performance and is based on a
	     retirement income goal. We show how this dynamic strategy could dominate standard
	     portfolio choices. The article introduces a new way to think about intermediate
	     retirement targets and explores the implications of the dynamic asset allocation
	     strategy for the level of savings required to achieve a retirement goal.Disclosure: The authors report no conflicts of interest.
					Editor’s Note
				This article was externally reviewed using our double-blind peer-review process.
		When the article was accepted for publication, the author thanked the reviewers in
		the acknowledgments. Christina Atanasova, Michael Drew, and one anonymous reviewer
		were the reviewers for this article.Submitted 1 October 2019Accepted 14 April 2020 by Stephen J. Brown.
Journal: Financial Analysts Journal
Pages: 38-55
Issue: 3
Volume: 76
Year: 2020
Month: 7
X-DOI: 10.1080/0015198X.2020.1758503
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1758503
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# input file: UFAJ_A_1760064_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Shomesh E. Chaudhuri
Author-X-Name-First: Shomesh E.
Author-X-Name-Last: Chaudhuri
Author-Name: Terence C. Burnham
Author-X-Name-First: Terence C.
Author-X-Name-Last: Burnham
Author-Name: Andrew W. Lo
Author-X-Name-First: Andrew W.
Author-X-Name-Last: Lo
Title: An Empirical Evaluation of Tax-Loss-Harvesting Alpha
Abstract: 
 Advances in financial technology have made tax-loss harvesting more feasible for retail
	     investors than such strategies were in the past. We evaluated the magnitude of this
	     “tax alpha” with the use of historical data from the CRSP monthly database
	     for the 500 securities with the largest market capitalizations from 1926 to 2018. Given
	     long-term and short-term capital gains tax rates of 15% and 35%, respectively, we found
	     that a tax-loss-harvesting strategy yielded a before-transaction-cost tax alpha of 1.08%
	     per year for our sample period. When the strategy was constrained by the “wash sale
	     rule,” the tax alpha decreased from 1.08% per year to 0.82% per year.Disclosure: The authors report no conflicts of interest.
					Editor’s Note
				This article was externally reviewed using our double-blind peer-review process. When
		the article was accepted for publication, the authors thanked the reviewers in their
		acknowledgments. Andrew Berkin and one anonymous reviewer were the reviewers for this
		article.Submitted 3 February 2020Accepted 14 April 2020 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 99-108
Issue: 3
Volume: 76
Year: 2020
Month: 7
X-DOI: 10.1080/0015198X.2020.1760064
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1760064
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# input file: UFAJ_A_1766287_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: William N. Goetzmann
Author-X-Name-First: William N.
Author-X-Name-Last: Goetzmann
Title: The Financial Analysts Journal and Investment Management
Abstract: 
 The Financial Analysts Journal is a leading forum for sharing knowledge
          about investment management. It often features academic research, but its focus has
          consistently been on practice and how new knowledge can support one of society’s
          most important endeavors: preserving and growing assets for our collective economic
          future. In this article, I review some key contributions about portfolio management
          published in this journal. The lively debates demonstrate how asset management has evolved
          through give-and-take discussion of innovation versus established practice. The
            Financial Analysts Journal has consistently introduced its readers to
          new ideas and methods. In doing so, it has greatly improved professional practice.Disclosure: The author reports no conflicts of interest.
          Editor’s Note
        Submitted 8 April 2020Accepted 29 April 2020 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 5-21
Issue: 3
Volume: 76
Year: 2020
Month: 7
X-DOI: 10.1080/0015198X.2020.1766287
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1766287
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# input file: UFAJ_A_1802984_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David Chambers
Author-X-Name-First: David
Author-X-Name-Last: Chambers
Author-Name: Elroy Dimson
Author-X-Name-First: Elroy
Author-X-Name-Last: Dimson
Author-Name: Charikleia Kaffe
Author-X-Name-First: Charikleia
Author-X-Name-Last: Kaffe
Title: Seventy-Five Years of Investing for Future Generations
Abstract: 
 University endowments invest for future generations, so their strategy should reflect
	    their long horizon. We researched whether they really do behave like long-term
	    investors. We examined the behavior of US endowments since 1945 and drew comparisons
	    with earlier periods. Using a long-run dataset on 12 major universities, we examined
	    their preferences for risky assets and documented their big strategic moves into
	    equities and, later, into alternatives. We then analysed how they invest at the
	    time of crises and the extent to which they exploit their long-horizon advantage.
	    We found that, on average, endowments invested countercyclically at crisis times,
	    particularly by increasing their allocations to risky assets after a crisis.Disclosure: The authors report no conflicts of interest.
					Editor’s Note
				Submitted 19 June 2020Accepted 26 July 2020 by Stephen J. BrownThis article was originally published online with minor errors in
					Table 3 and
					Table 5, which have been
					corrected for both online and print versions. Please see
					Correction 
				https://doi.org/10.1080/0015198X.2020.1836941
Journal: Financial Analysts Journal
Pages: 5-21
Issue: 4
Volume: 76
Year: 2020
Month: 10
X-DOI: 10.1080/0015198X.2020.1802984
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1802984
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Author-Name: Kenechukwu Anadu
Author-X-Name-First: Kenechukwu
Author-X-Name-Last: Anadu
Author-Name: Mathias Kruttli
Author-X-Name-First: Mathias
Author-X-Name-Last: Kruttli
Author-Name: Patrick McCabe
Author-X-Name-First: Patrick
Author-X-Name-Last: McCabe
Author-Name: Emilio Osambela
Author-X-Name-First: Emilio
Author-X-Name-Last: Osambela
Title: The Shift from Active to Passive Investing: Risks to Financial Stability?
Abstract: 
 The past two decades have seen a significant shift from active to passive
	    investment strategies. We examined how this shift affects financial stability
	    through its impacts on (1) funds’ liquidity and redemption risks, (2)
	    asset market volatility, (3) asset management industry concentration, and (4)
	    comovement of asset returns and liquidity. Overall, the shift appears to be
	    increasing some risks and reducing others. Some passive strategies amplify
	    market volatility, and the shift has increased industry concentration but has
	    diminished some liquidity and redemption risks. Evidence on the links between
	    indexing and comovement of asset returns and liquidity is mixed.Disclosure: The authors report no conflicts of interest.
					Editor’s Note
				Submitted 23 January 2020Accepted 22 May 2020 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 23-39
Issue: 4
Volume: 76
Year: 2020
Month: 10
X-DOI: 10.1080/0015198X.2020.1779498
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1779498
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# input file: UFAJ_A_1779561_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Cornelia Caseau
Author-X-Name-First: Cornelia
Author-X-Name-Last: Caseau
Author-Name: Gilles Grolleau
Author-X-Name-First: Gilles
Author-X-Name-Last: Grolleau
Title: Impact Investing: Killing Two Birds with One Stone?
Abstract: 
 A cornerstone of impact investing is the intentional provision of measurable
	   nonfinancial returns in addition to conventional financial returns. This attractive
	   promise also constitutes the Achilles’ heel of impact investing. When two or
	   more goals (e.g., impact and financial returns) are pursued through a single means
	   (e.g., investing), humans tend to believe that the means becomes less effective in
	   achieving either goal. We discuss the conceptual foundations of this likely bias and
	   its implications for the impact investing movement. We also suggest some practical
	   ways to overcome this issue.Disclosure: The authors declare that there is no conflict of
	     interest.
					Editor’s Note
				This article was externally reviewed using our double-blind peer-review process.
	     When the article was accepted for publication, the authors thanked the reviewers in
	     their acknowledgments. Rajna Gibson Brandon and one anonymous reviewer were the
	     reviewers for this article.Submitted 30 January 2020Accepted 2 June 2020 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 40-52
Issue: 4
Volume: 76
Year: 2020
Month: 10
X-DOI: 10.1080/0015198X.2020.1779561
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1779561
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Author-Name: Dion Bongaerts
Author-X-Name-First: Dion
Author-X-Name-Last: Bongaerts
Author-Name: Xiaowei Kang
Author-X-Name-First: Xiaowei
Author-X-Name-Last: Kang
Author-Name: Mathijs van Dijk
Author-X-Name-First: Mathijs
Author-X-Name-Last: van Dijk
Title: Conditional Volatility Targeting
Abstract: 
 In analyzing the performance of volatility-targeting strategies, we found that
	       conventional volatility targeting fails to consistently improve performance in
	       global equity markets and can lead to markedly greater drawdowns. Motivated by
	       return patterns in various volatility states, we propose a strategy of
	       conditional volatility targeting that adjusts risk exposures only
	       in the extremes during high- and low-volatility states. This strategy consistently
	       enhances Sharpe ratios and reduces drawdowns and tail risks, with low turnover and
	       leverage, when used in the major equity markets and for momentum factors across
	       regions. Conditional volatility management can also be applied to tactical
	       allocations among multiple assets or risk factors.Disclosure: The authors report no conflicts of interest. The views
		  expressed in this article are those of the authors in their personal capacity
		  and do not reflect the views of the Rotterdam School of Management or the Abu
		  Dhabi Investment Authority.
          Editor’s Note
        Submitted 6 March 2020Accepted 23 June 2020 by Stephen J. BrownThis article was externally reviewed using our double-blind peer-review process.
		  When the article was accepted for publication, the authors thanked the reviewers
		  in their acknowledgments. Lisa Goldberg and one anonymous reviewer were the
		  reviewers for this article.
Journal: Financial Analysts Journal
Pages: 54-71
Issue: 4
Volume: 76
Year: 2020
Month: 10
X-DOI: 10.1080/0015198X.2020.1790853
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1790853
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Author-Name: David Blitz
Author-X-Name-First: David
Author-X-Name-Last: Blitz
Author-Name: Guido Baltussen
Author-X-Name-First: Guido
Author-X-Name-Last: Baltussen
Author-Name: Pim van Vliet
Author-X-Name-First: Pim
Author-X-Name-Last: van Vliet
Title: When Equity Factors Drop Their Shorts
Abstract: 
 Although factor premiums originate in both long and short legs of factor portfolios, we found
	    that (1) most added value comes from the long legs, (2) the long legs offer more
	    diversification than the short legs, and (3) the performance of the short legs is generally
	    subsumed by that of the long legs. These results are robust over size, time, and markets and
	    cannot be attributed to differences in tail risk. We also found that the claim that the value
	    and low-risk factors are subsumed by the new (post-2015) Fama–French factors does not
	    hold for the long legs of these factors.Disclosure: The authors disclose that they are employed by Robeco, a firm that
	      offers various investment products. The construction of these products may, at times, draw
	      on insights related to this research. No other person or party at Robeco except the authors
	      had the right to review this article prior to its circulation. The views and results
	      presented in this article were not driven by the views or interests of Robeco and are not
	      a reflection of its points of view.
					Editor’s Note
				Submitted 21 November 2019Accepted 29 May 2020 by Stephen J. BrownThis article was externally reviewed using our double-blind peer-review process. When the
	     article was accepted for publication, the authors thanked the reviewers in their
	     acknowledgments. Malcolm Baker and one anonymous reviewer were the reviewers for this
	     article.
Journal: Financial Analysts Journal
Pages: 73-99
Issue: 4
Volume: 76
Year: 2020
Month: 10
X-DOI: 10.1080/0015198X.2020.1779560
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1779560
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# input file: UFAJ_A_1809224_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Manuel Ammann
Author-X-Name-First: Manuel
Author-X-Name-Last: Ammann
Author-Name: Sebastian Fischer
Author-X-Name-First: Sebastian
Author-X-Name-Last: Fischer
Author-Name: Florian Weigert
Author-X-Name-First: Florian
Author-X-Name-Last: Weigert
Title: Factor Exposure Variation and Mutual Fund Performance
Abstract: 
 We investigated the relationship between a mutual fund’s variation in factor
	       exposures and its future performance. Using a dynamic state-space version of the
	       Carhart (1997) four-factor model to capture factor variations, we found that funds
	       with volatile factor exposures underperform funds with stable factor exposures by
	       147 bps a year. This underperformance is explained neither by volatile factor
	       loadings of a fund’s equity holdings nor by a fund’s forced trading
	       through investor flows. We conclude that fund managers voluntarily attempt to time
	       factors but are unsuccessful at doing so.Disclosure: The authors report no conflicts of interest.
					Editor’s Note
				Submitted 13 February 2020Accepted 5 August 2020 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 101-118
Issue: 4
Volume: 76
Year: 2020
Month: 10
X-DOI: 10.1080/0015198X.2020.1809224
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1809224
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# input file: UFAJ_A_1809903_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Dale Kintzel
Author-X-Name-First: Dale
Author-X-Name-Last: Kintzel
Author-Name: John A. Turner
Author-X-Name-First: John A.
Author-X-Name-Last: Turner
Title: Provision of Longevity Insurance Annuities
Abstract: 
 Longevity insurance annuities are deferred annuities that begin payment at
	       advanced ages, such as age 82. They provide insurance against running out of
	       money in old age. They simplify the retirement spend-down calculations in
	       that they can be used to convert a problem with an unknown end date (date
	       of death) to one with a fixed end date, which is the start of the longevity
	       insurance annuity. They may allow retirees to have riskier portfolios because
	       they are a steady source of income. In this study, we compared the provision
	       of longevity insurance annuities in the private and public sectors. We
	       analyzed the need for longevity insurance annuities using Monte Carlo
	       simulations that demonstrate the risk of running out of money in a 401(k)
	       account and modeled how longevity annuities might work in practice.Disclosure: The authors report no conflicts of interest with
		  respect to this article. The research for this article was performed while
		  Dale Kintzel was employed as an economist at the US Social Security
		  Administration.
          Editor’s Note
        Submitted 17 January 2020Accepted 5 August 2020 by Stephen J. Brown.This article was externally reviewed using our double-blind peer-review
		  process. When the article was accepted for publication, the authors thanked
		  the reviewers in their acknowledgments. Moshe Arye Milevsky, Raul Leote de
		  Carvalho, and Don Ezra were the reviewers for this article.
Journal: Financial Analysts Journal
Pages: 119-133
Issue: 4
Volume: 76
Year: 2020
Month: 10
X-DOI: 10.1080/0015198X.2020.1809903
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1809903
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# input file: UFAJ_A_1817698_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Claude Erb
Author-X-Name-First: Claude
Author-X-Name-Last: Erb
Author-Name: Campbell R. Harvey
Author-X-Name-First: Campbell R.
Author-X-Name-Last: Harvey
Author-Name: Tadas Viskanta
Author-X-Name-First: Tadas
Author-X-Name-Last: Viskanta
Title: Gold, the Golden Constant, and Déjà Vu
Abstract: 
 Currently, the real, or inflation-adjusted, price of gold is almost as high as
	       it was in January 1980 and August 2011. Since 1975, periods of high real gold
	       prices have occurred during periods of elevated concern about high future price
	       inflation. Five years after the real price peaks in January 1980 and August
	       2011, the nominal (real) prices of gold fell 55% (67%) and 28% (33%), respectively.
	       Today’s high real price of gold suggests that gold is an expensive inflation
	       hedge with a low prospective real return. The financialization of gold ownership
	       by exchange-traded funds, however, may introduce a period of irrational exuberance.Disclosure: The authors report no conflicts of interest. The
		  views expressed here do not necessarily reflect those of Tadas Viskanta’s
		  employer, Ritholtz Wealth Management. Ritholtz Wealth Management may hold
		  positions in securities mentioned herein.Viewpoint is an occasional feature of the Financial Analysts
		  Journal. This piece was not subjected to the peer-review process.
	       It reflects the views of the authors and does not represent the official views
	       of the Financial Analysts Journal or CFA Institute.
Journal: Financial Analysts Journal
Pages: 134-142
Issue: 4
Volume: 76
Year: 2020
Month: 10
X-DOI: 10.1080/0015198X.2020.1817698
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1817698
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Author-Name: The Editors
Title: Our Thanks to Reviewers
Abstract: 
 We thank the 118 reviewers who took part in the double-blind peer-review process
	   of articles reviewed for 2020, assuring the ongoing quality of the Financial
	      Analysts Journal.
Journal: Financial Analysts Journal
Pages: i-ii
Issue: 4
Volume: 76
Year: 2020
Month: 10
X-DOI: 10.1080/0015198X.2020.1826818
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1826818
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Author-Name: The Editors
Title: Correction
Journal: Financial Analysts Journal
Pages: iii-iv
Issue: 4
Volume: 76
Year: 2020
Month: 10
X-DOI: 10.1080/0015198X.2020.1836941
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1836941
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Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Author-Name: Campbell R. Harvey
Author-X-Name-First: Campbell R.
Author-X-Name-Last: Harvey
Author-Name: Vitali Kalesnik
Author-X-Name-First: Vitali
Author-X-Name-Last: Kalesnik
Author-Name: Juhani T. Linnainmaa
Author-X-Name-First: Juhani T.
Author-X-Name-Last: Linnainmaa
Title: Reports of Value’s Death May Be Greatly Exaggerated
Abstract: 
 Value investing, as defined by the Fama–French high book-to-market minus
	       low book-to-market (HML) factor, has underperformed growth investing since 2007,
	       producing a drawdown of 55% as of mid-2020. The underperformance has led many
	       market observers to argue that value is dead. Our analysis attributes value’s
	       recent underperformance to two sources: (1) The HML book-value-to-price definition
	       fails to capture increasingly important intangible assets, and (2) valuations of
	       value stocks relative to growth stocks have tumbled. Both observations are
	       inconsistent with the argument for value’s death. We capitalize intangibles
	       and show that this measure of value outperforms the traditional measure by a
	       wide margin. We also describe a return decomposition and demonstrate that changes
	       in the valuation spread between the growth and value portfolios explain the entire
	       drawdown, with room to spare. The relative valuation of the value factor falls
	       from the top quartile of the historical distribution at the start of 2007 to the
	       bottom percentile as of June 2020Disclosure: Research Affiliates, LLC, has a commercial interest
		  in the subject matter.
					Editor’s Note:
				Submitted 3 June 2020Accepted 21 October 2020 by Stephen J. Brown.This article was externally reviewed using our double-blind peer-review process.
		  When the article was accepted for publication, the authors thanked the reviewers
		  in their acknowledgments. Andrew L. Berkin and one anonymous reviewer were the
		  reviewers for this article.Correction: This article was originally published with a production
		  error in Figure 1B and endnote
		  32, which have now been corrected in the online
		  version. Please see Correction (
		     https://doi.org/10.1080/0015198X.2021.1895584).
Journal: Financial Analysts Journal
Pages: 44-67
Issue: 1
Volume: 77
Year: 2021
Month: 1
X-DOI: 10.1080/0015198X.2020.1842704
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1842704
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Author-Name: Colby J. Pessina
Author-X-Name-First: Colby J.
Author-X-Name-Last: Pessina
Author-Name: Robert E. Whaley
Author-X-Name-First: Robert E.
Author-X-Name-Last: Whaley
Title: Levered and Inverse Exchange-Traded Products: Blessing or Curse?
Abstract: 
 Levered and inverse exchange-trade products (ETPs) are designed to provide geared
	       long and short exposures to the daily returns of various benchmark indexes. The
	       benchmarks may be any reference index, but the popular ones are indexes of stocks,
	       bonds, commodities, and volatility. The problem with these products is that they
	       are not generally well understood, particularly those with futures-based benchmarks.
	       Levered and inverse ETPs are neither suitable buy-and-hold investments nor effective
	       hedging tools. They are unstable and exist only as mechanisms for placing short-term
	       directional bets. Levered and inverse products are not, and cannot be, effective
	       investment management tools.Disclosure: The authors report no conflicts of interest.
					Editor’s Note:
				Submitted 22 April 2020Accepted 23 September 2020 by Stephen J. BrownThis article was externally reviewed using our double-blind peer-review process.
		  When the article was accepted for publication, the authors thanked the reviewers
		  in their acknowledgments. David Chambers and Fanesca Young were the reviewers
		  for this article.
Journal: Financial Analysts Journal
Pages: 10-29
Issue: 1
Volume: 77
Year: 2021
Month: 1
X-DOI: 10.1080/0015198X.2020.1830660
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1830660
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Author-Name: Heidi Raubenheimer
Author-X-Name-First: Heidi
Author-X-Name-Last: Raubenheimer
Title: 2020 Report to Readers
Abstract: 
 At the close of every calendar year, we report to our readers, authors, and other
	       stakeholders on the behind-the-scenes activities of the Financial Analysts
		  Journal. 
Journal: Financial Analysts Journal
Pages: 5-8
Issue: 1
Volume: 77
Year: 2021
Month: 1
X-DOI: 10.1080/0015198X.2020.1854022
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1854022
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# input file: UFAJ_A_1816366_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ananth Madhavan
Author-X-Name-First: Ananth
Author-X-Name-Last: Madhavan
Author-Name: Aleksander Sobczyk
Author-X-Name-First: Aleksander
Author-X-Name-Last: Sobczyk
Author-Name: Andrew Ang
Author-X-Name-First: Andrew
Author-X-Name-Last: Ang
Title: Toward ESG Alpha: Analyzing ESG Exposures through a Factor Lens
Abstract: 
 Using data on 1,312 active US equity mutual funds with $3.9 trillion in assets
	       under management, we analyzed the link between funds’ bottom-up,
	       holdings-based environmental, social, and governance (ESG) scores and funds’
	       active returns, style factor loadings, and alphas. We found that funds with high
	       ESG scores have profiles of factor loadings that are different from those of
	       low-scoring ESG funds. In particular, funds with high environmental scores tend
	       to have high quality and momentum factor loadings. In partitioning the ESG scores
	       into components that are related to factors and idiosyncratic components, we
	       found strong positive relationships between fund alphas and factor ESG scores.Disclosure: The authors report no conflicts of interest. The views
		  expressed here are ours alone. This material is not intended to be relied upon
		  as a forecast, research, or investment advice and is not a recommendation,
		  offer, or solicitation to buy or sell any securities or to adopt any investment
		  strategy. The authors have not received any outside funding for this research.
          Editor’s Note
        Submitted 1 June 2020Accepted 18 August 2020 by Stephen J. BrownThis article was externally reviewed using our double-blind peer-review process.
		  When the article was accepted for publication, the authors thanked the reviewers
		  in their acknowledgments. Keith H. Black, CFA, and one anonymous reviewer were
		  the reviewers for this article.
Journal: Financial Analysts Journal
Pages: 69-88
Issue: 1
Volume: 77
Year: 2021
Month: 1
X-DOI: 10.1080/0015198X.2020.1816366
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1816366
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Author-Name: Feifei Wang
Author-X-Name-First: Feifei
Author-X-Name-Last: Wang
Author-Name: Xuemin (Sterling) Yan
Author-X-Name-First: Xuemin (Sterling)
Author-X-Name-Last: Yan
Author-Name: Lingling Zheng
Author-X-Name-First: Lingling
Author-X-Name-Last: Zheng
Title: Should Mutual Fund Investors Time Volatility?
Abstract: 
 Increasing (decreasing) investment in an actively managed mutual fund when fund
	       volatility has recently been low (high) leads to a significant improvement in
	       investment performance. Specifically, volatility-scaled fund returns exhibit
	       significantly higher alphas and Sharpe ratios than the original (unscaled) fund
	       returns. Scaling by past downside volatility leads to even greater performance
	       improvement than scaling by total volatility. The superior performance of
	       volatility-managed mutual fund trading strategies is attributable to both volatility
	       timing and return timing. Fund flows are negatively related to past fund volatility,
	       suggesting that fund investors are aware of the benefit of volatility management.Disclosure: The authors report no conflicts of interest.
					Editor’s Note
				Submitted 3 March 2020Accepted 7 September 2020 by Stephen J. BrownThis article was externally reviewed using our double-blind peer-review process.
		  When the article was accepted for publication, the authors thanked the reviewers
		  in their acknowledgments. Claude B. Erb, CFA, and one anonymous reviewer were the
		  reviewers for this article.
Journal: Financial Analysts Journal
Pages: 30-42
Issue: 1
Volume: 77
Year: 2021
Month: 1
X-DOI: 10.1080/0015198X.2020.1822705
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1822705
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# input file: UFAJ_A_1841539_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mark Kritzman
Author-X-Name-First: Mark
Author-X-Name-Last: Kritzman
Author-Name: Ding Li
Author-X-Name-First: Ding
Author-X-Name-Last: Li
Author-Name: Grace (TianTian) Qiu
Author-X-Name-First: Grace (TianTian)
Author-X-Name-Last: Qiu
Author-Name: David Turkington
Author-X-Name-First: David
Author-X-Name-Last: Turkington
Title: Portfolio Choice with Path-Dependent Scenarios
Abstract: 
 Sophisticated investors rely on scenario analysis to select portfolios. We propose
	       a new approach to scenario analysis that enables investors to consider sequential
	       outcomes. We define scenarios not as average values but as paths for the economic
	       variables. And we measure the likelihood of these paths on the basis of the
	       statistical similarity of the paths to historical sequences. We also use a novel
	       forecasting technique called “partial sample regression” to map economic
	       outcomes onto asset class returns. This process allows investors to evaluate
	       portfolios on the basis of the likelihood that the scenario will produce a certain
	       pattern of returns over a specified investment horizon.Disclosure: The authors report no conflicts of interest.
          Editor’s Note:
        Submitted 28 May 2020Accepted 21 October 2020 by Stephen J. BrownThis material is for informational purposes only. The views expressed in this
		  material are the views of the authors, are provided “as-is” at the
		  time of first publication, are not intended for distribution to any person or
		  entity in any jurisdiction where such distribution or use would be contrary to
		  applicable law, and are not an offer or solicitation to buy or sell securities
		  or any product. The views expressed do not necessarily represent the views of
		  State Street Global Markets, State Street Corporation and its affiliates, Windham
		  Capital Management, or GIC, Singapore’s sovereign wealth fund, GIC Private
		  Limited, and its affiliates (collectively, “GIC”). While State Street,
		  Windham Capital Management and GIC have collaborated for purposes of conducting
		  research and developing this article, State Street, Windham Capital Management,
		  and GIC are not engaged in any joint venture, affiliated in any way, or collectively
		  providing or offering any services or products.
Journal: Financial Analysts Journal
Pages: 90-100
Issue: 1
Volume: 77
Year: 2021
Month: 1
X-DOI: 10.1080/0015198X.2020.1841539
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1841539
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Author-Name: Amitabh Dugar
Author-X-Name-First: Amitabh
Author-X-Name-Last: Dugar
Author-Name: Jacob Pozharny
Author-X-Name-First: Jacob
Author-X-Name-Last: Pozharny
Title: Equity Investing in the Age of Intangibles
Abstract: 
 Expenditures on the creation of intangible capital have increased, but accounting standards have
	       not kept pace. We investigated whether this has affected the value relevance of book value and
	       earnings. We constructed a composite measure of intangible intensity by which to classify
	       industries. The measure is based on intangible assets capitalized on the balance sheet; research
	       and development expenditures; and sales, general, and administrative expenditures. We show that
	       the value relevance of book value and earnings has declined for high-intangible-intensity
	       companies in the United States and abroad, but for the low-intangible-intensity group, it
	       has remained stable in the United States while increasing internationally.Editor’s Note:Submitted 19 October 2020Accepted 30 December 2020 by Stephen J. BrownDisclosure: The authors report no conflicts of interest.This article was externally reviewed using our double-blind peer-review process. When
		  the article was accepted for publication, the authors thanked the reviewers in their
		  acknowledgments. John Adams and one anonymous reviewer were the reviewers for this article.
Journal: Financial Analysts Journal
Pages: 21-42
Issue: 2
Volume: 77
Year: 2021
Month: 4
X-DOI: 10.1080/0015198X.2021.1874726
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1874726
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Author-Name: The Editors
Title: Correction
Journal: Financial Analysts Journal
Pages: 152-
Issue: 2
Volume: 77
Year: 2021
Month: 4
X-DOI: 10.1080/0015198X.2021.1895584
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1895584
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# input file: UFAJ_A_1861896_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Daniel V. Fauser
Author-X-Name-First: Daniel V.
Author-X-Name-Last: Fauser
Author-Name: Sebastian Utz
Author-X-Name-First: Sebastian
Author-X-Name-Last: Utz
Title: Risk Mitigation of Corporate Social Performance in US Class Action Lawsuits
Abstract: 
 We investigated the relationship between corporate environmental, social, and
                    governance (ESG) performance and litigation risk by examining US class action
                    lawsuits. We found that a 1 standard deviation improvement in the ESG
                    controversies of an average company in the sample reduced litigation risk from
                    3.1% to 2.4%. Moreover, an average company with low ESG performance exhibited a
                    loss in market value twice as large as that of a company with high ESG
                    performance—an abnormal loss of US$1.14 billion. Implementation of our
                    findings with a trading strategy yielded positive monthly alphas, suggesting
                    that investors benefit from lower litigation risk and the insurance-like
                    protection of high ESG performance.Disclosure: The authors report no conflicts of interest. This
                        research did not receive any specific grant from funding agencies in the
                        public, commercial, or not-for-profit sectors.
                    Editor’s note:
                Submitted 24 April 2020Accepted 1 December 2020 by Stephen J. Brown.This article was externally reviewed using our double-blind peer-review
                        process. When the article was accepted for publication, the authors thanked
                        the reviewers in their acknowledgments. Jie Cao and one anonymous reviewer
                        were the reviewers for this article.
Journal: Financial Analysts Journal
Pages: 43-65
Issue: 2
Volume: 77
Year: 2021
Month: 4
X-DOI: 10.1080/0015198X.2020.1861896
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1861896
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Handle: RePEc:taf:ufajxx:v:77:y:2021:i:2:p:43-65




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# input file: UFAJ_A_1877981_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Michael E. Drew
Author-X-Name-First: Michael E.
Author-X-Name-Last: Drew
Author-Name: Jason M. West
Author-X-Name-First: Jason M.
Author-X-Name-Last: West
Title: Retirement Income Sufficiency through Personalised Glidepaths
Abstract: 
 Portfolio “glidepaths” accommodate growth in a worker’s early
               working life and transition to lower risk settings as the worker nears retirement.
               The success of this design hinges on its objective of amassing wealth at the date of
               retirement, but the design offers little in the way of a solution for the provision
               of income during retirement. The relevant risk for workers is retirement income
               uncertainty. Allocating investments through time to satisfy an income goal is not
               equivalent to the maximisation of wealth at retirement. We demonstrate that
               glidepaths can be personalised for individuals to maximise expected retirement income
               sufficiency under a range of assumptions, including longevity risk.Disclosure: The authors report no conflicts of interest.
               Editor’s Note:
            Submitted 18 November 2020Accepted 11 January 2021 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 5-20
Issue: 2
Volume: 77
Year: 2021
Month: 4
X-DOI: 10.1080/0015198X.2021.1877981
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1877981
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# input file: UFAJ_A_1865695_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Markus Natter
Author-X-Name-First: Markus
Author-X-Name-Last: Natter
Author-Name: Martin Rohleder
Author-X-Name-First: Martin
Author-X-Name-Last: Rohleder
Author-Name: Marco Wilkens
Author-X-Name-First: Marco
Author-X-Name-Last: Wilkens
Title: Maturity-Matched Bond Fund Performance
Abstract: 
 Performance regressions lever expected benchmark returns linearly to the risk
                    exposures of the fund. The interest rate (IR) risk premium, however, usually
                    follows a decreasingly upward-sloping yield curve, characterizing the
                    nonlinearity between expected return and IR risk exposure—for example,
                    maturity or duration. If the exposures of the fund and the benchmark differ,
                    this discrepancy causes alpha to deviate from the active bond selection
                    performance it is supposed to measure. Performance ratings and investor flows
                    are affected by this alpha deviation. Our simple remedy is to
                    individually match funds and benchmarks using their durations. Beta and
                        R2 are candidates for alternative matchings.Disclosure: The authors report no conflicts of interest.
                    Editor’s Note:
                Submitted 10 July 2020Accepted 9 December 2020 by Stephen J. BrownThis article was externally reviewed using our double-blind peer-review
                        process. When the article was accepted for publication, the authors thanked
                        the reviewers in their acknowledgments. Quan Wen and one anonymous reviewer
                        were the reviewers for this article.
Journal: Financial Analysts Journal
Pages: 83-96
Issue: 2
Volume: 77
Year: 2021
Month: 4
X-DOI: 10.1080/0015198X.2020.1865695
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1865695
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Handle: RePEc:taf:ufajxx:v:77:y:2021:i:2:p:83-96




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# input file: UFAJ_A_1854543_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Lasse Heje Pedersen
Author-X-Name-First: Lasse Heje
Author-X-Name-Last: Pedersen
Author-Name: Abhilash Babu
Author-X-Name-First: Abhilash
Author-X-Name-Last: Babu
Author-Name: Ari Levine
Author-X-Name-First: Ari
Author-X-Name-Last: Levine
Title: Enhanced Portfolio Optimization
Abstract: 
 Portfolio optimization should provide large benefits for investors, but
	       standard mean–variance optimization (MVO) works so poorly in practice
	       that optimization is often abandoned. Many of the approaches developed to
	       address this issue are surrounded by mystique regarding how, why, and whether
	       they really work. So, we sought to simplify, unify, and demystify optimization.
	       We identified the portfolios that cause problems in standard MVO, and we
	       present here a simple “enhanced portfolio optimization” method.
	       Applying this method to industry momentum and time-series momentum across
	       equities and global asset classes, we found significant alpha beyond the
	       market, the 1/N portfolio, and standard asset pricing
	       factors.Disclosure: The authors report no conflicts of interest.
		  AQR Capital Management is a global investment management firm that may
		  or may not apply similar investment techniques or methods of analysis
		  as described here. The views expressed here are those of the authors and
		  not necessarily those of AQR. Lasse Heje Pedersen gratefully acknowledges
		  support from Center for Financial Frictions (Grant No. DNRF102).
					Editor’s Note:
				Submitted 13 August 2020Accepted 17 November 2020 by Stephen J. Brown
Journal: Financial Analysts Journal
Pages: 124-151
Issue: 2
Volume: 77
Year: 2021
Month: 4
X-DOI: 10.1080/0015198X.2020.1854543
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1854543
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Handle: RePEc:taf:ufajxx:v:77:y:2021:i:2:p:124-151




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# input file: UFAJ_A_1875716_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David Forsberg
Author-X-Name-First: David
Author-X-Name-Last: Forsberg
Author-Name: David R. Gallagher
Author-X-Name-First: David R.
Author-X-Name-Last: Gallagher
Author-Name: Geoffrey J. Warren
Author-X-Name-First: Geoffrey J.
Author-X-Name-Last: Warren
Title: Identifying Hedge Fund Skill by Using Peer Cohorts
Abstract: 
 We propose a cohort model that evaluates hedge funds against peer groups executing similar
     investment strategies formed by using return correlations. Our method improves the
     identification of skilled managers, as evidenced by a strong ability to explain hedge fund
     returns out-of-sample, with cohort alpha being more persistent than alpha based on the widely
     accepted seven-factor model. A hedge fund-of-funds analysis found significant performance
     enhancement from exposure to the best funds within each cohort. The cohort approach can be used
     to enhance the construction of hedge fund-of-funds portfolios by isolating strategy groupings
     as well as the best managers within each group.Disclosures: The authors have no conflicts of interest to declare. The content
      of this article reflects the views of the authors and not necessarily the views of BlueCove
      Limited.
          Editor’s Note:
        Submitted 2 September 2020.Accepted 6 January 2021 by Moshe Arye MilevskyThis article was externally reviewed using our double-blind peer-review process. When the
      article was accepted for publication, the authors thanked the reviewers in their
      acknowledgments. Nicole M. Boyson and one anonymous reviewer were the reviewers for this
      article.
Journal: Financial Analysts Journal
Pages: 97-123
Issue: 2
Volume: 77
Year: 2021
Month: 4
X-DOI: 10.1080/0015198X.2021.1875716
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1875716
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# input file: UFAJ_A_1865694_J.xml processed with: repec_from_tfjats.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Archana Jain
Author-X-Name-First: Archana
Author-X-Name-Last: Jain
Author-Name: Chinmay Jain
Author-X-Name-First: Chinmay
Author-X-Name-Last: Jain
Author-Name: Christine X. Jiang
Author-X-Name-First: Christine X.
Author-X-Name-Last: Jiang
Title: Active Trading in ETFs: The Role of High-Frequency Algorithmic Trading
Abstract: 
 In the study reported here, we explored high-frequency algorithmic trading and its
               effect on exchange-traded funds (ETFs). Using the cancel rate, the trade-to-order
               ratio, percentage odd-lot volume, and trade size as proxies for algorithmic trading,
               we found that more algorithmic trading in ETFs results in smaller and less persistent
               deviations of fund prices from their net asset values (NAVs). Arbitrage strategies
               adopted by algorithmic traders directly help reduce the magnitude and persistence of
               ETF price deviations from NAVs. Also, algorithmic trading improves ETF liquidity by
               lowering spreads and facilitates arbitrage.Disclosure: The authors report no conflicts of interest.
               Editor’s note:
            Submitted 6 July 2020Accepted 10 December 2020 by Stephen J. BrownThis article was externally reviewed using our double-blind peer-review process.
                  When the article was accepted for publication, the authors thanked the reviewers
                  in their acknowledgments. Marius Zoican and one anonymous reviewer were the
                  reviewers for this article.
Journal: Financial Analysts Journal
Pages: 66-82
Issue: 2
Volume: 77
Year: 2021
Month: 4
X-DOI: 10.1080/0015198X.2020.1865694
File-URL: http://hdl.handle.net/10.1080/0015198X.2020.1865694
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# input file: UFAJ_A_1921564_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Nicolas P.B. Bollen
Author-X-Name-First: Nicolas P.B.
Author-X-Name-Last: Bollen
Author-Name: Juha Joenväärä
Author-X-Name-First: Juha
Author-X-Name-Last: Joenväärä
Author-Name: Mikko Kauppila
Author-X-Name-First: Mikko
Author-X-Name-Last: Kauppila
Title: Hedge Fund Performance: End of an Era?
Abstract: 
 This article documents a decline in aggregate hedge fund performance over the past decade. We tested whether a set of prediction models can select subsets of individual funds that buck the trend and subsequently outperform. Two of the predictors reliably picked funds that lowered the volatility and raised the Sharpe ratio of a multi-asset-class portfolio relative to a stock/bond portfolio over the full 1997–2016 sample. Hedge fund allocations reduced volatility in two subperiods but failed to improve the Sharpe ratio from 2008 onward. We explore potential explanations for the erosion of hedge fund performance.
Journal: Financial Analysts Journal
Pages: 109-132
Issue: 3
Volume: 77
Year: 2021
Month: 07
X-DOI: 10.1080/0015198X.2021.1921564
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1921564
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# input file: UFAJ_A_1913040_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Patrick Augustin
Author-X-Name-First: Patrick
Author-X-Name-Last: Augustin
Author-Name: Ing-Haw Cheng
Author-X-Name-First: Ing-Haw
Author-X-Name-Last: Cheng
Author-Name: Ludovic Van den Bergen
Author-X-Name-First: Ludovic
Author-X-Name-Last: Van den Bergen
Title: Volmageddon and the Failure of Short Volatility Products
Abstract: 
 The rapid growth of exchange-traded products (ETPs) has raised concerns about their implications for financial stability. A case in point is the abrupt market crash of short volatility strategies on 5 February 2018. In this article, we describe this “Volmageddon” event and illustrate the risks associated with hedge and leverage rebalancing when markets are highly concentrated and volatile. The Volmageddon episode provides valuable risk management lessons because it illustrates the pitfalls of hedge and leverage rebalancing and is reminiscent of the losses incurred through portfolio insurance schemes.
Journal: Financial Analysts Journal
Pages: 35-51
Issue: 3
Volume: 77
Year: 2021
Month: 07
X-DOI: 10.1080/0015198X.2021.1913040
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1913040
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# input file: UFAJ_A_1915087_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hendrik Bessembinder
Author-X-Name-First: Hendrik
Author-X-Name-Last: Bessembinder
Author-Name: Te-Feng Chen
Author-X-Name-First: Te-Feng
Author-X-Name-Last: Chen
Author-Name: Goeun Choi
Author-X-Name-First: Goeun
Author-X-Name-Last: Choi
Author-Name: K. C. John Wei
Author-X-Name-First: K. C. John
Author-X-Name-Last: Wei
Title: Chinese and Global ADRs: The US Investor Experience
Abstract: 
 We study outcomes to ADR (American Depositary Receipt) investments between August 1954 and September 2020, with particular attention to ADRs associated with Chinese firms. Overall, ADRs improved investors’ wealth by $1.03 trillion, with more than a third of this amount attributable to ADRs associated with Chinese firms. A value-weighted portfolio of ADRs associated with Chinese firms earned 14.1% per year since the first Chinese ADR was created in 1993, as compared with 9.9% per year for the overall US stock market over the same period. These data are relevant to current policy discussions focused on Chinese firms listed in the United States.
Journal: Financial Analysts Journal
Pages: 53-68
Issue: 3
Volume: 77
Year: 2021
Month: 07
X-DOI: 10.1080/0015198X.2021.1915087
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1915087
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# input file: UFAJ_A_1927386_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: Correction
Journal: Financial Analysts Journal
Pages: 156-156
Issue: 3
Volume: 77
Year: 2021
Month: 07
X-DOI: 10.1080/0015198X.2021.1927386
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1927386
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# input file: UFAJ_A_1929687_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Micha Bender
Author-X-Name-First: Micha
Author-X-Name-Last: Bender
Author-Name: Benjamin Clapham
Author-X-Name-First: Benjamin
Author-X-Name-Last: Clapham
Author-Name: Peter Gomber
Author-X-Name-First: Peter
Author-X-Name-Last: Gomber
Author-Name: Jascha-Alexander Koch
Author-X-Name-First: Jascha-Alexander
Author-X-Name-Last: Koch
Title: To Bundle or Not to Bundle? A Review of Soft Commissions and Research Unbundling
Abstract: 
 Brokerage houses historically have provided research and related services together with order execution without separate fees. This practice of research bundling through so-called soft commissions has triggered an intense and ongoing debate considering that research bundling leads to nontransparent pricing and, therefore, can induce agency conflicts. A new European regulation has banned the use of soft commissions by requiring fee separation for execution and research services. Against this backdrop, we provide a systematic review of the literature on soft commissions to build a profound basis for further regulatory discussions and to uncover future research opportunities.
Journal: Financial Analysts Journal
Pages: 69-92
Issue: 3
Volume: 77
Year: 2021
Month: 07
X-DOI: 10.1080/0015198X.2021.1929687
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1929687
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# input file: UFAJ_A_1929030_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Andrew W. Lo
Author-X-Name-First: Andrew W.
Author-X-Name-Last: Lo
Title: The Financial System Red in Tooth and Claw: 75 Years of Co-Evolving Markets and Technology
Abstract: 
 The 75th anniversary of the founding of the Financial Analysts Journal offers a rare vista of the evolutionary path of financial analysis and its practitioners. That path is by no means random but is shaped by a complex ecosystem in which technological innovation interacts with shifting business conditions and a growing population of financial stakeholders. Using the lens of the Adaptive Markets Hypothesis—the principles of evolutionary biology and ecology applied to the financial system—we can clearly identify eight discrete financial “eras” in which unique combinations of economic need and technological advances gave rise to new products, services, and financial institutions. By understanding the underlying drivers and resulting dynamics of these eras, we can begin to develop a deeper appreciation for the origins of financial innovation and its great promise for our future.
Journal: Financial Analysts Journal
Pages: 5-33
Issue: 3
Volume: 77
Year: 2021
Month: 07
X-DOI: 10.1080/0015198X.2021.1929030
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1929030
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# input file: UFAJ_A_1909943_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Alexander Cheema-Fox
Author-X-Name-First: Alexander
Author-X-Name-Last: Cheema-Fox
Author-Name: Bridget Realmuto LaPerla
Author-X-Name-First: Bridget Realmuto
Author-X-Name-Last: LaPerla
Author-Name: George Serafeim
Author-X-Name-First: George
Author-X-Name-Last: Serafeim
Author-Name: David Turkington
Author-X-Name-First: David
Author-X-Name-Last: Turkington
Author-Name: Hui (Stacie) Wang
Author-X-Name-First: Hui (Stacie)
Author-X-Name-Last: Wang
Title: Decarbonizing Everything
Abstract: 
 We analyze how the use of different climate risk measures leads to different portfolio carbon outcomes and risk-adjusted returns. Our findings are synthesized in a rules-based investment framework, which selects a different type of climate metric across industries and weighs industries in the portfolio based on the variability of carbon outcomes among firms within each industry. We conclude that analyzing the merits and applicability of various climate data can help investors manage climate risk while increasing risk-adjusted returns.
Journal: Financial Analysts Journal
Pages: 93-108
Issue: 3
Volume: 77
Year: 2021
Month: 07
X-DOI: 10.1080/0015198X.2021.1909943
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1909943
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Handle: RePEc:taf:ufajxx:v:77:y:2021:i:3:p:93-108




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# input file: UFAJ_A_1908775_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Guido Baltussen
Author-X-Name-First: Guido
Author-X-Name-Last: Baltussen
Author-Name: Martin Martens
Author-X-Name-First: Martin
Author-X-Name-Last: Martens
Author-Name: Olaf Penninga
Author-X-Name-First: Olaf
Author-X-Name-Last: Penninga
Title: Predicting Bond Returns: 70 Years of International Evidence
Abstract: 
 We use 70 years of international data from the major bond markets to examine bond return predictability through in-sample and out-of-sample tests. Our results reveal economically strong and statistically significant bond return predictability. This finding is robust over markets and time periods, including 30 years of out-of-sample data, prolonged periods of rising or falling rates, and a dataset of nine additional countries. Furthermore, the results are not explained by market or macroeconomic risks, nor can they be easily attributed to transaction costs or other investment frictions. These results reveal predictable dynamics in government bond returns relevant for academics and practitioners.
Journal: Financial Analysts Journal
Pages: 133-155
Issue: 3
Volume: 77
Year: 2021
Month: 07
X-DOI: 10.1080/0015198X.2021.1908775
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1908775
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# input file: UFAJ_A_1965862_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Liao Peng
Author-X-Name-First: Liao
Author-X-Name-Last: Peng
Author-Name: Liguang Zhang
Author-X-Name-First: Liguang
Author-X-Name-Last: Zhang
Author-Name: Wanyi Chen
Author-X-Name-First: Wanyi
Author-X-Name-Last: Chen
Title: Capital Market Liberalization and Investment Efficiency: Evidence from China
Abstract: 
 For this study, we adopted a recent financial reform in China and used a difference-in-difference model to investigate its impact on corporate investment efficiency. The results indicate that stock market liberalization has significantly improved corporate investment efficiency, primarily by restraining overinvestment. This effect exists chiefly in enterprises without former foreign ownership, those with low analyst coverage, and those that are privately owned. Further analysis reveals that improvements in corporate information disclosure and the corporate governance level are important transmission channels for improved efficiency. This study enriches research on the economic consequences of capital market liberalization and foreign investors’ governance channels, thereby providing implications for governments.
Journal: Financial Analysts Journal
Pages: 23-44
Issue: 4
Volume: 77
Year: 2021
Month: 10
X-DOI: 10.1080/0015198X.2021.1965862
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1965862
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Author-Name: Rajna Gibson Brandon
Author-X-Name-First: Rajna
Author-X-Name-Last: Gibson Brandon
Author-Name: Philipp Krueger
Author-X-Name-First: Philipp
Author-X-Name-Last: Krueger
Author-Name: Peter Steffen Schmidt
Author-X-Name-First: Peter Steffen
Author-X-Name-Last: Schmidt
Title: ESG Rating Disagreement and Stock Returns
Abstract: 
 Using environmental, social, and governance (ESG) ratings from seven different data providers for a sample of firms in the S&P 500 Index between 2010 and 2017, we studied the relationship between ESG rating disagreement and stock returns. We found that stock returns are positively related to ESG rating disagreement, suggesting a risk premium for firms with higher ESG rating disagreement. The relationship is primarily driven by disagreement about the environmental dimension. We discuss the practical implications of our findings for firms’ equity cost of capital as well as for investment managers and asset owners who use ESG investment strategies.
Journal: Financial Analysts Journal
Pages: 104-127
Issue: 4
Volume: 77
Year: 2021
Month: 10
X-DOI: 10.1080/0015198X.2021.1963186
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1963186
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# input file: UFAJ_A_1960133_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Philippe Jorion
Author-X-Name-First: Philippe
Author-X-Name-Last: Jorion
Title: Hedge Funds vs. Alternative Risk Premia
Abstract: 
 Alternative risk premia (ARP) are designed to provide low-cost exposures to long–short risk premia often embedded in hedge fund returns. This article describes the performance of the ARP market in the form of bank-provided total return swaps, which are investable strategies that provide after-cost access to ARP. Over the 2010–20 period, many of these risk premia provided significantly positive returns. In addition, these ARP explain a high fraction of returns on hedge fund indexes, especially for quantitative strategies, along with traditional market factors. Finally, we find that ARP and market factors largely eat away hedge fund index returns.
Journal: Financial Analysts Journal
Pages: 65-81
Issue: 4
Volume: 77
Year: 2021
Month: 10
X-DOI: 10.1080/0015198X.2021.1960133
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1960133
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# input file: UFAJ_A_1954377_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hendrik Kaufmann
Author-X-Name-First: Hendrik
Author-X-Name-Last: Kaufmann
Author-Name: Philip Messow
Author-X-Name-First: Philip
Author-X-Name-Last: Messow
Author-Name: Jonas Vogt
Author-X-Name-First: Jonas
Author-X-Name-Last: Vogt
Title: Boosting the Equity Momentum Factor in Credit
Abstract: 
 Machine learning techniques have gained popularity in recent years but only to a limited extent in fixed-income research. This article shows some new work in the application of “boosted regression trees” for the equity momentum factor in the corporate bond market. We report significant performance gains to investors from using machine learning–driven forecasts, roughly doubling the alpha and information ratio of better known equity momentum strategies. In addition to past equity returns, we include size and liquidity of stocks and bonds in our model framework.
Journal: Financial Analysts Journal
Pages: 83-103
Issue: 4
Volume: 77
Year: 2021
Month: 10
X-DOI: 10.1080/0015198X.2021.1954377
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1954377
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# input file: UFAJ_A_1981097_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: Our Thanks to Reviewers
Abstract: 
 We thank the 155 reviewers who took part in the double-blind peer-review process of articles reviewed for 2021, assuring the ongoing quality of the Financial Analysts Journal.
Journal: Financial Analysts Journal
Pages: i-ii
Issue: 4
Volume: 77
Year: 2021
Month: 10
X-DOI: 10.1080/0015198X.2021.1981097
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1981097
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# input file: UFAJ_A_1963187_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Kevin Khang
Author-X-Name-First: Kevin
Author-X-Name-Last: Khang
Author-Name: Thomas Paradise
Author-X-Name-First: Thomas
Author-X-Name-Last: Paradise
Author-Name: Joel Dickson
Author-X-Name-First: Joel
Author-X-Name-Last: Dickson
Title: Tax-Loss Harvesting: An Individual Investor’s Perspective
Abstract: 
 In the tax-loss harvesting literature, a typical investor is assumed to have an unlimited supply of offsetting capital gains and can earn annualized tax alpha on the order of 100 bps. Using boosted regression tree analysis and nationally representative investor-level data, we quantified how investor-characteristic and return environment differences yield significant heterogeneity in expected tax-loss harvesting benefits. Overall, investor profiles drive roughly 60% of the variation in tax-loss harvesting outcomes. Our findings demonstrate that investors (and their advisers) can better target who might (and might not) benefit from various tax-loss harvesting strategies based on individual profile differences.
Journal: Financial Analysts Journal
Pages: 128-150
Issue: 4
Volume: 77
Year: 2021
Month: 10
X-DOI: 10.1080/0015198X.2021.1963187
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1963187
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# input file: UFAJ_A_1947024_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Laura T. Starks
Author-X-Name-First: Laura T.
Author-X-Name-Last: Starks
Title: Environmental, Social, and Governance Issues and the Financial Analysts Journal
Abstract: 
 The Financial Analysts Journal has a history of publishing academic and practitioner articles on environmental, social, and governance (ESG) issues; many appeared decades before the terminology became common. In celebration of the 75th anniversary, the author provides brief reviews of these articles, including reflections on how the insights brought out in this collective body of work remain important today for investors’ decisions.
Journal: Financial Analysts Journal
Pages: 5-21
Issue: 4
Volume: 77
Year: 2021
Month: 10
X-DOI: 10.1080/0015198X.2021.1947024
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1947024
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# input file: UFAJ_A_1960782_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Andrew Ang
Author-X-Name-First: Andrew
Author-X-Name-Last: Ang
Author-Name: Linxi Chen
Author-X-Name-First: Linxi
Author-X-Name-Last: Chen
Author-Name: Michael Gates
Author-X-Name-First: Michael
Author-X-Name-Last: Gates
Author-Name: Paul D. Henderson
Author-X-Name-First: Paul D.
Author-X-Name-Last: Henderson
Title: Index + Factors + Alpha
Abstract: 
 We establish, under both theoretical conditions and empirical application, the separate roles of (1) market asset class exposure through index funds; (2) style factor exposure, such as exposure to value, momentum, and quality, which have traditionally delivered higher and differentiated returns than market index exposure; and (3) pure alpha-seeking sources of return in excess of index and factor returns. A new methodology determines optimal allocations of index, factors, and alpha-seeking funds by imposing priors on the information ratios of factors and alpha strategies. We expect in many cases, prior standard deviations for factor funds will be smaller than those for alpha strategies, whereas prior means for alpha strategies may be larger than those for factor funds.
Journal: Financial Analysts Journal
Pages: 45-64
Issue: 4
Volume: 77
Year: 2021
Month: 10
X-DOI: 10.1080/0015198X.2021.1960782
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1960782
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# input file: UFAJ_A_1984826_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: K. J. Martijn Cremers
Author-X-Name-First: K. J. Martijn
Author-X-Name-Last: Cremers
Author-Name: Jon A. Fulkerson
Author-X-Name-First: Jon A.
Author-X-Name-Last: Fulkerson
Author-Name: Timothy B. Riley
Author-X-Name-First: Timothy B.
Author-X-Name-Last: Riley
Title: Active Share and the Predictability of the Performance of Separate Accounts
Abstract: 
 Separate accounts are a large and unique, but understudied, part of the investment management industry. Within our sample, on net, the average separate account underperforms, but for those with high active share, we find positive performance persistence. Among high active share separate accounts, a portfolio of those with strong past performance has a subsequent net alpha of 1.38% per year (t = 2.11). That result strengthens when return dispersion is high and among separate accounts with a small cap style, a fundamental investment approach, or lower cash holdings. These results provide out-of-sample support for the predictive utility of active share.
Journal: Financial Analysts Journal
Pages: 39-57
Issue: 1
Volume: 78
Year: 2022
Month: 1
X-DOI: 10.1080/0015198X.2021.1984826
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1984826
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# input file: UFAJ_A_1973879_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: George Serafeim
Author-X-Name-First: George
Author-X-Name-Last: Serafeim
Author-Name: Aaron Yoon
Author-X-Name-First: Aaron
Author-X-Name-Last: Yoon
Title: Which Corporate ESG News Does the Market React To?
Abstract: 
 We analyze 109,014 firm–day observations for 3,109 companies and examine market reaction to different ESG news. We find that prices react only to financially material ESG news, and the reaction is larger for news that is positive, receive more news coverage, and related to social capital issues. Using a prediction model based on pre-existing ESG ratings, we separate news into expected and unexpected components and find the market reacts to unexpected news. We conclude that investors are motivated by financial rather than nonpecuniary motive as they differentiate in their reactions based on whether the news is likely to affect fundamentals.
Journal: Financial Analysts Journal
Pages: 59-78
Issue: 1
Volume: 78
Year: 2022
Month: 1
X-DOI: 10.1080/0015198X.2021.1973879
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1973879
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# input file: UFAJ_A_1984825_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Luke DeVault
Author-X-Name-First: Luke
Author-X-Name-Last: DeVault
Author-Name: Scott Cederburg
Author-X-Name-First: Scott
Author-X-Name-Last: Cederburg
Author-Name: Kainan Wang
Author-X-Name-First: Kainan
Author-X-Name-Last: Wang
Title: Is “Not Trading” Informative? Evidence from Corporate Insiders’ Portfolios
Abstract: 
 Some individuals, e.g., those holding multiple directorships, are insiders at multiple firms. When they execute an insider trade at one firm, they may reveal information about the value of all—both the traded insider position and not-traded insider position(s)—the securities held in their “insider portfolio.” We find that insider “not-sold” stocks outperform “not-bought” stocks. Implementable trading strategies that buy not-sold stocks following the disclosure of a sale earn alphas up to 4.8% per year after trading costs. The results suggest that even insider sales that are motivated by liquidity and diversification needs can provide value-relevant information about insider holdings.
Journal: Financial Analysts Journal
Pages: 79-100
Issue: 1
Volume: 78
Year: 2022
Month: 1
X-DOI: 10.1080/0015198X.2021.1984825
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1984825
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# input file: UFAJ_A_1965861_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Josh Davis
Author-X-Name-First: Josh
Author-X-Name-Last: Davis
Author-Name: Matt Dorsten
Author-X-Name-First: Matt
Author-X-Name-Last: Dorsten
Author-Name: Normane Gillmann
Author-X-Name-First: Normane
Author-X-Name-Last: Gillmann
Author-Name: Jerry Tsai
Author-X-Name-First: Jerry
Author-X-Name-Last: Tsai
Title: Carry Momentum
Abstract: 
 Assets whose carry is trending up, namely, assets with high carry momentum, tend to have higher returns than those with low carry momentum. Using data from different asset classes, we show that portfolios with high-carry-momentum assets delivered higher returns than portfolios with low-carry-momentum assets. The return differentials cannot be explained by exposure to traditional market risks or by such seemingly related factors as time-series momentum and carry. The results can be motivated by a model in which investors’ demand for an asset depends on the market’s view on the expected returns. An increase in carry raises investors’ belief in the attractiveness of an asset, leading to the possibility for higher demand in the market and in turn to the potential for higher prices and positive returns.
Journal: Financial Analysts Journal
Pages: 5-38
Issue: 1
Volume: 78
Year: 2022
Month: 1
X-DOI: 10.1080/0015198X.2021.1965861
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1965861
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# input file: UFAJ_A_1996200_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David Forsberg
Author-X-Name-First: David
Author-X-Name-Last: Forsberg
Author-Name: David R. Gallagher
Author-X-Name-First: David R.
Author-X-Name-Last: Gallagher
Author-Name: Geoffrey J. Warren
Author-X-Name-First: Geoffrey J.
Author-X-Name-Last: Warren
Title: Capacity Constraints in Hedge Funds: The Relation between Fund Performance and Cohort Size
Abstract: 
 We provide evidence consistent with scale diseconomies for hedge funds being related to the aggregate assets pursing particular investment strategies. This study extends Forsberg, Gallagher and Warren who identified skilled managers with persistent performance by forming peer cohorts of hedge funds using return correlations. Our analysis shows fund performance had a significant negative relation with cohort size, while the relation with fund size is inconsistent across specifications but evident where funds faced limited competition. We also document a weaker relation between performance and inflows where funds faced less competition, suggesting that cohort structure might influence propensity to accept assets.
Journal: Financial Analysts Journal
Pages: 57-77
Issue: 2
Volume: 78
Year: 2022
Month: 4
X-DOI: 10.1080/0015198X.2021.1996200
File-URL: http://hdl.handle.net/10.1080/0015198X.2021.1996200
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# input file: UFAJ_A_2033105_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Patrick Bolton
Author-X-Name-First: Patrick
Author-X-Name-Last: Bolton
Author-Name: Marcin Kacperczyk
Author-X-Name-First: Marcin
Author-X-Name-Last: Kacperczyk
Author-Name: Frédéric Samama
Author-X-Name-First: Frédéric
Author-X-Name-Last: Samama
Title: Net-Zero Carbon Portfolio Alignment
Abstract: 
 We outline a simple and robust methodology to align portfolios with a science-based, carbon budget consistent with maintaining a temperature rise below 1.5 °C with 83% probability. We show how to keep the tracking error at a negligible level. This approach works for both passive and active managers. It also establishes an exit roadmap for carbon-intensive corporates, thereby generating a form of competition to decarbonize within each sector. We also discuss four sources of risks: uncertainty around a rapidly shrinking carbon budget, time impacts on decarbonization rates, implementation risk due to market-wide selling pressure, and uncertainty about taxes on polluting companies.
Journal: Financial Analysts Journal
Pages: 19-33
Issue: 2
Volume: 78
Year: 2022
Month: 4
X-DOI: 10.1080/0015198X.2022.2033105
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2033105
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# input file: UFAJ_A_2034468_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Elise Payzan-LeNestour
Author-X-Name-First: Elise
Author-X-Name-Last: Payzan-LeNestour
Author-Name: James Doran
Author-X-Name-First: James
Author-X-Name-Last: Doran
Author-Name: Lionnel Pradier
Author-X-Name-First: Lionnel
Author-X-Name-Last: Pradier
Author-Name: Tālis J. Putniņš
Author-X-Name-First: Tālis J.
Author-X-Name-Last: Putniņš
Title: Harnessing Neuroscientific Insights to Generate Alpha
Abstract: 
 Building on evidence from neuroscience and psychology, we predict that prolonged exposure to high volatility causes market participants to subsequently underestimate volatility (and vice versa), leading to predictability in stock returns. We find VIX distortions consistent with this prediction and construct a trading strategy that exploits it. Applied to SPY ETFs and VIX futures contracts, the strategy significantly outperforms a buy-and-hold index portfolio, with higher annualized performance, lower volatility, and alphas exceeding 4%.
Journal: Financial Analysts Journal
Pages: 79-95
Issue: 2
Volume: 78
Year: 2022
Month: 4
X-DOI: 10.1080/0015198X.2022.2034468
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2034468
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# input file: UFAJ_A_2044718_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jonathan M. Karpoff
Author-X-Name-First: Jonathan M.
Author-X-Name-Last: Karpoff
Author-Name: Robert Litan
Author-X-Name-First: Robert
Author-X-Name-Last: Litan
Author-Name: Catherine Schrand
Author-X-Name-First: Catherine
Author-X-Name-Last: Schrand
Author-Name: Roman L. Weil
Author-X-Name-First: Roman L.
Author-X-Name-Last: Weil
Title: What ESG-Related Disclosures Should the SEC Mandate?
Abstract: 
 As the U.S. Securities and Exchange Commission considers appropriate “ESG” disclosure mandates, the Financial Economist’s Roundtable contributes to the debate with a statement summarizing its policy discussion. The FER believes financial regulators should limit mandates to matters that directly affect the firm’s cash flows. Further, when issuer filings include ESG ratings, those filings should include information about the raters, the factors used, and the weights on the factors. The FER recommends that the SEC should not mandate disclosure of the firm’s impacts on environmental and social (E&S) outcomes.
Journal: Financial Analysts Journal
Pages: 9-18
Issue: 2
Volume: 78
Year: 2022
Month: 4
X-DOI: 10.1080/0015198X.2022.2044718
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2044718
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# input file: UFAJ_A_2044717_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Luis García-Feijóo
Author-X-Name-First: Luis
Author-X-Name-Last: García-Feijóo
Title: 2021 Report to Readers
Journal: Financial Analysts Journal
Pages: 5-7
Issue: 2
Volume: 78
Year: 2022
Month: 4
X-DOI: 10.1080/0015198X.2022.2044717
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2044717
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# input file: UFAJ_A_2029081_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Tālis J. Putniņš
Author-X-Name-First: Tālis J.
Author-X-Name-Last: Putniņš
Title: Free Markets to Fed Markets: How Modern Monetary Policy Impacts Equity Markets
Abstract: 
 The US Federal Reserve doubled its balance sheet during the COVID-19 pandemic in the most aggressive unconventional monetary policy on record. I show that the scale and scope of these actions substantially impacted stock markets, explaining at least one-third of their rebound. The impact occurs predominantly through bond yields (discount rates) and expectations of future macroeconomic conditions (future cash flows). I find while the Fed’s balance sheet expansions are more rapid than its contractions, the stock market is more sensitive to contractions. The findings have implications for possible impacts of central banks unwinding the positions accumulated during the pandemic.
Journal: Financial Analysts Journal
Pages: 35-56
Issue: 2
Volume: 78
Year: 2022
Month: 4
X-DOI: 10.1080/0015198X.2022.2029081
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2029081
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# input file: UFAJ_A_2071581_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Michael Schnetzer
Author-X-Name-First: Michael
Author-X-Name-Last: Schnetzer
Author-Name: Thorsten Hens
Author-X-Name-First: Thorsten
Author-X-Name-Last: Hens
Title: Evolutionary Finance for Multi-Asset Investors
Abstract: 
 Standard strategic asset allocation procedures usually neglect market interaction. However, returns are not generated in a vacuum but the result of the market’s price discovery mechanism. Evolutionary finance accounts for this and endogenizes asset prices.This paper develops a multi-asset evolutionary finance model. Requiring little more than dividend and interest rate data, it provides a valuable guide to this class of models. While traditional mean/variance optimization is concerned with finding the optimal allocation, evolutionary finance’s focus is on finding the optimal strategy. This paper shows that yield-based strategies outperform competing alternatives and are evolutionarily advantageous for multi-asset investors.
Journal: Financial Analysts Journal
Pages: 115-127
Issue: 3
Volume: 78
Year: 2022
Month: 7
X-DOI: 10.1080/0015198X.2022.2071581
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2071581
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# input file: UFAJ_A_2066452_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Guido Baltussen
Author-X-Name-First: Guido
Author-X-Name-Last: Baltussen
Author-Name: Stan Beckers
Author-X-Name-First: Stan
Author-X-Name-Last: Beckers
Author-Name: Jan Jaap Hazenberg
Author-X-Name-First: Jan Jaap
Author-X-Name-Last: Hazenberg
Author-Name: Willem Van Der Scheer
Author-X-Name-First: Willem
Author-X-Name-Last: Van Der Scheer
Title: Fund Selection: Sense and Sensibility
Abstract: 
 Studying a comprehensive universe of European-domiciled cross-border UCITS equity and fixed income funds we find that (i) active equity funds on average outperform passive alternatives before fees by about the level of the fees, (ii) active fixed income funds underperform on a net basis, (iii) fees consume a significant part of the value added of active management, (iv) simple fund selection rules help to identify the better active managers. Finally, we develop the concept of minimum required selection skill and find that investors in actively managed funds could meet this hurdle provided fees are limited.
Journal: Financial Analysts Journal
Pages: 30-48
Issue: 3
Volume: 78
Year: 2022
Month: 7
X-DOI: 10.1080/0015198X.2022.2066452
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2066452
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Handle: RePEc:taf:ufajxx:v:78:y:2022:i:3:p:30-48




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# input file: UFAJ_A_2074241_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hamid Boustanifar
Author-X-Name-First: Hamid
Author-X-Name-Last: Boustanifar
Author-Name: Young Dae Kang
Author-X-Name-First: Young Dae
Author-X-Name-Last: Kang
Title: Employee Satisfaction and Long-Run Stock Returns, 1984–2020
Abstract: 
 Economic theory predicts that (in the absence of mispricing) the excess return to socially responsible businesses is negative in equilibrium. In contrast, using the state-of-art empirical models and a sample spanning four decades (1984–2020), an equal-weighted portfolio of companies that treat their employees the best earns an excess return of 2% to 2.7% per year. The estimated alphas are positive in most periods within the sample (with no upward or downward trend) and are particularly large during crisis periods. Overall, the results suggest that the stock market (still) undervalues employee satisfaction.
Journal: Financial Analysts Journal
Pages: 129-151
Issue: 3
Volume: 78
Year: 2022
Month: 7
X-DOI: 10.1080/0015198X.2022.2074241
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2074241
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Handle: RePEc:taf:ufajxx:v:78:y:2022:i:3:p:129-151




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# input file: UFAJ_A_2073782_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Athanasios Sakkas
Author-X-Name-First: Athanasios
Author-X-Name-Last: Sakkas
Author-Name: Nikolaos Tessaromatis
Author-X-Name-First: Nikolaos
Author-X-Name-Last: Tessaromatis
Title: Forecasting the Long-Term Equity Premium for Asset Allocation
Abstract: 
 Long-term country equity premium forecasts based on a cross-sectional global factor model (CS-GFM), where factors represent compensation for risks proxied by valuation and financial variables are superior, statistically and economically, to forecasts based on time-series prediction models commonly used in academia and practice. CS-GFM equity premium forecasts produce significant utility gains compared to long-term asset allocation strategies based on eighteen commonly used prediction models, consistently across the US and eleven developed equity markets.
Journal: Financial Analysts Journal
Pages: 9-29
Issue: 3
Volume: 78
Year: 2022
Month: 7
X-DOI: 10.1080/0015198X.2022.2073782
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2073782
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# input file: UFAJ_A_2065870_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Asli Eksi
Author-X-Name-First: Asli
Author-X-Name-Last: Eksi
Author-Name: Hossein Kazemi
Author-X-Name-First: Hossein
Author-X-Name-Last: Kazemi
Title: Hedged Mutual Funds and Competition for Sources of Alpha
Abstract: 
 Hedged mutual funds flourished following the 2007–2009 financial crisis. They became particularly popular with financial advisors because of their alleged downside protection. Did these funds deliver what they promised? We examine the performance of these funds with a focus on the post-2009 period. While they generated positive alphas before the crisis, we find that this abnormal performance vanishes in the post-2009 period as their strategies became increasingly crowded due to the above popularity. We show that flows to hedged mutual funds are negatively related to investor sentiment, implying that investors use these funds as a hedge against downside risk.
Journal: Financial Analysts Journal
Pages: 70-93
Issue: 3
Volume: 78
Year: 2022
Month: 7
X-DOI: 10.1080/0015198X.2022.2065870
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2065870
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Handle: RePEc:taf:ufajxx:v:78:y:2022:i:3:p:70-93




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# input file: UFAJ_A_2085017_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Thomas Mählmann
Author-X-Name-First: Thomas
Author-X-Name-Last: Mählmann
Author-Name: Galina Sukonnik
Author-X-Name-First: Galina
Author-X-Name-Last: Sukonnik
Title: Investing with Style in Liquid Private Debt
Abstract: 
 This paper extends the analysis of systematic investment approaches to broadly syndicated leveraged loans. We find that exposures linked to (short-term) momentum and valuation styles (and a combination thereof) are well-compensated: monthly rebalanced long-only portfolios of high value and momentum loans generate Sharpe and information ratios well above one and economically and statistically significant alphas. Factor portfolio performance deteriorates but remains significant over longer investment horizons. An important implication of our research is that active credit managers employing loan trading strategies that are momentum- and value-neutral do not make use of a viable source of additional return.
Journal: Financial Analysts Journal
Pages: 94-114
Issue: 3
Volume: 78
Year: 2022
Month: 7
X-DOI: 10.1080/0015198X.2022.2085017
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2085017
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Handle: RePEc:taf:ufajxx:v:78:y:2022:i:3:p:94-114




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# input file: UFAJ_A_2087448_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Stefano Cavaglia
Author-X-Name-First: Stefano
Author-X-Name-Last: Cavaglia
Author-Name: John Hua Fan
Author-X-Name-First: John Hua
Author-X-Name-Last: Fan
Author-Name: Zhenping Wang
Author-X-Name-First: Zhenping
Author-X-Name-Last: Wang
Title: Portable Beta and Total Portfolio Management
Abstract: 
 Alternative Risk Premia (ARP) strategies have traditionally been sold as stand-alone products to complement a reference portfolio. We illustrate how ARP can be integrated with a reference portfolio to achieve optimal total portfolio outcomes. From 1931 to 2020, a factor diversifying overlay reduces the risk of the reference portfolio and captures a welfare enhancing diversification premium. The relaxation of the risk budget enhances the fund Sharpe ratios through strategic factor tilts and by levering existing asset class or active management exposures. We provide a modular framework illustrating how ARP overlays may complement the decentralized investment management model to benefit plan constituents.
Journal: Financial Analysts Journal
Pages: 49-69
Issue: 3
Volume: 78
Year: 2022
Month: 7
X-DOI: 10.1080/0015198X.2022.2087448
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2087448
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# input file: UFAJ_A_2074773_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: William N. Goetzmann
Author-X-Name-First: William N.
Author-X-Name-Last: Goetzmann
Title: Shareholder Democracy, Meet Memocracy
Journal: Financial Analysts Journal
Pages: 5-8
Issue: 3
Volume: 78
Year: 2022
Month: 7
X-DOI: 10.1080/0015198X.2022.2074773
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2074773
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# input file: UFAJ_A_2089008_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jun Duanmu
Author-X-Name-First: Jun
Author-X-Name-Last: Duanmu
Author-Name: Qiping Huang
Author-X-Name-First: Qiping
Author-X-Name-Last: Huang
Author-Name: Yongjia Li
Author-X-Name-First: Yongjia
Author-X-Name-Last: Li
Author-Name: Lingna Sun
Author-X-Name-First: Lingna
Author-X-Name-Last: Sun
Title: Litigation Risk and Stock Return Anomaly
Abstract: 
 We create a proxy for security litigation risk using a dynamic logistic model and find that low-litigation-risk firms outperform high-litigation-risk firms. The out-of-sample long-short portfolio delivers an annual alpha of over 8%. This anomalous return is mainly driven by long positions in low-litigation-risk firms. The results are not affected by the realization of the lawsuits and are robust after controlling for other well-known anomaly factors. We provide evidence that the litigation-risk anomalous return is driven by investors’ under-reaction to the changes in firms’ litigation risk.
Journal: Financial Analysts Journal
Pages: 145-162
Issue: 4
Volume: 78
Year: 2022
Month: 10
X-DOI: 10.1080/0015198X.2022.2089008
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2089008
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# input file: UFAJ_A_2092384_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Pascal Böni
Author-X-Name-First: Pascal
Author-X-Name-Last: Böni
Author-Name: Sophie Manigart
Author-X-Name-First: Sophie
Author-X-Name-Last: Manigart
Title: Private Debt Fund Returns, Persistence, and Market Conditions
Abstract: 
 This paper examines net-of-fees private debt fund performance, performance persistence across funds managed by the same general partner and a general partner’s ability to time the market. We document that private debt funds outperform bond and equity market benchmarks in the cross-section, with high performance dispersion across strategies and performance quartiles. Lagged performance significantly affects current fund performance. While ex ante and ex post credit market conditions strongly affect fund performance, general partners can only partially time them.
Journal: Financial Analysts Journal
Pages: 121-144
Issue: 4
Volume: 78
Year: 2022
Month: 10
X-DOI: 10.1080/0015198X.2022.2092384
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2092384
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# input file: UFAJ_A_2100233_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Alexander Cheema-Fox
Author-X-Name-First: Alexander
Author-X-Name-Last: Cheema-Fox
Author-Name: George Serafeim
Author-X-Name-First: George
Author-X-Name-Last: Serafeim
Author-Name: Hui (Stacie) Wang
Author-X-Name-First: Hui (Stacie)
Author-X-Name-Last: Wang
Title: Climate Change Vulnerability and Currency Returns
Abstract: 
 Using measures of physical risk from climate change, we develop a methodology to allocate currency pairs according to a country’s vulnerability and construct portfolios with decreasing vulnerability to physical risk. We show that non-G10 currencies are more vulnerable to physical risk, have become less vulnerable over time, and that the vulnerability measure is correlated with higher losses from natural disasters. Portfolios exposed to currencies with decreasing vulnerability have exhibited positive abnormal returns, with the abnormal return coming from currencies that have relatively high levels of vulnerability. These results exist in non-G10 currencies, while no relation is found within G10 currencies.
Journal: Financial Analysts Journal
Pages: 37-58
Issue: 4
Volume: 78
Year: 2022
Month: 10
X-DOI: 10.1080/0015198X.2022.2100233
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2100233
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# input file: UFAJ_A_2116253_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: Our Thanks to Reviewers
Journal: Financial Analysts Journal
Pages: i-ii
Issue: 4
Volume: 78
Year: 2022
Month: 10
X-DOI: 10.1080/0015198X.2022.2116253
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2116253
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Handle: RePEc:taf:ufajxx:v:78:y:2022:i:4:p:i-ii




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# input file: UFAJ_A_2096990_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Yihan Li
Author-X-Name-First: Yihan
Author-X-Name-Last: Li
Author-Name: Xin Liu
Author-X-Name-First: Xin
Author-X-Name-Last: Liu
Author-Name: Vesa Pursiainen
Author-X-Name-First: Vesa
Author-X-Name-Last: Pursiainen
Title: Analyst Incentives and Stock Return Synchronicity: Evidence from MiFID II
Abstract: 
 MiFID II affects sell-side analyst incentives in Europe, forcing analysts to justify the value they add. While the number of analysts decreases, the average stock return synchronicity with the market also decreases, implying an improvement in price informativeness. The decrease in synchronicity is larger for firms that are more important for the analysts and brokers covering them. It is also asymmetric and substantially larger for negative market movements. Our results suggest that, by changing incentives, MiFID II not only improves the quality of individual analyst work, but also achieves an improvement in the aggregate stock price informativeness.
Journal: Financial Analysts Journal
Pages: 77-97
Issue: 4
Volume: 78
Year: 2022
Month: 10
X-DOI: 10.1080/0015198X.2022.2096990
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2096990
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# input file: UFAJ_A_2100232_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Timothy Riley
Author-X-Name-First: Timothy
Author-X-Name-Last: Riley
Author-Name: Qing Yan
Author-X-Name-First: Qing
Author-X-Name-Last: Yan
Title: Maximum Drawdown as Predictor of Mutual Fund Performance and Flows
Abstract: 
 Mutual funds’ maximum drawdowns (MDDs) are persistent, indicative of manager skill, and predictive of subsequent performance. Among funds with relatively strong past performance, those with relatively low past MDDs, on average, have an out-of-sample alpha of 2.40% per year. That alpha is magnified when markets are turbulent—a time during which manager skill should be most valuable. Investors are averse to drawdown risk. After controlling for typical measures of past performance, fund flows remain a decreasing function of MDDs, particularly among investors with greater risk aversion and during times of heightened risk aversion.
Journal: Financial Analysts Journal
Pages: 59-76
Issue: 4
Volume: 78
Year: 2022
Month: 10
X-DOI: 10.1080/0015198X.2022.2100232
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2100232
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# input file: UFAJ_A_2083900_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Nico Lehnertz
Author-X-Name-First: Nico
Author-X-Name-Last: Lehnertz
Author-Name: Carolin Plagmann
Author-X-Name-First: Carolin
Author-X-Name-Last: Plagmann
Author-Name: Eva Lutz
Author-X-Name-First: Eva
Author-X-Name-Last: Lutz
Title: Effects of Venture Capital Mega-Deals on IPO Success and Post-IPO Performance
Abstract: 
 Venture capital financing rounds with transaction volumes of 100 million US dollars or more have become an integral part of the US venture capital market within the last decade. We aim to determine whether such mega-deals are a quality signal for equity investors in the event of an IPO. Based on a sample of 364 US IPOs, we find that companies that have received a venture capital mega-deal perform, on average, superior IPOs and exhibit favorable post-IPO performance.
Journal: Financial Analysts Journal
Pages: 99-120
Issue: 4
Volume: 78
Year: 2022
Month: 10
X-DOI: 10.1080/0015198X.2022.2083900
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2083900
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# input file: UFAJ_A_2095193_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Daniel Mantilla-Garcia
Author-X-Name-First: Daniel
Author-X-Name-Last: Mantilla-Garcia
Author-Name: Lionel Martellini
Author-X-Name-First: Lionel
Author-X-Name-Last: Martellini
Author-Name: Vincent Milhau
Author-X-Name-First: Vincent
Author-X-Name-Last: Milhau
Author-Name: Hector Enrique Ramirez-Garrido
Author-X-Name-First: Hector Enrique
Author-X-Name-Last: Ramirez-Garrido
Title: Improving Interest Rate Risk Hedging Strategies through Regularization
Abstract: 
 The effectiveness of duration and convexity hedging strategies deteriorates in the presence of non-parallel shifts of the yield curve. In the absence of appropriate constraints, the extension of these strategies accounting for changes in the shape of the yield curve generates unstable weights and extreme leverage, leading to poor out-of-sample hedging performance. To address this conundrum, we recast the bond portfolio immunization problem as a multifactor optimization program with leverage constraints and weight regularization. These regularized immunization strategies offer a robust improvement in hedging performance and are particularly well-suited to secure future cash flow needs such as pension liabilities.
Journal: Financial Analysts Journal
Pages: 18-36
Issue: 4
Volume: 78
Year: 2022
Month: 10
X-DOI: 10.1080/0015198X.2022.2095193
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2095193
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# input file: UFAJ_A_2093604_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Gregory W. Brown
Author-X-Name-First: Gregory W.
Author-X-Name-Last: Brown
Author-Name: Keith J. Crouch,
Author-X-Name-First: Keith J.
Author-X-Name-Last: Crouch,
Author-Name: Andra Ghent
Author-X-Name-First: Andra
Author-X-Name-Last: Ghent
Author-Name: Robert S. Harris
Author-X-Name-First: Robert S.
Author-X-Name-Last: Harris
Author-Name: Yael V. Hochberg
Author-X-Name-First: Yael V.
Author-X-Name-Last: Hochberg
Author-Name: Tim Jenkinson
Author-X-Name-First: Tim
Author-X-Name-Last: Jenkinson
Author-Name: Steven N. Kaplan
Author-X-Name-First: Steven N.
Author-X-Name-Last: Kaplan
Author-Name: Richard Maxwell
Author-X-Name-First: Richard
Author-X-Name-Last: Maxwell
Author-Name: David T. Robinson
Author-X-Name-First: David T.
Author-X-Name-Last: Robinson
Title: Should Defined Contribution Plans Include Private Equity Investments?
Abstract: 
 This paper evaluates the pros and cons of including private equity fund investments in defined contribution plans. Potential benefits include higher returns and improved diversification as well as a relatively safe method for accessing investments previously only available to institutions and the very wealthy. Despite these enticing benefits, they need to be weighed against potential challenges and costs that may arise from creating this broader access to private funds. The complicated structure and uncertainty around the mechanism to provide required liquidity backstops may bring increased fees or even disrupt the private fund model.
Journal: Financial Analysts Journal
Pages: 5-17
Issue: 4
Volume: 78
Year: 2022
Month: 10
X-DOI: 10.1080/0015198X.2022.2093604
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2093604
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# input file: UFAJ_A_2129947_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David Blanchett
Author-X-Name-First: David
Author-X-Name-Last: Blanchett
Title: Redefining the Optimal Retirement Income Strategy
Abstract: 
 This paper introduces a cohesive series of models designed to improve retirement income projections. First, the retirement income goal (i.e., liability) is decomposed based on assumed spending elasticity (e.g., “needs” and “wants”). Second, spending is assumed to evolve throughout retirement using a dynamic withdrawal strategy leveraging the funded ratio concept. Third, optimal strategies are determined using an expected utility model based on prospect theory, which also yields a client-friendly outcomes metric. Overall, this framework can result in advice and guidance that is notably different than models using more basic (and common) assumptions, especially approaches relying on probability of success-related metrics.
Journal: Financial Analysts Journal
Pages: 5-16
Issue: 1
Volume: 79
Year: 2023
Month: 1
X-DOI: 10.1080/0015198X.2022.2129947
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2129947
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# input file: UFAJ_A_2112895_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Koye Somefun
Author-X-Name-First: Koye
Author-X-Name-Last: Somefun
Author-Name: Romain Perchet
Author-X-Name-First: Romain
Author-X-Name-Last: Perchet
Author-Name: Chenyang Yin
Author-X-Name-First: Chenyang
Author-X-Name-Last: Yin
Author-Name: Raul Leote de Carvalho
Author-X-Name-First: Raul
Author-X-Name-Last: Leote de Carvalho
Title: Allocating to Thematic Investments
Abstract: 
 We introduce the notion of themes as an additional investment dimension beyond asset classes, regions, sectors and styles, and propose a framework to allocate to thematic investments at a strategic asset allocation level. Allocating to themes requires discipline because thematic investments are not only exposed to the theme but also to the traditional risk factors. Our approach uses a framework based on robust portfolio optimisation, which accounts for the expected excess return from the exposure to the theme and from exposures to traditional risk factors. We provide an example to illustrate how thematic investments fit in traditional multi-asset portfolios.
Journal: Financial Analysts Journal
Pages: 18-36
Issue: 1
Volume: 79
Year: 2023
Month: 1
X-DOI: 10.1080/0015198X.2022.2112895
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2112895
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# input file: UFAJ_A_2100234_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Blair Hull
Author-X-Name-First: Blair
Author-X-Name-Last: Hull
Author-Name: Anlong Li
Author-X-Name-First: Anlong
Author-X-Name-Last: Li
Author-Name: Xiao Qiao
Author-X-Name-First: Xiao
Author-X-Name-Last: Qiao
Title: Option Pricing via Breakeven Volatility
Abstract: 
 The fair value of an option is given by breakeven volatility, the value of implied volatility that sets the profit and loss of a delta-hedged option to zero. We calculate breakeven volatility for 400,000 options on the S&P 500 and build a predictive model for these volatilities. A two-stage regression approach captures the majority of the observed variation. By providing a link between option characteristics and breakeven volatility, we establish a non-parametric approach to pricing options without the need to specify the underlying price process. We illustrate the economic value of our approach with a simulated trading strategy based on breakeven volatility predictions.
Journal: Financial Analysts Journal
Pages: 99-119
Issue: 1
Volume: 79
Year: 2023
Month: 1
X-DOI: 10.1080/0015198X.2022.2100234
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2100234
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# input file: UFAJ_A_2129946_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Greg Hall
Author-X-Name-First: Greg
Author-X-Name-Last: Hall
Author-Name: Kate Liu
Author-X-Name-First: Kate
Author-X-Name-Last: Liu
Author-Name: Lukasz Pomorski
Author-X-Name-First: Lukasz
Author-X-Name-Last: Pomorski
Author-Name: Laura Serban
Author-X-Name-First: Laura
Author-X-Name-Last: Serban
Title: Supply Chain Climate Exposure
Abstract: 
 We propose an intuitive measure of supply chain climate risks, reflecting the fact that even a green company may have material climate exposure if its customers or suppliers face climate risks. Our measure captures price movements around climate news better than traditional climate data and shows performance patterns consistent with re-pricing of climate risks. The metric is more suitable for risk measurement than scope 3 emissions and requires raw data that is broadly accessible for large cross-sections of stocks and is of higher quality than currently available scope 3 data. We discuss applications for both portfolio and corporate decision-making.
Journal: Financial Analysts Journal
Pages: 58-76
Issue: 1
Volume: 79
Year: 2023
Month: 1
X-DOI: 10.1080/0015198X.2022.2129946
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2129946
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# input file: UFAJ_A_2150500_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mikheil Esakia
Author-X-Name-First: Mikheil
Author-X-Name-Last: Esakia
Author-Name: Felix Goltz
Author-X-Name-First: Felix
Author-X-Name-Last: Goltz
Title: Targeting Macroeconomic Exposures in Equity Portfolios: A Firm-Level Measurement Approach for Out-of-Sample Robustness
Abstract: 
 We propose firm-level measures of exposures to macroeconomic risks that substantially improve out-of-sample robustness compared to standard estimation approaches. Systematic equity strategies constructed from such measures offer more consistent macro exposures out of sample than strategies that allocate across sectors or equity-style factors. We do not find significant cost to the performance of such systematic strategies in exchange for targeting exposures to macroeconomic risks, such as interest rates, term spread, credit spread, or inflation. Our methodology can be used to construct equity portfolios for investors who have hedging demands or active views regarding macroeconomic conditions.
Journal: Financial Analysts Journal
Pages: 37-57
Issue: 1
Volume: 79
Year: 2023
Month: 1
X-DOI: 10.1080/0015198X.2022.2150500
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2150500
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# input file: UFAJ_A_2126590_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Samarpan Nawn
Author-X-Name-First: Samarpan
Author-X-Name-Last: Nawn
Author-Name: Gaurav Raizada
Author-X-Name-First: Gaurav
Author-X-Name-Last: Raizada
Title: Trade Informativeness in Modern Markets
Abstract: 
 Using transactions-based calendar time (TBCT) portfolio analysis, we investigate informativeness of trades of investor categories, namely institutions, proprietary traders, and retail clients. We find that trade informativeness is positive for institutional and negative for retail-client investors. The informativeness of liquidity-demanding trades are less than the informativeness of liquidity-supplying trades for all trading groups, over both long and short horizons. We also find that institutions are benefitted by algorithmic executions compared to manual executions and this benefit is elevated on days of high volume and volatility. Proprietary algorithmic traders (high-frequency traders) generate positive alpha for their trades only from their liquidity-supplying trades.
Journal: Financial Analysts Journal
Pages: 77-98
Issue: 1
Volume: 79
Year: 2023
Month: 1
X-DOI: 10.1080/0015198X.2022.2126590
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2126590
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Handle: RePEc:taf:ufajxx:v:79:y:2023:i:1:p:77-98




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# input file: UFAJ_A_2182600_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Vikas Agarwal
Author-X-Name-First: Vikas
Author-X-Name-Last: Agarwal
Author-Name: Linlin Ma
Author-X-Name-First: Linlin
Author-X-Name-Last: Ma
Author-Name: Kevin Mullally
Author-X-Name-First: Kevin
Author-X-Name-Last: Mullally
Title: Managerial Multitasking in the Mutual Fund Industry
Abstract: 
 Managerial multitasking has become a common practice in the mutual fund industry. Although multitasking may have certain benefits for fund companies and portfolio managers, these arrangements have significant drawbacks for fund investors. We find that multitasking is associated with worse fund performance. Moreover, we find significant performance deterioration when a single-tasking manager switches to multitasking. We further demonstrate evidence that suggests that multitasking reduces the attention or limits the investment options a manager can allocate to their funds. Our study prescribes caution when assigning a portfolio manager a greater workload, as doing so adversely affects fund performance and, at some point, the ability of the fund family to attract capital.
Journal: Financial Analysts Journal
Pages: 65-75
Issue: 2
Volume: 79
Year: 2023
Month: 4
X-DOI: 10.1080/0015198X.2023.2182600
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2182600
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Handle: RePEc:taf:ufajxx:v:79:y:2023:i:2:p:65-75




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# input file: UFAJ_A_2169027_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: J. Benson Durham
Author-X-Name-First: J. Benson
Author-X-Name-Last: Durham
Title: What Do TIPS Say about Real Interest Rates and Required Returns?
Abstract: 
 An arbitrage-free model decomposes yields on Treasury Inflation-Protected Securities (TIPS) into expected real rates, real frictionless term premiums, and liquidity premiums. Estimation eschews non-market information, incorporates a novel observable liquidity factor, and addresses factor persistence and sample biases, including real-time estimation. Results include a modest secular decline in equilibrium real rates and a much larger drop in frictionless required excess real returns, on net, from July 1999 to September 2022. Real term premiums appear to be pro-cyclical, which implies that the default risk-free asset is a hedge, and some evidence suggests that TIPS liquidity premiums are counter-cyclical.
Journal: Financial Analysts Journal
Pages: 21-44
Issue: 2
Volume: 79
Year: 2023
Month: 4
X-DOI: 10.1080/0015198X.2023.2169027
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2169027
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# input file: UFAJ_A_2160620_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Najah Attig
Author-X-Name-First: Najah
Author-X-Name-Last: Attig
Author-Name: Oumar Sy
Author-X-Name-First: Oumar
Author-X-Name-Last: Sy
Title: Diversification during Hard Times
Abstract: 
 Using a large sample of stocks from 48 developed and emerging markets over 1995 to 2021, we find evidence that suggests that international diversification is the best risk-reduction tool when all markets are considered. However, after the turn of the millennium, industrial diversification is the best alternative for funds limited to developed markets, especially when they are restricted to a region. Importantly, the benefits of diversification persist through hard times, such as the Asian financial crisis, the IT bubble burst, the global financial crisis, and the COVID-19 pandemic, demonstrating their countercyclicality and proving their value when investors need them the most.
Journal: Financial Analysts Journal
Pages: 45-64
Issue: 2
Volume: 79
Year: 2023
Month: 4
X-DOI: 10.1080/0015198X.2022.2160620
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2160620
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# input file: UFAJ_A_2191546_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Luis García-Feijóo
Author-X-Name-First: Luis
Author-X-Name-Last: García-Feijóo
Title: 2022 Report to Readers
Journal: Financial Analysts Journal
Pages: 5-6
Issue: 2
Volume: 79
Year: 2023
Month: 4
X-DOI: 10.1080/0015198X.2023.2191546
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2191546
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# input file: UFAJ_A_2173506_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Robert D. Arnott
Author-X-Name-First: Robert D.
Author-X-Name-Last: Arnott
Author-Name: Christopher Brightman
Author-X-Name-First: Christopher
Author-X-Name-Last: Brightman
Author-Name: Vitali Kalesnik
Author-X-Name-First: Vitali
Author-X-Name-Last: Kalesnik
Author-Name: Lillian Wu
Author-X-Name-First: Lillian
Author-X-Name-Last: Wu
Title: Earning Alpha by Avoiding the Index Rebalancing Crowd
Abstract: 
 Traditional capitalization-weighted indices generally add stocks with high valuation multiples after persistent outperformance and sell stocks at low valuation multiples after persistent underperformance. It is well known that the price impact of these changes can be large once a change is announced. The subsequent reversal is less well known. For example, in the year after a change in the S&P 500 Index, discretionary deletions beat additions by 22%, on average. Simple rules, such as trading ahead of index funds or delaying reconstitution trades by 3 to 12 months, can add up to 23 basis points a year. This benefit roughly doubles when we cap-weight a portfolio selected based on the fundamental size of a company’s business or on its multi-year average market-cap.
Journal: Financial Analysts Journal
Pages: 76-97
Issue: 2
Volume: 79
Year: 2023
Month: 4
X-DOI: 10.1080/0015198X.2023.2173506
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2173506
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# input file: UFAJ_A_2183706_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Suk-Joon Byun
Author-X-Name-First: Suk-Joon
Author-X-Name-Last: Byun
Author-Name: Byounghyun Jeon
Author-X-Name-First: Byounghyun
Author-X-Name-Last: Jeon
Title: Momentum Crashes and the 52-Week High
Abstract: 
 Momentum strategies suffer from occasional large drawdowns referred to as momentum crashes when the market rebounds. We find that a surge of investor speculation toward stocks far from their 52-week highs can partially explain the momentum crashes. If a momentum strategy is revised to be neutral on a 52-week high effect, momentum crashes are significantly attenuated and the revised strategy does not exhibit procyclical returns. Furthermore, the revised strategy generates a higher Sharpe ratio in different sub-periods and international stock markets.
Journal: Financial Analysts Journal
Pages: 120-139
Issue: 2
Volume: 79
Year: 2023
Month: 4
X-DOI: 10.1080/0015198X.2023.2183706
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2183706
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# input file: UFAJ_A_2158709_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: C. Mitchell Conover
Author-X-Name-First: C. Mitchell
Author-X-Name-Last: Conover
Author-Name: Joseph D. Farizo
Author-X-Name-First: Joseph D.
Author-X-Name-Last: Farizo
Author-Name: Andrew C. Szakmary
Author-X-Name-First: Andrew C.
Author-X-Name-Last: Szakmary
Title: The Low-Risk Effect in Equities: Evidence from Industry Data in an Earlier Time
Abstract: 
 Recently, there has been discussion of a “replication crisis” in Finance, where many empirical results in financial research are said not to be replicable. Previous research finds that low-risk stocks have higher returns than higher-risk stocks on a risk-adjusted basis. We reexamine the low-risk effect using a unique dataset for U.S. industries from 1871 to 1925. We confirm the presence of the effect for portfolios of U.S. industries, indicating that the low-risk effect is not due to data mining in previous studies. Comparing the results to that for more recent data, we find that the overall effect is at least as strong in the earlier data. Given that some market frictions were fewer in the earlier period, the results suggest that implicit trading costs, illiquidity, and/or behavioral biases may play an important role in the low-risk effect.
Journal: Financial Analysts Journal
Pages: 98-119
Issue: 2
Volume: 79
Year: 2023
Month: 4
X-DOI: 10.1080/0015198X.2022.2158709
File-URL: http://hdl.handle.net/10.1080/0015198X.2022.2158709
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# input file: UFAJ_A_2176163_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Amit Goyal
Author-X-Name-First: Amit
Author-X-Name-Last: Goyal
Author-Name: Ramon Tol
Author-X-Name-First: Ramon
Author-X-Name-Last: Tol
Author-Name: Sunil Wahal
Author-X-Name-First: Sunil
Author-X-Name-Last: Wahal
Title: Forbearance in Institutional Investment Management: Evidence from Survey Data
Abstract: 
 We survey 218 institutional investors from 22 countries representing over $4.1 trillion in AUM to understand the drivers of forbearance in the termination of external asset managers. Although asset managers are fired for a variety of reasons, including taking on too much or too little risk as well as organizational changes at the investment manager or institutional investor level, poor performance is by far the dominant cause. There is surprising tolerance for underperformance and holding periods for investment managers are unexpectedly long. Forbearance is important and we argue that performance evaluation should be multifaceted, akin to a Bayesian decision-maker who conducts continued due diligence and updates beliefs about returns with process information.
Journal: Financial Analysts Journal
Pages: 7-20
Issue: 2
Volume: 79
Year: 2023
Month: 4
X-DOI: 10.1080/0015198X.2023.2176163
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2176163
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# input file: UFAJ_A_2212581_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Thomas M. Idzorek
Author-X-Name-First: Thomas M.
Author-X-Name-Last: Idzorek
Title: Personalized Multiple Account Portfolio Optimization
Abstract: 
 I develop a multi-account alpha-tracking error framework that simultaneously optimizes across an investor’s multiple accounts with different tax treatments, existing holdings, tax lots, and opportunity sets while considering taxes and trade costs in a single optimization. The objective function includes an optional term for an investor’s nonpecuniary preferences, such as various environmental, social, and governance (ESG) characteristics. By running the multi-account optimizer regularly, it also serves as a personalized asset location optimizer, tax-loss harvester, portfolio rebalancer, roll-over optimizer, and new client onboarding transition optimizer that simultaneously considers the numerous interconnected tradeoffs to produce ongoing personalized portfolio management.
Journal: Financial Analysts Journal
Pages: 155-170
Issue: 3
Volume: 79
Year: 2023
Month: 7
X-DOI: 10.1080/0015198X.2023.2212581
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2212581
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# input file: UFAJ_A_2196931_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Sina Ehsani
Author-X-Name-First: Sina
Author-X-Name-Last: Ehsani
Author-Name: Campbell R. Harvey
Author-X-Name-First: Campbell R.
Author-X-Name-Last: Harvey
Author-Name: Feifei Li
Author-X-Name-First: Feifei
Author-X-Name-Last: Li
Title: Is Sector Neutrality in Factor Investing a Mistake?
Abstract: 
 Stock characteristics have two sources of predictive power. First, a characteristic might be valuable in identifying high or low expected returns across industries. Second, a characteristic might be useful in identifying individual stock expected returns within an industry. Past studies generally find that the firm-specific component is the strongest predictor, leading many to sector neutralize their factor exposures. We show both analytically and empirically that the average long–short investor is more likely to benefit from hedging out sector bets, whereas the long-only investor should, on average, avoid sector neutralization.
Journal: Financial Analysts Journal
Pages: 95-117
Issue: 3
Volume: 79
Year: 2023
Month: 7
X-DOI: 10.1080/0015198X.2023.2196931
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2196931
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# input file: UFAJ_A_2189891_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Bernard Dumas
Author-X-Name-First: Bernard
Author-X-Name-Last: Dumas
Author-Name: Tymur Gabuniya
Author-X-Name-First: Tymur
Author-X-Name-Last: Gabuniya
Author-Name: Richard C. Marston
Author-X-Name-First: Richard C.
Author-X-Name-Last: Marston
Title: Geographic Investing: Stock Return Indexes Based on Company Operations
Abstract: 
 Portfolio allocations to firms of various geographic areas should be guided by underlying risks of operations. In most statistical studies of international stock returns, a firm is included in a country’s index if its headquarters is located in that country, a classification scheme that ignores the operations of the firm taking place in multiple geographic areas. In prior work, we have proposed a model of country factors that is based on the business activities of all firms operating in a country, be they domestic firms or multinationals. In the present paper, we compare the resulting indexes with the domestic revenue exposure indexes already available in the industry. We conclude that our new indexes allow a portfolio manager to track geographic risk much more accurately.
Journal: Financial Analysts Journal
Pages: 64-74
Issue: 3
Volume: 79
Year: 2023
Month: 7
X-DOI: 10.1080/0015198X.2023.2189891
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2189891
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# input file: UFAJ_A_2214074_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jacky S. H. Lee
Author-X-Name-First: Jacky S. H.
Author-X-Name-Last: Lee
Author-Name: Marco Salerno
Author-X-Name-First: Marco
Author-X-Name-Last: Salerno
Title: Factor-Targeted Asset Allocation: A Reverse Optimization Approach
Abstract: 
 We demonstrate that using a mean-variance portfolio to obtain implied factor risk premia can result in stable weights for a factor portfolio when assets’ expected returns follow a factor structure that is subject to pricing errors. We propose a methodology to construct asset portfolios based on these factor portfolio weights, taking into account the possibility of pricing errors. Our simulation shows that these “factor-targeted” portfolios have higher and more stable Sharpe ratios than traditional allocation methodologies in various scenarios involving expected return assumptions. Furthermore, while our factor-targeted portfolios exhibit similar Sharpe ratios to the mean-variance portfolio built using factors for high levels of pricing errors, the factor-targeted portfolios have more stable portfolio weights, which makes them more appealing in practice.
Journal: Financial Analysts Journal
Pages: 75-94
Issue: 3
Volume: 79
Year: 2023
Month: 7
X-DOI: 10.1080/0015198X.2023.2214074
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2214074
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# input file: UFAJ_A_2215252_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Surpreet Bharjana
Author-X-Name-First: Surpreet
Author-X-Name-Last: Bharjana
Author-Name: Rohan Fletcher
Author-X-Name-First: Rohan
Author-X-Name-Last: Fletcher
Author-Name: Paul Lajbcygier
Author-X-Name-First: Paul
Author-X-Name-Last: Lajbcygier
Title: Factor Replication with Industry Stratification
Abstract: 
 Factor investing exploits asset pricing anomalies to enhance fund returns. Unlike traditional market capitalization indexes, factors have onerous replication costs. We consider the impact of omitting costly, small stocks by industry in stratified factor-replicating portfolios. Such industry stratification achieves broader industry coverage and lowers tracking error compared with competing approaches. We show that the improvement in tracking error is due to enhanced industry coverage, not risk exposure, resulting in substantial economic benefits.
Journal: Financial Analysts Journal
Pages: 118-135
Issue: 3
Volume: 79
Year: 2023
Month: 7
X-DOI: 10.1080/0015198X.2023.2215252
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2215252
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# input file: UFAJ_A_2188870_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Hendrik Bessembinder
Author-X-Name-First: Hendrik
Author-X-Name-Last: Bessembinder
Author-Name: Te-Feng Chen
Author-X-Name-First: Te-Feng
Author-X-Name-Last: Chen
Author-Name: Goeun Choi
Author-X-Name-First: Goeun
Author-X-Name-Last: Choi
Author-Name: K. C. John Wei
Author-X-Name-First: K. C. John
Author-X-Name-Last: Wei
Title: Long-Term Shareholder Returns: Evidence from 64,000 Global Stocks
Abstract: 
 We study long-run shareholder outcomes for more than 64,000 global common stocks during the January 1990 to December 2020 period. The majority, 55.2% of U.S. stocks and 57.4% of non-U.S. stocks, underperform one-month U.S. Treasury bills in terms of compound returns over the full sample. Focusing on aggregate shareholder outcomes, we find that the top-performing 2.4% of firms account for all of the $US 75.7 trillion in net global stock market wealth creation from 1990 to December 2020. Outside the United States, 1.41% of firms account for the $US 30.7 trillion in net wealth creation.
Journal: Financial Analysts Journal
Pages: 33-63
Issue: 3
Volume: 79
Year: 2023
Month: 7
X-DOI: 10.1080/0015198X.2023.2188870
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2188870
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# input file: UFAJ_A_2208028_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Jin Suk Park
Author-X-Name-First: Jin Suk
Author-X-Name-Last: Park
Author-Name: Mohammad Khaleq Newaz
Author-X-Name-First: Mohammad Khaleq
Author-X-Name-Last: Newaz
Title: Time-Series Predictability for Sector Investing
Abstract: 
 This study identifies the indicators of sector-level time-series predictability. The results show that investors can expect higher predictability in the more volatile sectors. In the developed markets, price downtrends, lower trading volume, and higher dividend yields indicate stronger predictability. The cyclical and sensitive super-sectors become more predictable as liquidity goes down. Particularly in the cyclical super-sectors, smaller market capitalization and larger term spread also indicate predictability. Sector selection based on the indicators can generate economic benefits.
Journal: Financial Analysts Journal
Pages: 136-154
Issue: 3
Volume: 79
Year: 2023
Month: 7
X-DOI: 10.1080/0015198X.2023.2208028
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2208028
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# input file: UFAJ_A_2185066_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Guido Baltussen
Author-X-Name-First: Guido
Author-X-Name-Last: Baltussen
Author-Name: Laurens Swinkels
Author-X-Name-First: Laurens
Author-X-Name-Last: Swinkels
Author-Name: Bart van Vliet
Author-X-Name-First: Bart
Author-X-Name-Last: van Vliet
Author-Name: Pim van Vliet
Author-X-Name-First: Pim
Author-X-Name-Last: van Vliet
Title: Investing in Deflation, Inflation, and Stagflation Regimes
Abstract: 
 We examine asset class and factor premiums across inflationary regimes. As periods of deflation, high inflation, and especially stagflation are relatively uncommon in recent history, we use a deep sample starting in 1875. Moderate inflation scenarios provide the highest returns across asset class and factor premiums. During deflationary periods, nominal returns are low, but real returns are attractive. By contrast, real equity and bond returns are negative during a high inflation regime and especially so during times of stagflation. During these “bad times,” factor premiums are positive, which helps to offset part of the real capital losses.
Journal: Financial Analysts Journal
Pages: 5-32
Issue: 3
Volume: 79
Year: 2023
Month: 7
X-DOI: 10.1080/0015198X.2023.2185066
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2185066
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# input file: UFAJ_A_2242075_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ludovic Phalippou
Author-X-Name-First: Ludovic
Author-X-Name-Last: Phalippou
Title: Thematic Investing with Big Data: The Case of Private Equity
Abstract: 
 Using natural language processing, we score companies based on the frequency with which news articles contain both their names and terms private equity and leveraged buy-out. An index is then created and can be updated seamlessly at high frequency. The weights are set as a function of the relative exposure to this theme. We add liquidity constraints to ensure minimal transaction costs. Even though the algorithm does not optimize on either return or correlation, this listed private equity index is highly correlated to commonly used private equity fund market indices: nearly 90% correlation with Burgiss LBO fund index. In addition, our index has similar returns as non-tradable Leveraged Buy-Outs (LBO) fund indices. Our approach can be generalized to many other investment themes.
Journal: Financial Analysts Journal
Pages: 30-40
Issue: 4
Volume: 79
Year: 2023
Month: 10
X-DOI: 10.1080/0015198X.2023.2242075
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2242075
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# input file: UFAJ_A_2251861_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: William N. Goetzmann
Author-X-Name-First: William N.
Author-X-Name-Last: Goetzmann
Title: Harry Markowitz in Memoriam
Journal: Financial Analysts Journal
Pages: 5-7
Issue: 4
Volume: 79
Year: 2023
Month: 10
X-DOI: 10.1080/0015198X.2023.2251861
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2251861
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# input file: UFAJ_A_2242758_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Alex Edmans
Author-X-Name-First: Alex
Author-X-Name-Last: Edmans
Title: Applying Economics—Not Gut Feel—to ESG
Abstract: 
 Interest in environmental, social, and governance (ESG) issues is at an all-time high. However, academic research is still relatively nascent, often leading us to apply gut feel on the grounds that ESG is too urgent to wait for peer-reviewed research. This paper highlights how the insights of mainstream economics can be applied to ESG, once we realize that ESG is no different to other investments with long-term financial and social returns. A large literature on corporate finance studies how to value investments; asset pricing explores how the stock market prices risks; welfare economics investigates externalities; optimal contracting considers how to achieve multiple objectives; private benefits analyze manager and investor preferences beyond shareholder value; and agency theory helps ensure that managers pursue shareholder preferences, including non-financial preferences. I identify how conventional thinking on ten common ESG myths is overturned when applying the insights of mainstream economics.
Journal: Financial Analysts Journal
Pages: 16-29
Issue: 4
Volume: 79
Year: 2023
Month: 10
X-DOI: 10.1080/0015198X.2023.2242758
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2242758
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# input file: UFAJ_A_2246579_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mario Bajo
Author-X-Name-First: Mario
Author-X-Name-Last: Bajo
Author-Name: Emilio Rodríguez
Author-X-Name-First: Emilio
Author-X-Name-Last: Rodríguez
Title: Green Parity and the Decarbonization of Corporate Bond Portfolios
Abstract: 
 This study explores the incorporation of climate change into fixed income investment. We investigate the cost of decarbonization and the selection of Sustainable Investment strategies in portfolio construction, providing a comprehensive analytical framework. Employing a passive management style and through empirical analysis, we assess the tradeoff between decarbonization and the associated cost in terms of benchmark deviation for a corporate bond portfolio. We also propose an innovative strategy called “Green Parity,” which helps to improve traditional approaches to decarbonization. Our results challenge the common belief that pursuing decarbonization targets inevitably compromises risk-return outcomes.
Journal: Financial Analysts Journal
Pages: 118-137
Issue: 4
Volume: 79
Year: 2023
Month: 10
X-DOI: 10.1080/0015198X.2023.2246579
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2246579
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# input file: UFAJ_A_2220648_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rob Bauer
Author-X-Name-First: Rob
Author-X-Name-Last: Bauer
Author-Name: Jeroen Derwall
Author-X-Name-First: Jeroen
Author-X-Name-Last: Derwall
Author-Name: Colin Tissen
Author-X-Name-First: Colin
Author-X-Name-Last: Tissen
Title: Private Shareholder Engagements on Material ESG Issues
Abstract: 
 We study private shareholder engagements with 2,465 listed firms about environmental, social, and governance (ESG) issues from 2007 to 2020. We examine the extent to which private engagements address financially material ESG issues and contribute to firm performance. We find that material engagements succeed more often than immaterial engagements and that the targets of successful material engagements significantly outperform their peers by 2.5% over the next 14 months. Further, we find that material engagements are more often associated with improvements in profitability and cost ratios than immaterial engagements. Finally, our evidence indicates that a decrease in CO2e emission intensity accompanies environmental engagements.
Journal: Financial Analysts Journal
Pages: 64-95
Issue: 4
Volume: 79
Year: 2023
Month: 10
X-DOI: 10.1080/0015198X.2023.2220648
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2220648
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# input file: UFAJ_A_2173492_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David Blitz
Author-X-Name-First: David
Author-X-Name-Last: Blitz
Author-Name: Matthias X. Hanauer
Author-X-Name-First: Matthias X.
Author-X-Name-Last: Hanauer
Author-Name: Iman Honarvar
Author-X-Name-First: Iman
Author-X-Name-Last: Honarvar
Author-Name: Rob Huisman
Author-X-Name-First: Rob
Author-X-Name-Last: Huisman
Author-Name: Pim van Vliet
Author-X-Name-First: Pim
Author-X-Name-Last: van Vliet
Title: Beyond Fama-French Factors: Alpha from Short-Term Signals
Abstract: 
 Short-term alpha signals are generally dismissed in traditional asset pricing models, primarily due to market friction concerns. However, this paper demonstrates that investors can obtain a significant net alpha by applying a combination of signals to a liquid global universe and with advanced buy/sell trading rules that mitigate transaction costs. The composite model consists of short-term reversal, short-term momentum, short-term analyst revisions, short-term risk, and monthly seasonality signals. The resulting alpha is present in out-of-sample and post-publication periods and across regions, translates into long-only applications, is robust to incorporating implementation lags of several days, and is uncorrelated to traditional Fama-French factors.
Journal: Financial Analysts Journal
Pages: 96-117
Issue: 4
Volume: 79
Year: 2023
Month: 10
X-DOI: 10.1080/0015198X.2023.2173492
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2173492
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Handle: RePEc:taf:ufajxx:v:79:y:2023:i:4:p:96-117




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# input file: UFAJ_A_2243205_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ivalina Kalcheva
Author-X-Name-First: Ivalina
Author-X-Name-Last: Kalcheva
Author-Name: Ping McLemore
Author-X-Name-First: Ping
Author-X-Name-Last: McLemore
Title: Intermediaries’ Incentives across Share Classes in the Same Fund
Abstract: 
 We provide supporting evidence that intermediaries’ incentives vary across retail share classes in the same fund. We find that when a fund has multiple share classes with different distribution fees, flow is less sensitive to poor performance for share classes with higher distribution fees. These results are more pronounced for funds when intermediaries are more inclined to favor one share class over another—specifically, for funds serving only retail investors, having a large dispersion in distribution fees across share classes, or having a share class that charges the maximum allowed distribution fee. Our results hold for funds with small spread in investors’ performance sensitivities and disappear in a placebo test. These findings cannot be explained by differences in share-class load fees or investor clientele.
Journal: Financial Analysts Journal
Pages: 41-63
Issue: 4
Volume: 79
Year: 2023
Month: 10
X-DOI: 10.1080/0015198X.2023.2243205
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2243205
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# input file: UFAJ_A_2271371_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: The Editors
Title: Our Thanks to Reviewers
Journal: Financial Analysts Journal
Pages: v-vi
Issue: 4
Volume: 79
Year: 2023
Month: 10
X-DOI: 10.1080/0015198X.2023.2271371
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2271371
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# input file: UFAJ_A_2240081_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Arnoud Boot
Author-X-Name-First: Arnoud
Author-X-Name-Last: Boot
Author-Name: Jan Krahnen
Author-X-Name-First: Jan
Author-X-Name-Last: Krahnen
Author-Name: Lemma Senbet
Author-X-Name-First: Lemma
Author-X-Name-Last: Senbet
Author-Name: Chester Spatt
Author-X-Name-First: Chester
Author-X-Name-Last: Spatt
Title: The Controversy over Proxy Voting: The Role of Fund Managers and Proxy Advisors
Abstract: 
 In this statement, we assess the role and power of proxy advisors and asset managers in corporate governance in a market that is characterized by a limited number of voting advisory firms (Institutional Shareholder Services and Glass Lewis) and a growing dominance of index investing concentrated in a few large asset managers, such as BlackRock, Vanguard, and State Street. We discuss the business model of proxy advisory firms and contrast its objectives with those of asset managers in the context of the informational screening/filtering role and voting analysis and conclude with a set of policy recommendations addressing transparency and regulatory oversight.
Journal: Financial Analysts Journal
Pages: 8-15
Issue: 4
Volume: 79
Year: 2023
Month: 10
X-DOI: 10.1080/0015198X.2023.2240081
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2240081
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# input file: UFAJ_A_2268556_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Edward F. McQuarrie
Author-X-Name-First: Edward F.
Author-X-Name-Last: McQuarrie
Title: Stocks for the Long Run? Sometimes Yes, Sometimes No
Abstract: 
 When Jeremy Siegel published his “Stocks for the Long Run” thesis, little was known about 19th-century stock and bond returns. Digital archives have made it possible to compute real total return on US stock and bond indexes from 1792. The new historical record shows that over multi-decade periods, sometimes stocks outperformed bonds, sometimes bonds outperformed stocks and sometimes they performed about the same. New international data confirm this pattern. Asset returns in the US in the 20th century do not generalize. Regimes of asset outperformance come and go; sometimes there is an equity premium, sometimes not.
Journal: Financial Analysts Journal
Pages: 12-28
Issue: 1
Volume: 80
Year: 2024
Month: 1
X-DOI: 10.1080/0015198X.2023.2268556
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2268556
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# input file: UFAJ_A_2285218_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Stephen C. Sexauer
Author-X-Name-First: Stephen C.
Author-X-Name-Last: Sexauer
Author-Name: Laurence B. Siegel
Author-X-Name-First: Laurence B.
Author-X-Name-Last: Siegel
Title: Harry Markowitz and the Philosopher’s Stone
Abstract: 
 We celebrate the life, work, and intellectual legacy of Harry Markowitz (1927–2023). Professor Markowitz’s philosophy and math have guided portfolio construction and asset allocation for 71 years. Markowitz optimization (MVO) was set forth in his 1952 University of Chicago Ph.D. dissertation. We trace the links from his work to William Sharpe’s CAPM and the investment giants who followed. MVO has been challenged and enhanced and has endured. But Markowitz did leave us the task of figuring out how to estimate the “stage one” inputs for MVO, which are expected return and risk. (Stage two is running the optimizer.) We propose a Bayesian approach to crafting those inputs.
Journal: Financial Analysts Journal
Pages: 1-11
Issue: 1
Volume: 80
Year: 2024
Month: 1
X-DOI: 10.1080/0015198X.2023.2285218
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2285218
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# input file: UFAJ_A_2240280_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Kenechukwu Anadu
Author-X-Name-First: Kenechukwu
Author-X-Name-Last: Anadu
Author-Name: John Levin
Author-X-Name-First: John
Author-X-Name-Last: Levin
Author-Name: Victoria Liu
Author-X-Name-First: Victoria
Author-X-Name-Last: Liu
Author-Name: Noam Tanner
Author-X-Name-First: Noam
Author-X-Name-Last: Tanner
Author-Name: Antoine Malfroy-Camine
Author-X-Name-First: Antoine
Author-X-Name-Last: Malfroy-Camine
Author-Name: Sean Baker
Author-X-Name-First: Sean
Author-X-Name-Last: Baker
Title: Swing Pricing Calibration: Using ETFs to Infer Swing Factors for Mutual Funds
Abstract: 
 Policymakers are assessing potential options to reduce the financial stability risks posed by open-ended mutual funds. One such option is swing pricing, or the process of adjusting a fund’s net asset value per share in response to its level of net investor activity. Calibrating a key component of swing pricing, the swing factor, can be difficult, particularly for funds that invest in certain types of debt instruments. We use the pricing dynamics of exchange-traded funds that invest primarily in short-term debt to infer a range of swing-factor-proxies for mutual funds that invest in similar assets. These proxies could be useful to inform swing factors (or costs for other economically equivalent mechanisms, such as liquidity fees) for certain bond funds, during periods of stress.
Journal: Financial Analysts Journal
Pages: 30-40
Issue: 1
Volume: 80
Year: 2024
Month: 1
X-DOI: 10.1080/0015198X.2023.2240280
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2240280
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# input file: UFAJ_A_2254199_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Antti Suhonen
Author-X-Name-First: Antti
Author-X-Name-Last: Suhonen
Title: Direct Lending Returns
Abstract: 
 I examine the performance of US business development companies (“BDC”). BDCs have produced returns in line with those of private funds engaged in direct lending. Leveraged loan and small-cap value equity returns explain a significant part of BDC performance, and the alpha of BDCs is zero on a market-value basis but a statistically significant 2.74% per annum based on net asset value (NAV) valuations. I find no evidence of an illiquidity premium, which suggests that the alpha could result from regulatory arbitrage or a peso problem. Cross-sectional BDC returns are widely dispersed and exhibit strong persistence in top- and bottom-quartile manager performance.
Journal: Financial Analysts Journal
Pages: 57-83
Issue: 1
Volume: 80
Year: 2024
Month: 1
X-DOI: 10.1080/0015198X.2023.2254199
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2254199
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# input file: UFAJ_A_2280035_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Desislava Vladimirova
Author-X-Name-First: Desislava
Author-X-Name-Last: Vladimirova
Author-Name: Jieyan Fang-Klingler
Author-X-Name-First: Jieyan
Author-X-Name-Last: Fang-Klingler
Title: Bonds with Benefits: Impact Investing in Corporate Debt
Abstract: 
 The regulatory focus on quantifiable sustainable investing shifts investors’ demand toward impact products, which creates challenges in achieving their primary target of outperformance. This study demonstrates the implications of sustainable investment in actively managed credit portfolios using carbon emissions, Sustainable Development Goals (SDGs), and green bonds. All three measures exhibit a low correlation with systematic factors, such as value and momentum, providing an opportunity for a sustainable alpha. Furthermore, we demonstrate a concave relationship between outperformance and sustainability. Therefore, systematic investors achieve a sustainable portfolio at a low cost, whereas sustainability-oriented investors harness factor returns and meet their initial targets.
Journal: Financial Analysts Journal
Pages: 41-56
Issue: 1
Volume: 80
Year: 2024
Month: 1
X-DOI: 10.1080/0015198X.2023.2280035
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2280035
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# input file: UFAJ_A_2259287_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Mustafa O. Caglayan
Author-X-Name-First: Mustafa O.
Author-X-Name-Last: Caglayan
Author-Name: Umut Celiker
Author-X-Name-First: Umut
Author-X-Name-Last: Celiker
Author-Name: Mete Tepe
Author-X-Name-First: Mete
Author-X-Name-Last: Tepe
Title: Are All Short-Term Institutional Investors Informed?
Abstract: 
 We examine whether being a hedge fund has any differential effect on the previously documented empirical relation between investment horizon and informativeness of institutional investors’ trades. We find that the positive and significant relation between short-term institutional demand and future stock returns exists only among hedge funds, while such relation does not exist for non–hedge fund institutions with short investment horizons. We also provide evidence that our results are not driven by (false) presumptions that hedge funds represent the majority of short-term institutional investors or that hedge fund demand constitute the lion’s share of the short-term institutional demand.
Journal: Financial Analysts Journal
Pages: 99-117
Issue: 1
Volume: 80
Year: 2024
Month: 1
X-DOI: 10.1080/0015198X.2023.2259287
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2259287
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# input file: UFAJ_A_2270084_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Christian L. Goulding
Author-X-Name-First: Christian L.
Author-X-Name-Last: Goulding
Author-Name: Campbell R. Harvey
Author-X-Name-First: Campbell R.
Author-X-Name-Last: Harvey
Author-Name: Michele G. Mazzoleni
Author-X-Name-First: Michele G.
Author-X-Name-Last: Mazzoleni
Title: Breaking Bad Trends
Abstract: 
 We document and quantify the negative impact of trend breaks (i.e., turning points in the trajectory of asset prices) on the performance of standard monthly trend-following strategies across several assets and asset classes. In the years of the US economy’s expansion following the global financial crisis of 2008, we find an increase in the frequency of trend breaks, which helps explain the lower performance of these trend strategies during this period. We illustrate how to repair such strategies using a dynamic trend-following approach that exploits the return-forecasting properties of the two types of trend breaks: market corrections and rebounds.
Journal: Financial Analysts Journal
Pages: 84-98
Issue: 1
Volume: 80
Year: 2024
Month: 1
X-DOI: 10.1080/0015198X.2023.2270084
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2270084
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# input file: UFAJ_A_2292545_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Sara Ain Tommar
Author-X-Name-First: Sara
Author-X-Name-Last: Ain Tommar
Author-Name: Serge Darolles
Author-X-Name-First: Serge
Author-X-Name-Last: Darolles
Author-Name: Emmanuel Jurczenko
Author-X-Name-First: Emmanuel
Author-X-Name-Last: Jurczenko
Title: Private Equity Performance around the World
Abstract: 
 We construct a novel dataset to explore the returns of private equity in international markets (i.e., other than North America). We investigate fund performance and persistence and compare the findings to the extensive evidence on North American funds. We find that both investment strategy and investment geography characterize the performance and return persistence of private equity. Buyout funds have the highest returns in Europe, while growth equity funds perform better in Asia-Pacific. Venture capital returns are modest across all international geographies. As documented in the literature for North America, large capital inflows result in lower returns in Europe, while this does not affect other investment geographies. We also find evidence of important market segmentation and strong return persistence for buyout and growth funds in Europe, as well as for a sample of globally diversified, US-sponsored buyout funds. We do not find evidence of persistence in Asia-Pacific or other world locations. Our results are robust to different performance measures and various tests for selection effects. They also hold important implications for both fund managers and investors targeting international markets.
Journal: Financial Analysts Journal
Pages: 99-121
Issue: 2
Volume: 80
Year: 2024
Month: 4
X-DOI: 10.1080/0015198X.2023.2292545
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2292545
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# input file: UFAJ_A_2258061_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Yin Chen
Author-X-Name-First: Yin
Author-X-Name-Last: Chen
Author-Name: Roni Israelov
Author-X-Name-First: Roni
Author-X-Name-Last: Israelov
Title: Exclude with Impunity: Personalized Indexing and Stock Restrictions
Abstract: 
 Using simulated historical backtests, we study the impact of stock exclusions on the performance of passive and active portfolios. We find that at low to moderate numbers, stock exclusions have very little influence on passive portfolios. Their effects on active portfolios vary by the factor in consideration and the portfolio construction method, but the magnitudes are much smaller than suggested by the percentage of stocks being excluded. We find similar patterns with industry-concentrated exclusions. Overall, our results suggest that investors should feel comfortable excluding a fairly large number of stocks before experiencing any significant deterioration in their investment performance.
Journal: Financial Analysts Journal
Pages: 7-25
Issue: 2
Volume: 80
Year: 2024
Month: 4
X-DOI: 10.1080/0015198X.2023.2258061
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2258061
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# input file: UFAJ_A_2317323_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rob Arnott
Author-X-Name-First: Rob
Author-X-Name-Last: Arnott
Author-Name: Feifei Li
Author-X-Name-First: Feifei
Author-X-Name-Last: Li
Author-Name: Juhani Linnainmaa
Author-X-Name-First: Juhani
Author-X-Name-Last: Linnainmaa
Title: Smart Rebalancing
Abstract: 
 The sometimes vast gap between live results and paper portfolio performance is caused in part by trading costs, discontinuous trading, and missed trades or other frictions, along with asset management fees. Smart beta and factor strategies are not exempt from this sort of “implementation shortfall.” This paper provides new evidence on the efficacy of prioritizing transactions so as to focus portfolio turnover on the trades that offer the strongest signals and hence the highest potential performance impact. Rebalancing filters of this sort can capture much of the factor premia for a long-only paper portfolio while cutting turnover and trading costs relative to a fully rebalanced portfolio.
Journal: Financial Analysts Journal
Pages: 26-51
Issue: 2
Volume: 80
Year: 2024
Month: 4
X-DOI: 10.1080/0015198X.2024.2317323
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2317323
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# input file: UFAJ_A_2284625_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Zhiqian Jiang
Author-X-Name-First: Zhiqian
Author-X-Name-Last: Jiang
Author-Name: Baixiao Liu
Author-X-Name-First: Baixiao
Author-X-Name-Last: Liu
Author-Name: Andrew Schrowang
Author-X-Name-First: Andrew
Author-X-Name-Last: Schrowang
Author-Name: Wei Xu
Author-X-Name-First: Wei
Author-X-Name-Last: Xu
Title: Short Squeezes
Abstract: 
 We investigate the prevalence and persistence of short squeezes and the corresponding economic consequences on the stocks being squeezed. Using daily short sale data, we provide evidence that a short squeeze on average subsides within seven trading days and can be driven by both the capital constraint of the short sellers and the short sale constraint of the underlying stocks. The risk of being squeezed is higher during major macroeconomic events. Further analyses reveal that squeezed stocks experience an increase in the demand for and the cost of borrowing the shares and in trading volume, idiosyncratic volatility, and abnormal returns.
Journal: Financial Analysts Journal
Pages: 152-173
Issue: 2
Volume: 80
Year: 2024
Month: 4
X-DOI: 10.1080/0015198X.2023.2284625
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2284625
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# input file: UFAJ_A_2283445_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Emmanuel R. Pezier
Author-X-Name-First: Emmanuel R.
Author-X-Name-Last: Pezier
Author-Name: Paolo F. Volpin
Author-X-Name-First: Paolo F.
Author-X-Name-Last: Volpin
Title: Shareholder Activism in Small-Cap Newly Public Firms
Abstract: 
 We examine a private dataset of engagements by a UK fund in small-cap newly public firms. The fund inherits unwanted holdings from disparate investors and earns fees liquidating its portfolio. It considers activism only when blocks cannot be exited efficiently. Engagements are with firms that have founder chairpersons or CEOs, other blockholders thought to be supportive, and few outside directors. Engagements are conducted behind-the-scenes, without involving other shareholders, are strikingly successful, and result in cumulative abnormal returns of 8% to 10% when objectives are met. The fund outperforms benchmarks, and we estimate that abnormal returns derive mostly from engagements rather than stock picking.
Journal: Financial Analysts Journal
Pages: 52-73
Issue: 2
Volume: 80
Year: 2024
Month: 4
X-DOI: 10.1080/0015198X.2023.2283445
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2283445
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# input file: UFAJ_A_2313692_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Kai Cao
Author-X-Name-First: Kai
Author-X-Name-Last: Cao
Author-Name: Haifeng You
Author-X-Name-First: Haifeng
Author-X-Name-Last: You
Title: Fundamental Analysis via Machine Learning
Abstract: 
 We examine the efficacy of machine learning in a central task of fundamental analysis: forecasting corporate earnings. We find that machine learning models not only generate significantly more accurate and informative out-of-sample forecasts than the state-of-the-art models in the literature but also perform better compared to analysts’ consensus forecasts. This superior performance appears attributable to the ability of machine learning to uncover new information through identifying economically important predictors and capturing nonlinear relationships. The new information uncovered by machine learning models is of considerable economic value to investors. It has significant predictive power with respect to future stock returns, with stocks in the most favorable new information quintile outperforming those in the least favorable quintile by approximately 34 to 77 bps per month on a risk-adjusted basis.
Journal: Financial Analysts Journal
Pages: 74-98
Issue: 2
Volume: 80
Year: 2024
Month: 4
X-DOI: 10.1080/0015198X.2024.2313692
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2313692
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# input file: UFAJ_A_2326395_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Luis García-Feijóo
Author-X-Name-First: Luis
Author-X-Name-Last: García-Feijóo
Title: 2023 Report to Readers
Journal: Financial Analysts Journal
Pages: 5-6
Issue: 2
Volume: 80
Year: 2024
Month: 4
X-DOI: 10.1080/0015198X.2024.2326395
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2326395
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# input file: UFAJ_A_2292534_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Wei Dai
Author-X-Name-First: Wei
Author-X-Name-Last: Dai
Author-Name: Mamdouh Medhat
Author-X-Name-First: Mamdouh
Author-X-Name-Last: Medhat
Author-Name: Robert Novy-Marx
Author-X-Name-First: Robert
Author-X-Name-Last: Novy-Marx
Author-Name: Savina Rizova
Author-X-Name-First: Savina
Author-X-Name-Last: Rizova
Title: Reversals and the Returns to Liquidity Provision
Abstract: 
 Different aspects of liquidity impact the performance of short-run reversals in different ways, consistent with the predictions of microstructure models. Higher volatility is associated with faster, initially stronger reversals, while lower turnover is associated with more persistent, ultimately stronger reversals. These facts also hold outside the US and explain several seemingly disparate results in the literature.
Journal: Financial Analysts Journal
Pages: 122-151
Issue: 2
Volume: 80
Year: 2024
Month: 4
X-DOI: 10.1080/0015198X.2023.2292534
File-URL: http://hdl.handle.net/10.1080/0015198X.2023.2292534
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# input file: UFAJ_A_2335142_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: David Blitz
Author-X-Name-First: David
Author-X-Name-Last: Blitz
Author-Name: Mike Chen
Author-X-Name-First: Mike
Author-X-Name-Last: Chen
Author-Name: Clint Howard
Author-X-Name-First: Clint
Author-X-Name-Last: Howard
Author-Name: Harald Lohre
Author-X-Name-First: Harald
Author-X-Name-Last: Lohre
Title: 3D Investing: Jointly Optimizing Return, Risk, and Sustainability
Abstract: 
 Traditional mean-variance portfolio optimization is based on the premise that investors only care about risk and return. However, some investors also have non-financial objectives such as sustainability goals. We show how the traditional approach can readily be extended to mean-variance-sustainability optimization and explain why this 3D investing approach is ex-ante Pareto-optimal. We illustrate its efficacy empirically in several studies, including carbon footprint and sustainable development goal objectives. Importantly, we highlight conditions under which a 3D optimization approach is superior to a naïve 2D approach augmented with sustainability constraints.
Journal: Financial Analysts Journal
Pages: 59-75
Issue: 3
Volume: 80
Year: 2024
Month: 7
X-DOI: 10.1080/0015198X.2024.2335142
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2335142
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# input file: UFAJ_A_2332164_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Gianluca De Nard
Author-X-Name-First: Gianluca
Author-X-Name-Last: De Nard
Author-Name: Robert F. Engle
Author-X-Name-First: Robert F.
Author-X-Name-Last: Engle
Author-Name: Bryan Kelly
Author-X-Name-First: Bryan
Author-X-Name-Last: Kelly
Title: Factor-Mimicking Portfolios for Climate Risk
Abstract: 
 We propose and implement a procedure to optimally hedge climate change risk. First, we construct climate risk indices through textual analysis of newspapers. Second, we present a new approach to compute factor-mimicking portfolios to build climate risk hedge portfolios. The new mimicking portfolio approach is much more efficient than traditional sorting or maximum correlation approaches by taking into account new methodologies of estimating large-dimensional covariance matrices in short samples. In an extensive empirical out-of-sample performance test, we demonstrate the superior all-around performance delivering markedly higher and statistically significant alphas and betas with the climate risk indices.
Journal: Financial Analysts Journal
Pages: 37-58
Issue: 3
Volume: 80
Year: 2024
Month: 7
X-DOI: 10.1080/0015198X.2024.2332164
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2332164
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# input file: UFAJ_A_2359902_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rajkumar Janardanan
Author-X-Name-First: Rajkumar
Author-X-Name-Last: Janardanan
Author-Name: Xiao Qiao
Author-X-Name-First: Xiao
Author-X-Name-Last: Qiao
Author-Name: K. Geert Rouwenhorst
Author-X-Name-First: K. Geert
Author-X-Name-Last: Rouwenhorst
Title: ESG and Derivatives
Abstract: 
 Like stocks and bonds, derivatives investments have a measurable environmental, social, and governance (ESG) impact. This paper provides a rationale and a simple framework for applying ESG screens to portfolios that include derivatives, with a particular application to commodity futures. Commodities are ranked based on their top-down ESG scores, and we evaluate the impact of two hypothetical ESG screens for a diversified commodity futures portfolio.
Journal: Financial Analysts Journal
Pages: 5-16
Issue: 3
Volume: 80
Year: 2024
Month: 7
X-DOI: 10.1080/0015198X.2024.2359902
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2359902
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# input file: UFAJ_A_2351020_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Roger Clarke
Author-X-Name-First: Roger
Author-X-Name-Last: Clarke
Author-Name: Harindra de Silva
Author-X-Name-First: Harindra
Author-X-Name-Last: de Silva
Author-Name: Steven Thorley
Author-X-Name-First: Steven
Author-X-Name-Last: Thorley
Title: Nonlinear Factor Returns in the US Equity Market
Abstract: 
 We examine nonlinear return-to-characteristic relationships for five equity market factors: value, momentum, small size, low beta, and profitability. Our study employs monthly returns and characteristics for the largest one thousand US stocks from 1964 to 2023 with a focus on average active returns over the last 20 years. Beyond simplicity in modeling the return-generating process, we find no reason to assume a linear relationship between characteristics and security returns. Allowance for nonlinearity leads to increases in information ratios for factor portfolios neutralized with respect to nonlinear exposure to the other factors.
Journal: Financial Analysts Journal
Pages: 76-102
Issue: 3
Volume: 80
Year: 2024
Month: 7
X-DOI: 10.1080/0015198X.2024.2351020
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2351020
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# input file: UFAJ_A_2317333_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Roderick Molenaar
Author-X-Name-First: Roderick
Author-X-Name-Last: Molenaar
Author-Name: Edouard Sénéchal
Author-X-Name-First: Edouard
Author-X-Name-Last: Sénéchal
Author-Name: Laurens Swinkels
Author-X-Name-First: Laurens
Author-X-Name-Last: Swinkels
Author-Name: Zhenping Wang
Author-X-Name-First: Zhenping
Author-X-Name-Last: Wang
Title: Empirical Evidence on the Stock–Bond Correlation
Abstract: 
 The correlation between stock and bond returns is a cornerstone of asset allocation decisions. History reveals abrupt regime shifts in correlation after long periods of relative stability. We investigate the drivers of the correlation between stocks and bonds and find that inflation, real rates, and government creditworthiness are important explanatory variables. We examine the implications of a shift in the stock–bond correlation and find that increases are associated with higher multi-asset portfolio risk and higher bond risk premia.
Journal: Financial Analysts Journal
Pages: 17-36
Issue: 3
Volume: 80
Year: 2024
Month: 7
X-DOI: 10.1080/0015198X.2024.2317333
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2317333
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# input file: UFAJ_A_2350952_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Axel Cabrol
Author-X-Name-First: Axel
Author-X-Name-Last: Cabrol
Author-Name: Wolfgang Drobetz
Author-X-Name-First: Wolfgang
Author-X-Name-Last: Drobetz
Author-Name: Tizian Otto
Author-X-Name-First: Tizian
Author-X-Name-Last: Otto
Author-Name: Tatjana Puhan
Author-X-Name-First: Tatjana
Author-X-Name-Last: Puhan
Title: Predicting Corporate Bond Illiquidity via Machine Learning
Abstract: 
 This paper tests the predictive performance of machine learning methods in estimating the illiquidity of US corporate bonds. Machine learning techniques outperform the historical illiquidity-based approach, the most commonly applied benchmark in practice, from both a statistical and an economic perspective. Gradient-boosted regression trees perform particularly well. Historical illiquidity is the most important single predictor variable, but several fundamental and return- as well as risk-based covariates also possess predictive power. Capturing nonlinear effects and interactions among these predictors further enhances forecasting performance. For practitioners, the choice of the appropriate machine learning model depends on the specific application.
Journal: Financial Analysts Journal
Pages: 103-127
Issue: 3
Volume: 80
Year: 2024
Month: 7
X-DOI: 10.1080/0015198X.2024.2350952
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2350952
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# input file: UFAJ_A_2395232_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Dat Mai
Author-X-Name-First: Dat
Author-X-Name-Last: Mai
Title: Time-Varying Drivers of Stock Prices
Abstract: 
 This paper provides novel evidence of the time-varying roles of subjective expectations in explaining stock price variations. Cash flow expectations matter more during times of financial uncertainty and recessions, especially among the hardest-hit industries such as Telecommunications during the dot-com bubble, Financials during the Great Recession, and Healthcare during the COVID-19 pandemic. Conversely, discount rates explain more price variations during expansionary periods. Inflation expectations, while accounting for more than half of price fluctuations in high-inflation environments, play a negligible role otherwise. Finally, factor returns tend to move against earnings growth expectations under low financial uncertainty but move in sync with earnings growth expectations when financial uncertainty is high.
Journal: Financial Analysts Journal
Pages: 108-133
Issue: 4
Volume: 80
Year: 2024
Month: 10
X-DOI: 10.1080/0015198X.2024.2395232
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2395232
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# input file: UFAJ_A_2358737_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Rui Ma
Author-X-Name-First: Rui
Author-X-Name-Last: Ma
Author-Name: Ben R. Marshall
Author-X-Name-First: Ben R.
Author-X-Name-Last: Marshall
Author-Name: Nhut H. Nguyen
Author-X-Name-First: Nhut H.
Author-X-Name-Last: Nguyen
Author-Name: Nuttawat Visaltanachoti
Author-X-Name-First: Nuttawat
Author-X-Name-Last: Visaltanachoti
Title: Estimating Long-Term Expected Returns
Abstract: 
 Estimating long-term expected returns as accurately as possible is of critical importance. Researchers typically base their estimates on yield and growth, valuation, or a combined yield, growth, and valuation (“three-component”) framework. We run a horse race of the abilities of different frameworks and input proxies within each framework to estimate 10- and 20-year out-of-sample returns. The three-component model based on the TRCAPE valuation proxy outperforms estimates based on historical mean benchmark returns, with mean square error improvements exceeding 30%. Using this approach in asset allocation decisions results in an improvement in Sharpe ratios of more than 50%.
Journal: Financial Analysts Journal
Pages: 134-154
Issue: 4
Volume: 80
Year: 2024
Month: 10
X-DOI: 10.1080/0015198X.2024.2358737
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2358737
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# input file: UFAJ_A_2374226_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Ivo Welch
Author-X-Name-First: Ivo
Author-X-Name-Last: Welch
Title: A Heuristic for Fat-Tailed Stock Market Returns
Abstract: 
 Large negative stock and equity portfolio rates of return occur more frequently than they should under the Gaussian normal distribution. They tend to be kurtotic, roughly as if they were drawn from Student T-distributions with 2 to 5 degrees of freedom. A very easy adjustment to help assess the probability of losses is to work with a transformed Z score, Z′=−1.25− log (−Z). For example, one should expect a stock return that is 17 standard deviations below the mean under the empirical distribution as often as one would expect to see a draw that is Z′=|–1.25− log (17)≈−4| standard deviations below the mean under the idealized normal distribution.
Journal: Financial Analysts Journal
Pages: 18-26
Issue: 4
Volume: 80
Year: 2024
Month: 10
X-DOI: 10.1080/0015198X.2024.2374226
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2374226
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# input file: UFAJ_A_2375957_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Martin S. Fridson
Author-X-Name-First: Martin S.
Author-X-Name-Last: Fridson
Author-Name: Jack J. Beyda
Author-X-Name-First: Jack J.
Author-X-Name-Last: Beyda
Author-Name: John H. Lee
Author-X-Name-First: John H.
Author-X-Name-Last: Lee
Title: “Earnings per Share Don’t Count” at 50
Abstract: 
 The July/August 1974 issue of Financial Analysts Journal included an article with the provocative title, “Earnings per Share Don’t Count.” Author Joel M. Stern, then a vice-president of Chase Manhattan Bank, was denying the relevance of the central metric of prevailing equity analysis, known by the abbreviation EPS. He encouraged investors to look beyond Wall Street’s customary EPS × P/E multiple = price target model. Stern’s landmark article opened the door for research that offers a broader perspective on the sources of equity value. Today’s wider set of valuation tools is essential in view of the changed composition of the stock universe over the past several decades.
Journal: Financial Analysts Journal
Pages: 5-10
Issue: 4
Volume: 80
Year: 2024
Month: 10
X-DOI: 10.1080/0015198X.2024.2375957
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2375957
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# input file: UFAJ_A_2397335_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Wayne Lim
Author-X-Name-First: Wayne
Author-X-Name-Last: Lim
Title: Accessing Private Markets: What Does It Cost?
Abstract: 
 This paper provides the first empirical analysis of the costs of financial intermediation across private markets and a framework to estimate ex-post costs using observed fund terms. I access a proprietary dataset, develop a novel model, and estimate that it costs investors $0.05 to $0.26 per dollar committed over funds’ lifetimes. The corresponding fee drag on gross-to-net total value to paid-in capital is 0.1x to 0.7x and 5% to 8% in annualized terms. The results demonstrate cost economies of scale in which larger funds cost less in management fees. Finally, the fraction of costs attributable to non-performance fees is 53% to 75%.
Journal: Financial Analysts Journal
Pages: 27-52
Issue: 4
Volume: 80
Year: 2024
Month: 10
X-DOI: 10.1080/0015198X.2024.2397335
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2397335
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# input file: UFAJ_A_2382672_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Paul D. Kaplan
Author-X-Name-First: Paul D.
Author-X-Name-Last: Kaplan
Author-Name: Thomas M. Idzorek
Author-X-Name-First: Thomas M.
Author-X-Name-Last: Idzorek
Title: The Importance of Joining Lifecycle Models with Mean-Variance Optimization
Abstract: 
 For nearly three-quarters of a century, there has been a large separation between lifecycle finance models stemming from numerous Nobel laureates and the single-period mean-variance optimization-oriented models starting with Markowitz. Recent advances allow for a new class of models that combine both lifecycle models and mean-variance models. This new class of models uses lifecycle models to answer key financial planning questions and then mean-variance optimization models to answer investment questions. Goals-based models are often silent on many financial planning questions addressed by lifecycle finance and should thus be joined with lifecycle models.
Journal: Financial Analysts Journal
Pages: 11-17
Issue: 4
Volume: 80
Year: 2024
Month: 10
X-DOI: 10.1080/0015198X.2024.2382672
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2382672
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Handle: RePEc:taf:ufajxx:v:80:y:2024:i:4:p:11-17



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# input file: UFAJ_A_2388024_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Clint Howard
Author-X-Name-First: Clint
Author-X-Name-Last: Howard
Title: Choices Matter When Training Machine Learning Models for Return Prediction
Abstract: 
 Applying machine learning to cross-sectional stock return prediction requires careful consideration of modeling choices. Common approaches that fail to account for heterogeneity or imbalanced stock representation in training data can lead to suboptimal performance. I study two strategies to address these issues: training group-specific models and predicting relative returns. Both approaches yield similar economic improvements over models trained on the full cross-section of US stock returns, with value-weighted trading strategies benefiting significantly. The findings underscore the importance of aligning machine learning modeling decisions with desired economic outcomes and provide guidance for researchers and practitioners seeking robust machine learning models.
Journal: Financial Analysts Journal
Pages: 81-107
Issue: 4
Volume: 80
Year: 2024
Month: 10
X-DOI: 10.1080/0015198X.2024.2388024
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2388024
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Handle: RePEc:taf:ufajxx:v:80:y:2024:i:4:p:81-107



Template-Type: ReDIF-Article 1.0
# input file: UFAJ_A_2360390_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20240625T135222 git hash: cf9af5b024
Author-Name: Alexey Ivashchenko
Author-X-Name-First: Alexey
Author-X-Name-Last: Ivashchenko
Author-Name: Robert Kosowski
Author-X-Name-First: Robert
Author-X-Name-Last: Kosowski
Title: Transaction Costs and Capacity of Systematic Corporate Bond Strategies
Abstract: 
 Can systematic corporate bond investments generate attractive returns net of costs? To answer this question, we apply the principle of market microstructure invariance and obtain bond transaction costs increasing in trade size. As the size of the bond fund increases, the market impact reduces net returns to zero. High-turnover strategies hit capacity constraints fast. Low-turnover credit risk–focused strategies have much higher capacities that can be further increased by constraining portfolio rebalancing in realistic ways. Transaction costs do not absorb the corporate bond risk premium even in the largest possible market portfolios.
Journal: Financial Analysts Journal
Pages: 53-80
Issue: 4
Volume: 80
Year: 2024
Month: 10
X-DOI: 10.1080/0015198X.2024.2360390
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2360390
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Handle: RePEc:taf:ufajxx:v:80:y:2024:i:4:p:53-80

Template-Type: ReDIF-Article 1.0
# input file: UFAJ_A_2442290_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20241127T073524 git hash: 0fa6686462
Author-Name: Allison Adams
Author-X-Name-First: Allison
Author-X-Name-Last: Adams
Title: Publisher’s Note
Journal: Financial Analysts Journal
Pages: 5-5
Issue: 1
Volume: 81
Year: 2025
Month: 1
X-DOI: 10.1080/0015198X.2024.2442290
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2442290
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Handle: RePEc:taf:ufajxx:v:81:y:2025:i:1:p:5-5



Template-Type: ReDIF-Article 1.0
# input file: UFAJ_A_2411941_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20241127T073524 git hash: 0fa6686462
Author-Name: Douglas (DJ) Fairhurst
Author-X-Name-First: Douglas (DJ)
Author-X-Name-Last: Fairhurst
Author-Name: Daniel Greene
Author-X-Name-First: Daniel
Author-X-Name-Last: Greene
Title: How Much Does ChatGPT Know about Finance?
Abstract: 
 This paper analyzes more than 10,000 large language model (LLM) responses to finance-related prompts and identifies tradeoffs that can guide both academics and practitioners in using these models for finance applications. Using novel data, we show that some models and methods of interactions are appropriate for users who place a high value on accuracy (i.e., correctness), while others are better for generating responses that are similar to human expert-written text. We identify which finance tasks are associated with higher levels of LLM accuracy and show that the appropriate use of LLMs is task-specific, not job-specific.
Journal: Financial Analysts Journal
Pages: 12-32
Issue: 1
Volume: 81
Year: 2025
Month: 1
X-DOI: 10.1080/0015198X.2024.2411941
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2411941
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Handle: RePEc:taf:ufajxx:v:81:y:2025:i:1:p:12-32



Template-Type: ReDIF-Article 1.0
# input file: UFAJ_A_2444384_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20241127T073524 git hash: 0fa6686462
Author-Name: Joseph E. Aldy
Author-X-Name-First: Joseph E.
Author-X-Name-Last: Aldy
Author-Name: Patrick Bolton
Author-X-Name-First: Patrick
Author-X-Name-Last: Bolton
Author-Name: Zachery M. Halem
Author-X-Name-First: Zachery M.
Author-X-Name-Last: Halem
Author-Name: Marcin T. Kacperczyk
Author-X-Name-First: Marcin T.
Author-X-Name-Last: Kacperczyk
Title: Show & Tell: An Analysis of Corporate Climate Messaging and Its Financial Impacts
Abstract: 
 As climate-induced physical and transition risks to corporations are becoming more and more material, investors are increasingly scrutinizing a patchwork of voluntary climate-related public communications, namely emission disclosures, emission reduction commitments, and soft information from earnings calls and other corporate announcements. We observe, for large-cap US firms, a rise in the usage of all forms of climate communication from 2010 to 2020. Public communication is commonly used by firms in emission-intensive sectors, such as industrials, materials, and utilities. We provide evidence that increased transparency from disclosure, especially of scope 1 and scope 2 emissions, can offset a significant portion of the P/E discount associated with carbon emissions, especially for firms in the energy and industrial sectors. A similar offsetting effect is observed for positive climate-related sentiment during earnings calls Q&A, but not for the management update section of earnings calls. In contrast, decarbonization commitments have a subsequent statistically insignificant impact on valuation.
Journal: Financial Analysts Journal
Pages: 82-101
Issue: 1
Volume: 81
Year: 2025
Month: 1
X-DOI: 10.1080/0015198X.2024.2444384
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2444384
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Handle: RePEc:taf:ufajxx:v:81:y:2025:i:1:p:82-101



Template-Type: ReDIF-Article 1.0
# input file: UFAJ_A_2401765_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20241127T073524 git hash: 0fa6686462
Author-Name: Hendrik Bessembinder
Author-X-Name-First: Hendrik
Author-X-Name-Last: Bessembinder
Author-Name: Te-Feng Chen
Author-X-Name-First: Te-Feng
Author-X-Name-Last: Chen
Author-Name: Goeun Choi
Author-X-Name-First: Goeun
Author-X-Name-Last: Choi
Author-Name: K. C. John Wei
Author-X-Name-First: K. C. John
Author-X-Name-Last: Wei
Title: How Should Investors’ Long-Term Returns Be Measured?
Abstract: 
 We assess measures of long-horizon investment outcomes and clarify underlying trading strategy interpretations. We focus attention on a measure we call the “sustainable return,” defined as the rate of periodic withdrawal for consumption consistent with the preservation of real capital. We use this notion to highlight the role of return sequence risk, which is distinct from risk in the overall level of returns. We illustrate this and several other long-horizon measures in a global stock sample, emphasizing limitations of the arithmetic and geometric means of short-interval returns and the necessity in many contexts to consider the reinvestment of interim cash flows.
Journal: Financial Analysts Journal
Pages: 33-62
Issue: 1
Volume: 81
Year: 2025
Month: 1
X-DOI: 10.1080/0015198X.2024.2401765
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2401765
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Handle: RePEc:taf:ufajxx:v:81:y:2025:i:1:p:33-62



Template-Type: ReDIF-Article 1.0
# input file: UFAJ_A_2437982_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20241127T073524 git hash: 0fa6686462
Author-Name: Stephen Penman
Author-X-Name-First: Stephen
Author-X-Name-Last: Penman
Author-Name: Julie Zhu
Author-X-Name-First: Julie
Author-X-Name-Last: Zhu
Title: Safe Equities: An Alternative Allocation to Bonds
Abstract: 
 An allocation of investment funds between equities and bonds, commonly a 60/40 split, is often advised to provide some protection from the risk in equities while still maintaining an equity exposure. However, in recent years when equity and bonds have been positively correlated, bonds have failed to provide the desired protection. This paper reports on an alternative: an allocation to relatively safe equities within a 100% equity portfolio. These safe equities, identified by fundamental analysis, provide a hedge in equity market drawdowns but with upside return: positive skewness with limited downside. An empirical analysis confirms this benefit, both in periods when equity and bond returns were positively correlated and when they were negatively correlated.
Journal: Financial Analysts Journal
Pages: 63-81
Issue: 1
Volume: 81
Year: 2025
Month: 1
X-DOI: 10.1080/0015198X.2024.2437982
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2437982
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Handle: RePEc:taf:ufajxx:v:81:y:2025:i:1:p:63-81



Template-Type: ReDIF-Article 1.0
# input file: UFAJ_A_2439724_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20241127T073524 git hash: 0fa6686462
Author-Name: Luis García-Feijóo
Author-X-Name-First: Luis
Author-X-Name-Last: García-Feijóo
Author-Name: William N. Goetzmann
Author-X-Name-First: William N.
Author-X-Name-Last: Goetzmann
Title: Innovation and the Human Dimension of Investment Management
Journal: Financial Analysts Journal
Pages: 7-11
Issue: 1
Volume: 81
Year: 2025
Month: 1
X-DOI: 10.1080/0015198X.2024.2439724
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2439724
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Handle: RePEc:taf:ufajxx:v:81:y:2025:i:1:p:7-11



Template-Type: ReDIF-Article 1.0
# input file: UFAJ_A_2403359_J.xml processed with: repec_from_jats12.xsl darts-xml-transformations-20241127T073524 git hash: 0fa6686462
Author-Name: Wolfgang Breuer
Author-X-Name-First: Wolfgang
Author-X-Name-Last: Breuer
Author-Name: Andreas Knetsch
Author-X-Name-First: Andreas
Author-X-Name-Last: Knetsch
Author-Name: Eric Sachsenhausen
Author-X-Name-First: Eric
Author-X-Name-Last: Sachsenhausen
Title: Influence and Predictive Value of Seeking Alpha Articles
Abstract: 
 We find that recommendations issued by Seeking Alpha authors can affect trading activity substantially, which makes them an interesting source of information for retail and professional traders alike. A recommendation’s chances to become influential in this sense are greater for more accessible articles and depend on characteristics that are observable without reading the text. This result is in line with the existence of processing costs, as Seeking Alpha community members might be unwilling to spend much effort reading full articles and instead use superficial criteria to decide which articles to follow. Article features that are consistent with a detailed, in-depth analysis provide more valuable mid- to long-term investment advice. However, the immediate reaction from readers to such articles appears to be less pronounced. We provide evidence for potentially profitable investment strategies based on those article features.
Journal: Financial Analysts Journal
Pages: 102-128
Issue: 1
Volume: 81
Year: 2025
Month: 1
X-DOI: 10.1080/0015198X.2024.2403359
File-URL: http://hdl.handle.net/10.1080/0015198X.2024.2403359
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Handle: RePEc:taf:ufajxx:v:81:y:2025:i:1:p:102-128