Asset Allocation

Forecasting EREIT Returns

2008-07-10T20:50:00.000-07:00

Forecasting EREIT Returns

Camilo Serrano, Martin Hoesli,
Volume: 13
Issue Number: 4
Year: 2007
Publication: Journal of Real Estate Portfolio Management

Executive Summary. This paper analyzes the role played by financial assets, direct real estate, and the Fama and French (1993) factors in explaining equity real estate investment trust (EREIT) returns and examines the usefulness of these variables in forecasting returns. Four models are analyzed and their predictive potential is assessed by comparing three forecasting methods: time varying coefficient (TVC) regressions, vector autoregressive (VAR) systems, and neural networks models. Trading strategies on these forecasts are compared to a passive buy-and-hold strategy. The results show that EREIT returns are better explained by models including the Fama and French factors. The VAR forecasts are better than the TVC forecasts, but the best predictions are obtained with neural networks and especially when they are applied to the model using stock, bond, real estate, size, and book-to-market factors.

Correlation, Return Gaps and the Benefits of Diversification

2008-05-22T11:16:00.000-07:00

Correlation, Return Gaps and the Benefits of Diversification

Statman, Meir and Scheid, Jonathan, "Correlation, Return Gaps and the Benefits of Diversification" (November 2007).

Abstract:
Correlation is the common indicator for the benefits of diversification, but it is not a good indicator. This is for two reasons. First, the benefits of diversification depend not only on the correlations between returns but also on the standard deviations of returns. Second, correlation does not provide an intuitive measure of the benefits of diversification. Return gaps are better indicators. Return gaps are the difference between the returns of two assets or between two portfolios.

For example, the estimated 12-month return gap between the S&P 500 Index and the Russell 2000 Index and during February 2002 – January 2007 was 8.90%, implying that investors who concentrated their portfolios in one index or the other should have expected to lead or lag investors who diversified between the two in equal proportions by 4.45%. The realized 12-month return gaps ranged from 0.1% to 28.7%. It is hard to deduce these figure intuitively from the relatively high 0.82 correlation between the two. Similarly, it is hard to deduce intuitively from the relatively high 0.86 correlation between the S&P 500 and EAFE Indexes that their estimated 12-month return gap was 6.86% and their realized 12-month return gaps ranged from 1.8% to 23.0%. Moreover, the figures belie any claim that these assets' risk-reduction benefits have largely vanished.

Beta Based Asset Allocation: Simplicity and Transparancy

2008-04-03T23:51:00.000-07:00

Beta Based Asset Allocation: Simplicity and Transparancy

By P. Brett Hammond, TIAA-CREF Institute (Winter 2007)

This is a companion piece to a paper titled Reverse Asset Allocation: Alternatives at the Core, written in the second quarter of 2007. As discussed in that paper, the challenges and potential benefits of alternative assets include portfolio instability and counterintuitive results on the one hand, and superior return and risk expectations on the other — characteristics that become strikingly evident through asset allocation exercises involving alternatives

International Price and Earnings Momentum

2008-03-18T01:41:00.000-07:00

International Price and Earnings Momentum

Leippold, Markus and Lohre, Harald, (March 4, 2008)

Abstract:

We find that price and earnings momentum are pervasive features of developed equity markets when controlling for multiple testing issues. Having ruled out data snooping as possible explanation for both phenomena, the evidence becomes even more startling. Recently, Chordia and Shivakumar (2006) argue that U.S. price momentum is subsumed by earnings momentum. We replicate their empirical finding for the U.S. and show that it does carry over to Europe on an aggregate level, but it does not apply to each and every European country. While the above explanation seems to be confined to certain time periods, earnings momentum nevertheless appears to be a crucial factor in explaining the price momentum anomaly in many developed markets. Since we cannot establish a decent relation between the earnings momentum phenomenon and macroeconomic risks we suspect a behavioral-based explanation to be at work. Narrowing the search for such a behavioral explanation we provide evidence that the anomaly is most likely not related to dispersion in analysts' earnings forecast.

S&P Global Index Review

2008-02-29T02:07:00.000-08:00

S&P Global Index Review

The Global Index Review is designed for money managers and derivative traders to help them assess the performance and correlations of the S&P indices against other popular indices. Published quarterly, the Global Index Review provides a graphic summary of each Standard & Poor’s equity index and compares performance, where appropriate, against other leading indices around the world. It includes data and comparative analysis on the S&P Global 1200, S&P/Citigroup Indices, regional components, as well as sector, style and domestic indices with indices from MSCI, FTSE, Russell, Wilshire, Dow Jones STOXX, and Nikkei. The Global Index Review offers comparative performance, portfolio characteristics, sector weights, tracking statistics and correlations. For easy referencing, this publication is broken into regional chapters
including:

- Global Indices
- U.S. Indices
- European Indices
- Japanese Indices
- Canadian Indices
- Australian Indices
- Asia and Latin America
- Alternative Indices

S&P Alternate Assets Report

2008-02-29T02:00:00.001-08:00

S&P Alternate Assets Report

The quarterly S&P Global Alternative Assets Report provides institutional investors with comprehensive performance analysis across a number of alternative asset classes.

Global alternative assets included in this issue:

S&P Listed Private Equity
S&P Global Infrastructure
S&P MLP
S&P U.S. Preferred Stock
S&P/TSX Preferred Share
S&P Global Timber & Forestry
S&P Select Frontier
S&P Global Property 40

Performance of Canadian E-REITs

2008-02-17T05:06:00.000-08:00

Performance of Canadian E-REITs

Lawrence Kryzanowski
Finance Department, John Molson School of Business, Concordia University,
1455 de Maisonneuve Blvd. West, Montreal, Quebec, Canada, H3G 1M8
E-mail: lkryzan@alcor.concordia.ca.
Margarita Tcherednitchenko
Finance Department, John Molson School of Business, Concordia University,
1455 de Maisonneuve Blvd. West, Montreal, Quebec, Canada, H3G 1M8
E-mail: cheritka@yahoo.com

INTERNATIONAL REAL ESTATE REVIEW
2007 Vol. 10 No. 2: pp. 1 - 22

The return performance and factor sensitivities of Canadian equity real estate investment trusts (E-REITs) are examined. Today, typical and average Canadian E-REIT IPOs are correctly priced based on first-day and subsequent short-run returns. The overpricing evident earlier in the 1993-96 period for typical and average E-REIT IPOs has corrected. E-REITs are equity investments with about one-half the market risk, and greater sensitivity to interest-rate changes, than the S&P/TSX Composite Index. E-REITs outperformed the S&P/TSX Composite over the 1996-2004 period on a return, risk, and market- and/or risk-adjusted basis. Thus, E-REITs provided material diversification benefits with no sacrifice in return, when added to a common stock portfolio during the studied period.

Does the Composition of the Market Portfolio Matter for Performance Rankings of Post-1986 Equity REITs?

2008-02-17T04:56:00.000-08:00

Does the Composition of the Market Portfolio Matter for Performance Rankings of Post-1986 Equity REITs?

Justin D. Benefield, Randy I. Anderson , Leonard V. Zumpano, Journal of Real Estate Portfolio Management, Volume 13, no. 3.

Executive Summary. Real estate investment trust (REIT) research indicates that performance rankings do not differ between market proxies containing real estate and the Standard and Poor’s 500, while mutual fund research shows that the proxy chosen significantly impacts performance rankings. Previous REIT performance ranking studies used rather obscure market indices, and only included time periods prior to the Tax Reform Act of 1986. Common market proxies are used to address whether the proxy chosen matters in REIT performance studies. Performance rankings utilize standard singlefactor methodologies and, where possible, their multifactor equivalents. Across all comparisons, results indicate that performance rankings of post-1986 equity REITs are insensitive to the market proxy chosen.

Do REITs Behave More Like Real Estate Now?

2008-02-14T22:12:00.000-08:00

Do REITs Behave More Like Real Estate Now?

Tsai, I-Chun, Chen, Ming-Chi and Sing, Tien Foo, (November 2007)

Abstract
This paper applies the Time Varying Coefficient (TVC) approach to examine the systematic risks of the National Association of Real Estate Investment Trusts (NAREIT) return index using the Capital Asset Pricing Model (CAPM) framework. We found that the systematic risk of Real Estate Investment Trusts (REITs) is time varying with the REIT-beta declining over time. The declining beta reflects the greater acceptance of REITs as an important asset class in investors' portfolios. Investors would accept a lower risk premium because investors are better able to price the underlying assets the longer REIT assets are securitized. The results support the view that the real estate securities behave more like real estate and less like the general stock market.

Private Equity and Strategic Asset Allocation

2008-02-12T10:01:00.000-08:00

Private Equity and Strategic Asset Allocation

Tom Idzorek, CFA, V.P., Director of Research & Product Development, Ibbotsen, October 31, 2007

Executive Summary

This paper studies the role of U.S. Private Equity and Non-U.S. Private Equity in a strategic asset allocation. There is relatively little guidance in the literature on how much investors should allocate to private equity in a strategic asset allocation setting because of 1) confusion between the private equity asset class and private equity funds and 2) considerable debate over historical returns. Private equity is both an asset class and an investment strategy. Distinguishing between the private equity asset class and the private equity investment strategy can be confusing and creates challenges for asset allocators. Ideally, one could invest in a basket of all private corporations in which the weights of the companies in the basket are based on their true values. Such a basket would be a true representation of the private equity asset class. When investors make an allocation to private equity, it is not a passive investment in the basket of all private companies that form the private equity asset class. Rather, for most investors, the allocation to private equity is an investment in a skill-based strategy in which the two primary sub-strategies are leveraged buyouts and venture capital. The fragmented structure of the private equity market is such that private equity investors cannot fully-diversify away from private company specific risk; thus, all private equity investments are a mixture of systematic risk exposure to the private equity asset class and to private company specific risk. Securitization is changing the private equity asset class and, over time, what was once an alpha strategy will become a traditional beta asset class. In this paper, we use two new indices to proxy the private
equity asset class – the Red Rocks Listed Private Equity IndexSM (LPE IndexSM) for U.S. private equity and the Red Rocks International Listed Private Equity IndexSM (International LPE IndexSM) for non-U.S. private equity. The listed private equity indices may more accurately reflect the performance characteristics, especially the volatility, of the private equity asset class than appraisal-based private equity indices. In a series of historical optimizations, we find that including U.S. Private Equity in the opportunity set would have dramatically improved the risk and return characteristics over the past 10 year period. From the beginning of 1997 to the end of 2006, U.S. Private Equity and Non-U.S. Private Equity were the best performing asset classes in our opportunity set, although the performance of the private equity proxies appears to be highly sensitive to the weighting scheme of the proxies. This sensitivity highlights that all private equity investments still contain a high level of specific risk. Over time, we think securitization will reduce the amount of specific risk associated with private equity portfolios. In a forward-looking optimization using a set of returns based on a global implementation of the CAPM, the asset allocations with a standard deviation below 19% were only slightly improved by including private equity in the opportunity set. The benefit of including private equity in the opportunity set is most significant for higher risk, equity-centric asset allocations. Finally, listed private equity will make it possible to apply tactical asset allocations to the asset class.

Portfolio Construction for Taxable Investors

2008-02-06T20:48:00.000-08:00

Portfolio Construction for Taxable Investors

Scott J. Donaldson, CFA,CFP, and Frank A. Ambrosio, CFA, Vanguard Investment Counseling & Research (2007)

Executive summary. Most investment portfolios are designed to meet a specific future financial need—either a single goal or a multifaceted set of objectives. To reach those goals and objectives, a disciplined method of portfolio construction must be established that balances the potential risks and returns of various types of investments. This paper reviews various aspects of our research involving five major investment decisions that need to be made, in successive order, in the portfolio construction process. The decisions are:

Asset allocation—Choosing asset-class weights: equities, fixed income, cash, and so on.

Sub-asset allocation—Choosing investments within an asset class, such as U.S. or international equities; or large-, mid-, or small-capitalization equities.

Active and/or passive allocations—Choosing indexed and/or actively managed assets.

Asset location—Deciding on the placement of investments in taxable and/or tax-advantaged accounts.

Manager selection—Choosing individual managers, funds, or securities to fill allocations.

The top-down order in which these decisions are made is important in establishing a well-constructed portfolio. Many investors use a bottom-up approach, placing more emphasis on manager/security selection or sub-asset allocation (based on an investment’s recent returns) than on asset allocation, the most important portfolio decision. However, in using a bottom-up approach, the selection of the investments—potentially the more uncertain part of portfolio construction—would then determine the more important part—the overall asset allocation. After deciding the asset allocation of the portfolio, it is important to keep in mind that broad diversification, with exposure to all parts of the stock and bond markets, is a powerful strategy for managing portfolio risk. Diversification across asset classes reduces a portfolio’s exposure to the risks common to an entire asset class. Diversification within asset classes reduces a portfolio’s exposure to the risks associated with a particular company, sector, or market. This diversification can be achieved through index and/or actively managed investment strategies. The decision to purchase certain investments within either tax-advantaged and/or taxable accounts, known as asset location, is a valuable tool to increase potential after-tax returns. This can be achieved by placing tax efficient assets in taxable accounts and tax inefficient assets in tax-advantaged accounts. Selecting specific investments to represent the various market segments should come last. A common error in portfolio construction is that of choosing specific investments that may appear to be worthwhile individually, but make little sense when combined in a portfolio. In the end, this collection of investments does not necessarily form a coherent asset allocation or sub-asset allocation that matches the investor’s objectives and risk tolerance.

Economic Integration and Mature Portfolios

2008-02-06T09:02:00.000-08:00

Economic Integration and Mature Portfolios

Christelis, Dimitris, Georgarakos, Dimitris and Haliassos, Michael, (January 31, 2008). Center for Financial Studies, Forthcoming

Abstract:
This paper documents and studies sources of international differences in participation and holdings in stocks, private businesses, and homes among households aged 50 in the US, England, and eleven continental European countries, using new internationally comparable, household-level data. With greater integration of asset and labor markets and policies, households of given characteristics should be holding more similar portfolios for old age. We decompose observed differences across the Atlantic, within the US, and within Europe into those arising from differences: a) in the distribution of characteristics and b) in the influence of given characteristics. We find that US households are generally more likely to own these assets than their European counterparts. However, European asset owners tend to hold smaller real, PPP-adjusted amounts in stocks and larger in private businesses and primary residence than US owners at comparable points in the distribution of holdings, even controlling for differences in configuration of characteristics. Differences in characteristics often play minimal or no role. Differences in market conditions are much more pronounced among European countries than among US regions, suggesting significant potential for further integration.

Do Reits Outperform Stocks and Fixed-Income Assets? New Evidence from Mean-Variance and Stochastic Dominance Approaches

2008-01-08T02:48:00.000-08:00

Do Reits Outperform Stocks and Fixed-Income Assets? New Evidence from Mean-Variance and Stochastic Dominance Approaches

Chiang, Thomas Chinan, Lean, Hooi Hooi and Wong, Wing-Keung, (June 1, 2007)

Abstract:
This paper re-examines the performance of REITs, stocks, and fixed-income assets based on the preferences of risk-averse and risk-seeking investors using mean-variance and stochastic dominance approaches. Our findings indicate no first-order stochastic dominance and no arbitrage opportunity among these assets. However, our stochastic dominance results reveal that in order to maximize their expected utility, the risk-averse prefer fixed-income assets over real estate, which, in turn, is preferable to stocks. On the other hand, to maximize their expected utility, all risk-seeking investors would prefer to invest in stocks than in real estate, but real estate, in turn,is preferable to fixed-income assets.

Opportunistic Rebalancing: A New Paradigm for Wealth Managers

2008-01-03T20:21:00.000-08:00

Opportunistic Rebalancing: A New Paradigm for Wealth Managers

Gobind Daryanani CFP®, Ph.D., FPA Journal (January, 2008)

Executive Summary
Wealth managers traditionally rebalance portfolios quarterly or annually to control risk due to asset class drifts. This paper proposes a new paradigm for planners: rebalance less frequently, but look more frequently to find the best opportunities for rebalancing.
The proposed approach, called opportunistic rebalancing, not only controls portfolio drift, but also provides significant return improvements by capturing buy-low/sell-high opportunities as asset classes sporadically drift relative to each other.
The paper studies a wide range of market conditions to show that rebalancing return benefits can be more than doubled compared with the traditional annual rebalancing.
These additional benefits, attributed to transient momentum and mean reversion effects, occur sporadically in time and can only be captured by monitoring portfolios frequently.
The studies suggest these practical guidelines: (1) use wider rebalance bands, (2) evaluate client portfolios biweekly, (3) only rebalance asset classes that are out of balance—not classes that are in balance, and (4) increase the number of uncorrelated classes used in portfolios.
The studies show that trading costs and tax deferral are small compared with rebalance benefits.
Opportunistic rebalancing has already been adopted by a number of leading wealth management firms across the country.

The theory and implications of expanding traditional portfolios

2007-12-22T15:46:00.000-08:00

The theory and implications of expanding traditional portfolios

Vanguard Investment Counseling & Research, 12/20/2007

Executive summary. Traditionally, investors have focused on portfolios consisting of the three primary asset classes—stocks, bonds, and cash. More recently, many investors have been considering expanding their traditional portfolios, as a result of three forces: the 2000–2002 bear market in equities, the widely held view that traditional assets will produce lower returns in the near future, and a growing push to diversify across asset classes and strategies. Many financial models often recommend allocations to non-traditional asset classes and strategies that have a low historical correlation to stocks, bonds, and cash. However, when exploring the implications of expanding a traditional portfolio, investors often overlook the challenges of implementing the recommended changes. We discuss why an investor may consider expanding a traditional portfolio, and we show that including non-traditional asset classes and strategies can work. We also discuss implementation risks for non-traditional asset classes and strategies, and offer some best practices for investors.

Middle East and North Africa Markets: Investment Challenges and Market Structure

2007-12-20T01:23:00.000-08:00

Middle East and North Africa Markets: Investment Challenges and Market Structure

Zaher, Tarek S., (November 1, 2007). Networks Financial Institute Working Paper No. 2007-WP-30

Abstract

This paper highlights the major developments and structural changes in the Middle East and North Africa (MENA) markets. Noticeable growth was observed in these markets during the last decade. This is evidenced from the record growth rates in market capitalization, number of listed companies, value traded and shares traded in most of the MENA capital markets. Stock market boom was also observed, by the end of 2005, in many of the MENA countries. This was followed by a major correction (crash) in these MENA countries. To support the growth in capital markets and attract more local and foreign investors, MENA markets would need continue to incorporate changes to procedures, laws and the professional infrastructure within the financial market and better dissemination of information. Compliance with international and regional laws is also essential for a healthy development.

The paper also examines the evidence underlying the notion that there is increased integration of MENA and developed country financial markets and that MENA market equities do not represent a separate asset class. We analyze the correlation structures among individual country equity markets and efficient frontiers over two sub periods. We also analyze the structure of the correlations among political risk indicators for a similar group of countries over similar time periods. The results of the study suggest that capital market integration has accelerated in recent years, both economically and politically, but only for three countries in the MENA region. We therefore conclude that the MENA market countries should continue to be viewed as separate asset class from developed countries. These markets seem to be highly segmented and provide great diversification potentials to global investors.

International Stock Market Correlations: A Sectoral Approach

2007-12-13T23:12:00.000-08:00

International Stock Market Correlations: A Sectoral Approach

Fasnacht, Philipp and Louberge, Henri, (December 2007). Paris December 2007 Finance International Meeting AFFI-EUROFIDA

Abstract:

A lot of studies dealing with international correlations look only at correlations at the market level and often use its time-varying nature as motivation for their work. However, why and how market correlations change is a point that is still not very well understood. As the market is composed of different sectors, we propose to look into this question by studying the behavior of equity correlations at the sectoral level. We show how sectoral correlation coefficients determine the market correlation coefficient and decompose the latter into two parts; one that represents country factors and one that represents industry factors. This decomposition allows us to get a clear idea on how and why market correlations change over time. We also get some interesting insights such as market level correlations are higher on average than sectoral correlations as well as that sectoral correlations between countries tend to do be more stable over time than market level correlations and sectoral correlations within countries. Finally, we present evidence that a few sector correlations related to Financial, Industrial and Consumer Services segments drive the evolution of the market level correlation.

Mortgage Backed Securities

2007-12-12T00:15:00.000-08:00

Solving The Mortgage Mystery by Barclays Global Investors, Investment Insights, 11.05

Mortgage-backed securities represent a major segment of the investment-grade fixed income universe in the United States and, therefore, a considerable portion of most investors’ fixed income portfolios. Despite their significant role in institutional portfolios, the complexities of mortgages have made it difficult for many investors to fully understand the idiosyncrasies associated with this asset class.
This paper sets out to help investors gain a better understanding of mortgages so they can effectively manage value and risk within the asset class and separate beta risk from alpha opportunities.

Analysis of Mortgage Backed Securities by Stein, Harvey J., Belikoff, Alexander L., Levin, Kirill and Tian, Xusheng, (January 5, 2007).

Valuation of mortgage backed securities (MBSs) and collateralized mortgage obligations (CMOs) is the big science of the financial world. There are many moving parts, each one drawing on expertise in a different field. Prepayment modeling draws on statistical modeling of economic behavior. Data selection draws on risk analysis. Interest rate modeling draws on classic arbitrage pricing theory applied to the fixed income market. Index projection draws on statistical analysis. Making the Monte Carlo analysis tractable requires working with numerical methods and investigation of a variety of variance reduction techniques. Tractability also requires parallelization, which draws on computer science in building computation clusters and analysis and optimization of parallel algorithms.

Here we detail the different components, describing the approach we have taken at Bloomberg in each area. Our particular emphasis is on the new interest rate modeling component we introduced for computing OAS, and the methods used to calibrate it accurately. We discuss the methods used to enable real time analysis of CMOs, analyzing the impact of various Monte Carlo variance reduction techniques as well as the technology used for parallelization of the computations. We also detail the validation of these components, showing that everything works well together, and yields good MBS and CMO valuation.

How Resilient are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions? by Mason, Joseph R. and Rosner, Josh, (February 13, 2007)

The mortgage-backed securities (MBS) market has experienced significant changes over the past couple of years. Non-agency ("private label") securities, which are not guaranteed by the government or the government sponsored enterprises, now account for the majority of MBS issued. In this report, we review the rise of collateralized debt obligations (CDOs), the relaxation of lending standards, and the implementation of loan mitigation practices. We analyze whether these structural changes have created an environment of understated risk to investors of MBS. We also measure the efficacy of ratings agencies when it comes to assessing market risk rather than credit risk. Our findings imply that even investment grade rated CDOs will experience significant losses if home prices depreciate. We conclude by providing several policy implications of our findings.

Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions by Mason, Joseph R. and Rosner, Josh, (May 3, 2007)

Many of the current difficulties in residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) can be attributed to a misapplication of agency ratings. Changes in mortgage origination and servicing make it difficult to evaluate the risk of RMBS and CDOs. We show that the big three ratings agencies are often confronted with an array of conflicting incentives, which can affect choices in subjective measurements of risk. Of even greater concern, however, is the fact that the process of creating RMBS and CDOs requires the ratings agencies to arguably become part of the underwriting team, leading to legal risks and even more conflicts. We analyze the fundamental differences between rating structured finance products like RMBS and CDOs and traditional products like corporate debt. We show that the inefficiencies of rating RMBS and CDOs are leading investors to discount U.S. markets. We conclude by providing several policy implications of our findings.

Dynamic Allocation Strategies for Distribution Portfolios: Determining the Optimal Distribution Glide Path

2007-12-03T20:09:00.000-08:00

Dynamic Allocation Strategies for Distribution Portfolios: Determining the Optimal Distribution Glide Path
by David M. Blanchett, CFP®, CLU, AIFA®, QPA, CFA (JFP, December 2007)

Executive Summary
The purpose of this paper is to determine the optimal allocation strategy (referred to as the distribution glide path) for a portfolio subject to withdrawals. But unlike most previous research, which uses static allocations, the paper includes a dynamic allocation methodology. It also introduces a methodology to incorporate risk into the decision process.
Using historical data from four asset categories from 1927 to 2006, 43 different distribution glide paths were considered for 21 different time periods and 51 different real withdrawal rates.
Despite the expected benefits of more sophisticated dynamic distribution allocation strategies, static equity allocations proved to be remarkably efficient.
The most optimal glide path from a pure probability-of-success perspective was the 100/0 (100 percent equity and 0 percent fixed income/cash) static allocation portfolio. But due to the underlying variability of a 100/0 portfolio, it is unlikely that this allocation will be appropriate for most retirees.
The absolute differences in the probability of failure among glide paths for shorter distribution periods and lower real withdrawal rates (less aggressive scenarios) were minor. The absolute differences for longer distribution periods and higher real withdrawal rates (more aggressive scenarios) were considerable.
The paper introduces a risk-adjusted measure called the Success to Variability ratio in order to incorporate portfolio variability (standard deviation) into the optimal glide path decision process.
When considering a variety of distribution periods and real withdrawal rates, as well as the probability of failure and the Success to Variability ratio, a balanced static allocation, such as 60 percent equity and 40 percent fixed income/cash, is likely one of the most efficient portfolio allocations for retirees.

The Risk/Return Benefits of Shorter-Term, High Quality Bonds

2007-11-03T10:30:00.000-07:00

The Risk/Return Benefits of Shorter-Term, High-Quality Bonds

Alejandro Murguía, Ph.D., and Dean T. Umemoto, CFP

Executive Summary
Fixed-income instruments are largely used within a portfolio to reduce volatility and provide a more consistent distribution stream for clients. Holding non-callable instruments backed by the U.S. government offer significant protection in times of financial crisis while reducing the long-term opportunity cost of bonds.
U.S. government instruments with maturities from one to five years present the most favorable risk/reward profile. Additionally, the term premiums for extending maturities begin to decline for longer-term bonds.
Mutual fund managers among the high-quality short-term (HS) and high-quality intermediate-term (HI) bond funds underperformed their corresponding government indexes and index funds over an entire decade. The average top quartile fixed-income managers in the HS and HI classes also underperformed their corresponding index funds.
We analyzed the credit composition of the ten top-performing actively managed portfolios across the HS and HI mutual funds. Much of the value-added returns from these actively managed portfolios seem to stem from additional credit and call-option risk.
There seems to be a direct inverse relationship between investment performance and fund expenses. The higher the investment return, the lower the fund expense ratio. Differences in expense ratios explain much of the differences in net returns.
Further analysis of the top performing funds reveals that non-active strategies such as an indexing or variable maturity approach may be an investor's best option.

What Professionals Must Know to Tax-Manage Bonds

2007-11-03T10:06:00.000-07:00

What Professionals Must Know to Tax-Manage Bonds

Ravi Agrawal, AAMS

Executive Summary
Bond tax swaps can be an effective way of enhancing returns over a buy-and-hold strategy, but a comprehensive understanding of newer tax laws is essential to the outcome.
Harvesting the capital gains of bonds has a high success rate, while harvesting the losses has a moderate success rate. Gain harvesting works best when interest rates have fallen sharply, the remaining maturities are short to intermediate, the premiums are high, and the issues are taxable. Loss harvesting is more successful when interest rates have risen sharply, the remaining maturities are long, the discounts are large, and the issues are municipals.
Higher income tax rates and lower capital gains rates favor gain harvesting and diminish the benefits of loss harvesting.
Harvesting capital losses is a common practice when interest rates rise. But this technique can be counterproductive, especially with shorter maturities, as additional taxes are often payable following a tax swap.
The method of accounting for premiums and discounts is also important to success. Premiums of taxable bonds should be amortized annually and deducted against interest. Market discounts that are taxed are better deferred until maturity.
Unbeknownst to some, all bonds bought at market discounts to issue price owe ordinary income taxes, even municipals.
Under optimum accounting methods, discount taxable bonds have an after-tax edge over premium taxable bonds, and premium tax-exempt bonds have an edge over discount tax-exempt bonds.

Reverse Asset Allocation: Alternatives At The Core,

2007-10-22T22:15:00.000-07:00

Reverse Asset Allocation: Alternatives At The Core

By P. Brett Hammond

INTRODUCTION
Institutional investors have shown an increasing interest in alternative asset classes—including private equity, venture capital, real estate, commodities, hedge funds, and others—due to their strong performance and low correlations with traditional assets. In addition, diminished expectations for returns from traditional assets have made alternative assets even more attractive. The inclusion of alternatives in formal asset allocation models, however, can make these models highly sensitive to small changes in a portfolio’s allocations. Moreover, because most alternatives do not have long track records, some institutions may be unsure how to predict the risk/return behavior of these investments in a traditional asset allocation model. A new approach—“reverse asset allocation”—addresses these challenges by taking into account the special characteristics of alternative assets. Unlike traditional asset allocation, which, to produce the bulk of overall return, puts equities at the core of the portfolio and then, to limit risk and improve efficiency, adds bonds plus alternatives, reverse asset allocation does the opposite. It begins by finding the expected return from a desired allocation to a core group of alternative assets, and then adds bonds and equities as the completion elements, to achieve the overall desired portfolio characteristics. The rationale for reversing the usual approach is based on the notion that alternatives offer an opportunity to obtain asset-based return alpha with low correlation to traditional asset classes while limiting risk.

A Closer Look at Stable Value Funds Performance

2007-10-14T20:06:00.000-07:00

A Closer Look At Stable Value Funds Performance

Babbel, David F. and Herce, Miguel,(September 18, 2007). Wharton Financial Institutions Center Working Paper #07-21

Abstract
There exists a paucity of academic literature on stable value (SV) funds, although a growing volume of industry and practitioner literature has provided an in-depth look at how the funds are managed and the guarantees secured. To date, no rigorous analysis has been published on the performance of stable value funds from the investor's point of view. In this study, we provide what we understand to be the first published analysis of the performance of stable value funds

The Stock–REIT Relationship and Optimal Asset Allocations

2007-10-12T01:21:00.000-07:00

The Stock–REIT Relationship and Optimal Asset Allocations

Doug Waggle, and Pankaj Agrrawal, Journal of Real Estate Portfolio Management, (Volume 12, Number 3, 2006)

Executive Summary.

In this paper, the marginal effects of changes (due to non-stationarity or estimation errors) in the REIT-stock risk premium and the REIT-stock correlation on the optimal portfolio asset mix of REITs, stocks, and bonds are determined. Employing a meanvariance utility function and considering different levels of investor risk aversion, the findings reveal that the expected return of REITs, relative to that of stocks, is a much more important factor than the REIT-stock correlation in making portfolio decisions. A 1% change in the forecast return for REITs dramatically impacts optimal portfolio allocations for investors of all risk levels. A significant change of 0.1 in the REIT-stock correlation, on the other hand, has only minimal impact on optimal portfolio weights.

Securitized Real Estate and its Link With Financial Assets and Real Estate: An International Analysis

Hoesli, Martin and Serrano Moreno, Camilo, (April 2006)

Abstract:

This paper provides cross-country evidence of the link between securitized real estate and stocks, bonds, and direct real estate. First, we investigate the behavior of betas in 16 countries and identify the causes of their variation. Second, securitized real estate returns are regressed on "pure" stock, bond and real estate factors. The betas are generally found to decrease over the 1990-2004 period, but the causes for such decline differ across countries. Securitized real estate returns are found to be positively associated with stock and direct real estate returns, but negatively related to bond returns. Financial assets contribute greatly to the variance of securitized real estate, while the impact of direct real estate is limited. However, a large fraction of the variance is not accounted for by these factors, especially in the U.S., suggesting that other factors are at play.

Rebalancing for Taxable Accounts

2007-10-08T22:56:00.000-07:00

Rebalancing for Taxable Accounts

Mark W. Riepe, CFA, and Bill Swerbenski, CFA (JFP Journal, April 2007)

Tips When Rebalancing in a Taxable Account
1. Exert more care when rebalancing in taxable accounts.
2. Avoid generating rebalancing trades by directing new money into underweighted asset classes.
3. When sensible, execute trades to generate tax losses that can then be used to offset any capital gains generated by
rebalancing trades.
4. Be patient and wait until eligible for long-term capital gains treatment.
5. If taxable and tax-deferred accounts are both allocated toward the same goal, have the tax-deferred account bear as much of the
rebalancing load as possible.

Is Rebalancing a Portfolio During Retirement Necessary?

2007-10-08T22:44:00.000-07:00

Is Rebalancing a Portfolio During Retirement Necessary?

John J. Spitzer, Ph.D., and Sandeep Singh, Ph.D., CFA, (JFP Journal, June 2007)

This paper investigates the strategy of rebalancing the retirement portfolio during the withdrawal phase.The goal is to provide the largest number of equal (real) withdrawals from a given retirement portfolio.
The study investigates six different allocations of stock and five different harvesting rules, only one of which rebalances the portfolio annually.The methods are tested using five different withdrawals rates (3–7 percent).The results look at shortfalls over 30 years, as well as shorter periods.
The study uses two analysis methods: bootstrap and historical inflation adjusted rates of return in their true temporal order. Both methods find that rebalancing provides no significant protection on portfolio longevity, and this holds for all withdrawal periods. In fact, in some cases, rebalancing increases the number of shortfalls.
Withdrawing bonds first, over stocks, performs the best of all the methods, though the resulting stock-heavy portfolio may make some investors uneasy. This method also is most apt to leave a larger remaining balance at the end of 30 years, while rebalancing leaves the smallest amount.
Withdrawing stocks first leaves more shortfalls than withdrawing low first or high first.
Confirming previous research, the larger the proportion of stocks to bonds, the longer the portfolio lasts; the higher the withdrawal rate, the more shortfalls.
The results suggest that the use of lifecycle funds or a life-cycle strategy that decreases stock proportions as one grows older needs empirical justification.

The Economics of Private Equity Funds

2007-09-20T20:50:00.000-07:00

The Economics of Private Equity Funds

Metrick, Andrew and Yasuda, Ayako, (September 9, 2007)

Abstract:

This paper analyzes the economics of the private equity industry using a novel model and dataset. We obtain data from a large investor in private equity funds, with detailed records on 238 funds raised between 1992 and 2006. Fund managers earn revenue from a variety of fees and profit-sharing rules. We build a model to estimate the expected revenue to managers as a function of these rules, and we test how this estimated revenue varies across the characteristics of our sample funds. Among our sample funds, about 60 percent of expected revenue comes from fixed-revenue components which are not sensitive to performance. We find major differences between venture capital (VC) funds and buyout (BO) funds – the two main sectors of the private equity industry. In general, BO fund managers earn lower revenue per managed dollar than do managers of VC funds, but nevertheless these BO managers earn substantially higher revenue per partner and per professional than do VC managers. Furthermore, BO managers build on their prior experience by raising larger funds, which leads to significantly higher revenue per partner and per professional, despite the fact that these larger funds have lower revenue per dollar. Conversely, while prior experience by VC managers does lead to higher revenue per partner in later funds, it does not lead to higher revenue per professional. Taken together, these results suggest that the BO business is more scalable than the VC business

Factor Funds, Mean-Variance Efficiency, and the Gains From International Diversification

2007-09-19T09:06:00.000-07:00

Factor Funds, Mean-Variance Efficiency, and the Gains From International Diversification

Eun, Cheol S., Lai, Sandy and Zhang, Zhe, (August 2007)

Abstract:

We propose a new investment strategy employing “factor funds” to systematically enhance the mean-variance efficiency of international diversification. Our approach is motivated by evidence from the empirical asset pricing literature and the direct link between factor-based asset pricing tests and investors' portfolio allocation problem. The success of size (SMB), book-to-market (HML), and momentum (MOM) factors in explaining stock returns and the country-specific properties of these factors imply that international factor funds can significantly enhance portfolio efficiency beyond what can be achieved by country market indices alone. Using data from ten developed countries over 1981-2004, we show that the Sharpe ratio of the “augmented” optimal portfolio involving international factor funds (0.76) far exceeds that of the “benchmark” optimal portfolio comprising country market indices only (0.19), strongly rejecting the intersection hypothesis which posits that the international factor funds do not span investment opportunities beyond what country market indices do. Among the three classes of factor funds, HML funds contribute most to the efficiency gains. The added gains from international factor diversification are significant for both in- and out-of-sample periods, and for a realistic range of additional investment costs for factor funds, and remain robust over time

This post has been added to Asset Class Reader: International Stocks

Asset Class Correlation

2007-09-03T15:58:00.000-07:00

Two papers in this ongoing series of studies on asset class correlation are available at the FPA Journal:

The Volatility of Correlation: Important Implications for the Asset Allocation Decision

William J. Coaker II, senior investment officer of equities for the San Francisco City-County Employees Retirement System.

Executive Summary

* The severity of how much correlation changes, even over longer periods of time, has not been adequately understood.

* This paper analyzes the changing correlation of 15 asset classes measured against the S&P 500 over a 35-year period, and the impact of those changes on asset allocation decisions. It measures the correlations in rolling one-, three-, five-, and ten-year time series, from 1970 to 2004.

* The article also evaluates whether 15 asset classes have helped or hurt in years the S&P 500 has declined, and whether growth or value styles are more correlated to the index.

* The average variance in correlation measured 0.98 over one year and 0.25 over ten years. In short, the relationship among many of the asset classes appears to be inherently unstable.

* Large value provides more diversification benefits than large growth, and small value provides more diversification than small blend or small growth. Emerging markets may provide higher returns and greater diversification than developed nations. But the low correlations of small value and real estate may not hold up during the next broad market decline.

* Correlations exhibit uniqueness, meaning periods are distinct from previous time periods. For example, international stocks' correlation to the S&P 500 was 0.48 from 1970 to 1997, but 0.83 from 1998 to 2002.

* Rather than rely on historical correlations, a more comprehensive and dynamic approach is needed in making asset allocation decisions.

Emphasizing Low-Correlated Assets: The Volatility of Correlation

William J. Coaker II, senior investment officer of equities for the San Francisco City-County Employees Retirement System.

Executive Summary

• The fact that correlations change is well known. But the severity of change, and which relationships are subject to change, needs to be better understood because it has important implications for containing risk.

• This study evaluates the volatility of correlation among 18 asset classes to each other to determine the consistency or inconsistency of relationships. It provides not only the long-term correlations of the assets, but the standard deviation of correlation and the range of correlations based on two standard deviations from the average correlation. It also summarizes the correlations in a probability distribution.

• In the asset allocation process, some assets often are used together even though diversification benefits have been very low. For example, the correlations of the S&P 500 to large growth, mid-blend to mid-growth, small blend to small growth, and large value to mid-value, have been very strong.

• Several assets often are neglected in the asset allocation decision, even though their diversification benefits have been very high. Natural resources, global bonds, and long-short, for example, stand out as having consistently low correlations to all the other assets in this study.

• Growth and blend styles are highly correlated, and using them together does little to reduce risk.

• Real estate, high-yield bonds, U.S. bonds, and long-short are more closely linked to value investing than growth. Emerging markets are somewhat more connected to growth than value.

• The asset allocation decision should emphasize low-correlated assets that satisfy return objectives.Two sample portfolios for different style investors show how risk and return are improved by combining lower-correlated assets.

Securitization: The Tool of Financial Transformation

2007-08-29T07:54:00.000-07:00

Two papers on Securitization and Collateralized Debt Obligations:

Securitization: The Tool of Financial Transformation

Fabozzi, Frank J. and Kothari, Vinod, Yale ICF Working Paper No. 07-07

Abstract:

Securitization as a financial instrument has had an extremely significant impact on the world's financial system. First, by integrating capital markets and the uses of resources - such as mortgage originators, finance companies, governments, etc. - it has strengthened the trend towards disintermediation. Having been able to mitigate agency costs, it has made lending more efficient; evidence of this can be observed in the mortgage markets. By permitting firms to originate and hold assets off the balance sheet, it has generated much higher levels of leverage and, though arguably, greater economies of scale. Combination of securitization techniques with credit derivatives and risk transfer devices continues to develop innovative methods of transforming risk into a commodity and allow various market participants to tap into sectors which were otherwise not open to them.

In its broadest sense, the term "securitization" implies a process by which a financial relationship is converted into a transaction. A financial transaction is the coming together of two or more entities; a financial relationship is their staying together. For example, a loan to a corporation is a financial relationship; once the loan is transformed into a tradable bond, it is a transaction. We find several examples in the history of the evolution of finance of relationships that have been converted into transactions. The creation of "stock," representing ownership in a corporation, is one of the earliest and most important examples of this process because of its impact on the growth of the corporate form of business organization. The process of converting loans to corporations of high credit quality corporate borrowers, and in the 1970s expanding that opportunity to speculative-grade corporate borrowers, into publicly traded bonds is another example of this. Commercial paper is another example of securitization of relationships as it securitizes a trade debt

Collateralized Debt Obligations and Credit Risk Transfer

Lucas, Douglas J., Goodman, Laurie and Fabozzi, Frank J., . Yale ICF Working Paper No. 07-06

Abstract:
Several studies have reported how new credit risk transfer vehicles have made it easier to reallocate large amounts of credit risk from the financial sector to the non-financial sector of the capital markets. In this article, we describe one of these new credit risk transfer vehicles, the collateralized debt obligation. Synthetic credit debt obligations utilize credit default swaps, another relatively new credit risk transfer vehicle.

Financial institutions face five major risks: credit, interest rate, price, currency, and liquidity. The development of the derivatives markets prior to 1990 provided financial institutions with efficient vehicles for the transfer of interest rate, price, and currency risks, as well as enhancing the liquidity of the underlying assets. However, it is only in recent years that the market for the efficient transfer of credit risk has developed. Credit risk is the risk that a debt instrument will decline in value as a result of the borrower's inability (real or perceived) to satisfy the contractual terms of its borrowing arrangement. In the case of corporate debt obligations, credit risk encompasses default, credit spread, and rating downgrade risks.

The most obvious way for a financial institution to transfer the credit risk of a loan it has originated is to sell it to another party. Loan covenants typically require that the obligor be informed of the sale. The drawback of a sale in the case of corporate loans is the potential impairment of the originating financial institution's relationship with the obligor of the loan sold. Syndicated loans overcome the drawback of an outright sale because banks in the syndicate may sell their loan shares in the secondary market. The sale may be through an assignment or through participation. While the former mechanism for a syndicated loan requires the approval of the obligor, the latter does not since the payments are merely passed through to the purchaser and therefore the obligor need not know about the sale.

Another form of credit risk transfer (CRT) vehicle developed in the 1980s is securitization [Fabozzi and Kothari (2007)]. In a securitization, a financial institution that originates loans pools them and sells them to a special purpose entity (SPE). The SPE obtains funds to acquire the pool of loans by issuing securities. Payment of interest and principal on the securities issued by the SPE is obtained from the cash flow of the pool of loans. While the financial institution employing securitization retains some of the credit risk associated with the pool of loans, the majority of the credit risk is transferred to the holders of the securities issued by the SPE.

Two recent developments for transferring credit risk are credit derivatives and collateralized debt obligations (CDOs). For financial institutions, credit derivatives allow the transfer of credit risk to another party without the sale of the loan. A CDO is an application of the securitization technology. With the development of the credit derivatives market, CDOs can be created without the actual sale of a pool of loans to an SPE using credit derivatives. CDOs created using credit derivatives are referred to as synthetic CDOs.

In this article, we discuss CDOs. We begin with the basics of CDOs and then discuss synthetic CDOs. The issues for regulators and supervisors of capital markets with respect to CDOs, as well as credit derivatives, are also discussed.

This entry has been added to Asset Class Reader: Nominal Bonds

Commercial equity real estate: A framework for analysis

2007-08-17T09:53:00.000-07:00

Commercial equity real estate: A framework for analysis

Christopher B. Philips, CFA, Vanguard Investment Counseling & Research, 08/17/2007

Executive summary. The U.S. commercial real estate market has been estimated to be as large as $5.3 trillion.1 Historically, commercial real estate has provided competitive real returns and diversification opportunities for traditional portfolios. Yet an important question remains: Can an investment in commercial real estate actually deliver the characteristics and benefits of the broad real estate market? Indeed, investment vehicles such as real estate investment trusts or even limited partnerships or private investment pools can look quite different than the broad real estate market. The complexity of this question is a possible reason why institutional investors on average allocate only 2.5% to 4% of their portfolios to commercial equity real estate (Greenwich Associates, 2006, and Pension Real Estate Association, 2005). In fact, in contrast to
the $5.3 trillion investable market, as of December 2006 private real estate holdings were estimated at $310 billion (Chin, Topintzi, and Hobbs, 2007) and public REITs at $400 billion. This analysis evaluates the commercial real estate market and offers perspective regarding the various investment options. We contend that:
• Commercial real estate represents a unique and significant asset class.
• A real estate investment trust index serves as a long-term proxy for the commercial real estate market.
• Since REITs represent exposure to the commercial real estate asset class, a specific allocation to REITs may be based on a portfolio’s mandated objective; expected returns, risks, and covariance to the portfolio; or a unique circumstance.
• Because REITs are part of a broad-based U.S. equity portfolio, when determining an appropriate allocation to REITs, investors must factor in the exposure already contained within the active and indexed portions of the portfolio.

This entry has been added to Asset Class Reader: REITS

Understanding alternative investments: The role of commodities in a portfolio

2007-08-02T07:35:00.000-07:00

Understanding alternative investments: The role of commodities in a portfolio

Kimberly A. Stockton, Vanguard Investment Counseling & Research, (08/02/2007)

Introduction
In recent years, a passive investment in commodities provided high, equity-like average returns, negative return correlations with traditional asset classes, and some protection against inflation. Augmenting a traditional portfolio with an allocation to commodity investments would have improved risk-adjusted portfolio returns. Consequently, interest in commodity investments has increased tremendously. This paper will describe the most popular means of passively investing in commodities—commodity futures indexes—and will discuss their role in a well-diversified portfolio. Although historical returns serve as a useful guide, long-term asset allocation decisions must be based on forward-looking expectations about commodity returns. Detailed analysis of commodity futures index returns will identify key drivers needed to form those expectations. Commodity futures index returns may be broken down into collateral return (U.S. Treasury bills), spot return (the return from changes in commodity prices) and roll return (the return associated with rolling a futures contract forward). Over long periods, the spot return is on average not much higher than inflation, so the roll return is an important contributor to the equity-like returns achieved by some commodity investments. Unfortunately, there is evidence that the roll return is declining or even disappearing in markets where it traditionally has been strongest (such as energy futures markets). So, although a small allocation to commodities may provide some diversification benefits, we caution against making an allocation to commodity investments based on extrapolations of historical returns.

Note: This post has been added to Asset Class Reader: Commodities

Analysis of the Investment Potential and Inflation-Hedging Ability of Precious Metals

2007-07-25T20:19:00.000-07:00

Analysis of the Investment Potential and Inflation-Hedging Ability of Precious Metals

McCown, James Ross and Zimmerman, John R., (July 23, 2007).

Abstract
Gold and silver show strong evidence of ability to hedge stock portfolios and inflation during the period from 1970 to 2006. However, negative betas are only observed for the 1970s, suggesting that it is the inflation-hedging ability that is the cause of the stock-hedging ability. Both metals show high correlation with expected future inflation as measured by the TIPS spreads, confirming Greenspan's (1993) conjecture that gold prices are an indicator of expected inflation.

Note: This post has been added to Asset Class Reader:Gold

Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance

2007-07-24T19:57:00.000-07:00

Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance

Roger G. Ibbotson, Moshe A. Milevsky, Peng Chen, CFA, and Kevin X. Zhe (2007)

Introduction
We can generally categorize a person’s life into three financial stages. The first stage is the growing up and getting educated stage. The second stage is the working part of a person’s life, and the final stage is retirement. This monograph focuses on the working and the retirement stages of a person’s life because these are the two stages when an individual is part of the economy and an investor. Even though this monograph is not really about the growing up and getting educated stage, this is a critical stage for everyone. The education and skills that we build over this first stage of our lives not only determine who we are but also provide us with a capacity to earn income or wages for the remainder of our lives. This earning power we call “human capital,” and we define it as the present value of the anticipated earnings over one’s remaining lifetime. The evidence is strong that the amount of education one receives is highly correlated with the present value of earning power. Education can be thought of as an investment in human capital. One focus of this monograph is on how human capital interacts with financial capital. Understanding this interaction helps us to create, manage, protect, bequest, and especially, appropriately consume our financial resources over our lifetimes. In particular, we propose ways to optimally manage our stock, bond, and so on, asset allocations with various types of insurance products. Along the way, we provide models that potentially enable individuals to customize their financial decision making to their own special circumstances.

A Primer on Tactical Asset Allocation

2007-07-11T21:22:00.000-07:00

The following Vanguard Institutional Paper examines the risks and rewards of Tactical Asset Allocation. Some definitions are in order (courtesy of investopedia):

Strategic Asset Allocation:

	A portfolio strategy that involves periodically rebalancing the portfolio in order to maintain a long-term goal for asset allocation.

	At the inception of the portfolio, a "base policy mix" is established based on expected returns. Because the value of assets can change given market conditions, the portfolio constantly needs to be re-adjusted to meet the policy

Tactical Asset Allocation:

	An active management portfolio strategy that rebalances the percentage of assets held in various categories in order to take advantage of market pricing anomalies or strong market sectors.

	This strategy allows portfolio managers to create extra value by taking advantage of certain situations in the marketplace. It is as a moderately active strategy since managers return to the portfolio's original strategic asset mix when desired short-term profits are achieved.

A Primer on Tactical Asset Allocation

Yesim Tokat, Ph.D.
Kimberly A. Stockton

Many pension funds, endowment funds, and other institutional investors are concerned that equities—typically their largest asset allocation—will have lower average returns over the next decade. In this environment, many investors have questioned the wisdom of thinking about asset allocation solely in strategic terms and have shown renewed interest in tactical approaches. Tactical asset allocation (TAA) is a dynamic strategy that actively adjusts a portfolio’s strategic asset allocation (SAA) based on short-term market forecasts. Its objective is to systematically exploit inefficiencies or temporary imbalances in equilibrium values among different asset or subasset classes. Over time, strategic long-term target allocations are the most important determinant of total return for a broadly diversified portfolio. TAA can add value at the margin, if designed with the appropriate rigor to overcome significant risk factors and obstacles unique to the strategy. Our results show that while some TAA strategies have added value, on average TAA strategies have not produced statistically significant excess returns over all time periods. This raises several important questions for institutional investors: What tools and processes do they need to have in place to make optimal decisions regarding TAA strategies? What are the right questions to ask a prospective manager? What are the critical components of a good model if they choose to run a TAA strategy in-house? This paper provides answers to these questions.

Asset Class Reader: Life Cycle Funds

2007-06-15T10:17:00.000-07:00

Life-Cycle Funds

Viceira, Luis M., (May 2007)

Abstract:

This paper reviews recent advances in academic models of asset allocation for long-term investors, and explores their implications for the design of investment products that help investors save for retirement, particularly life-cycle funds and life-style (or balanced) funds. The paper argues that modern portfolio theory provides scientific foundation for the "risk-based" asset allocation strategies and the "age-based" asset allocation strategies that characterize life-style and life-cycle funds. Risk-based allocation strategies can be optimal in an environment where investors face real interest rate (or reinvestment risk), while human wealth considerations give rise to horizon effects in asset allocation. However, this theory also makes a number of suggestions about how life-style and life-cycle funds should be structured, and shows for which types of investors these funds are appropriate investment choices. Thus, modern portfolio theory provides only qualified support for these funds. Nevertheless, the paper argues that properly designed life-cycle funds are better default investment choices than money market funds in defined-contribution pension plans. The paper also argues for the creation of life-cycle funds that allow for heterogeneity in risk tolerance, and for the creation of life-cycle funds specific to defined-contribution plans that can better account for the correlation between human capital and stock returns. It also suggests that investors who expect to receive Social Security benefits and pension income after retirement should choose a target retirement date for their funds based on their life-expectancy, not their expected retirement date.

Making Investment Choices as Simple as Possible: An Analysis of Target Date Retirement Funds

by Bodie, Zvi and Treussard, Jonathan (January 2007)

Abstract:
Many participants in self-directed retirement plans (401k, IRA, etc.) do not know enough about investing to choose rationally among alternatives. Others may know enough, but find it unpleasant or too time-consuming. Target-date funds (TDFs), also known as life-cycle funds, are being offered as a simple solution to their dilemma. 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 paper explores one way to achieve an even greater improvement. Using a compact continuous-time optimization model, we characterize a person for whom a TDF strategy would be optimal: a "natural TDF holder." We then show that the TDF strategy may be far from optimal for people who — although of the same age — 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 their time horizon. Participants with the same time horizon could then choose (or be advised to choose) either the TDF or the safe target-date fund depending on their risk aversion and human-capital risk. 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, and they decline with age. To reflect gradual changes in human capital risk over the life-cycle from predominantly "stock-like" to mostly "bond-like," TDFs should switch from a "linear" strategy to a "hump-shaped" strategy with respect to age.

Popping The Hood: An Analysis of Major Life Cycle Fund Families

A study of major fund family life cycle funds from Turnstone Advisory Group LLC.

Efficient Markets Hypothesis

2007-06-07T00:48:00.000-07:00

Efficient Markets Hypothesis

Lo, Andrew W., "Efficient Markets Hypothesis" . THE NEW PALGRAVE: A DICTIONARY OF ECONOMICS, L. Blume, S. Durlauf, eds., 2nd Edition, Palgrave Macmillan Ltd., 2007

Abstract:

The efficient markets hypothesis (EMH) maintains that market prices fully reflect all available information. Developed independently by Paul A. Samuelson and Eugene F. Fama in the 1960s, this idea has been applied extensively to theoretical models and empirical studies of financial securities prices, generating considerable controversy as well as fundamental insights into the price-discovery process. The most enduring critique comes from psychologists and behavioural economists who argue that the EMH is based on counterfactual assumptions regarding human behaviour, that is, rationality. Recent advances in evolutionary psychology and the cognitive neurosciences may be able to reconcile the EMH with behavioural anomalies.

Asset Class Reader: Social Responsibility Investing (SRI)

2007-05-11T08:12:00.000-07:00

Two recent studies on Social Responsibility Investing (SRI)

Socially Responsible Investments: Methodology, Risk Exposure and Performance

Renneboog, Luc, ter Horst, Jenke R. and Zhang, Chendi, (April 2007)

Abstract:

This paper surveys the literature on socially responsible investments (SRI). Over the past decade, SRI has experienced an explosive growth around the world. Particular to the SRI funds is that both financial goals and social objectives are pursued. While corporate social responsibility (CSR) - defined as good corporate governance, sound environmental standards, and good management towards stakeholder relations - may create value for shareholders, participating in other social and ethical issues is likely to destroy shareholder value. Furthermore, the risk-adjusted returns of SRI funds in the US and UK are not significantly different from those of conventional funds, whereas SRI funds in Continental Europe and Asia-Pacific strongly underperform benchmark portfolios. Finally, the volatility of money-flows is lower in SRI funds than of conventional funds, and SRI investors' decisions to invest in an SRI fund are less affected by management fees than the decisions by conventional fund investors.

The Price of Ethics: Evidence from Socially Responsible Mutual Funds

Renneboog, Luc, ter Horst, Jenke R. and Zhang, Chendi, (April 2007)

Abstract:

This paper estimates the price of ethics by studying the risk-return relation in socially responsible investment (SRI) funds. Consistent with investors paying a price for ethics, SRI funds in many European and Asia-Pacific countries strongly underperform domestic benchmark portfolios by about 5% per annum, although UK and US SRI funds do not significantly underperform their benchmarks. The underperformance of SRI funds does not seem to be driven by the loadings on an ethical risk factor. SRI funds do not suffer a cost of reduced selectivity nor do SRI funds managers time the market. There is mixed evidence of a smart money effect: SRI investors are unable to identify the funds that will outperform in the future, whereas they show some fund-selection ability in identifying ethical funds that will perform poorly. The screening activities of SRI funds have a significant impact on funds' risk adjusted returns and loadings on risk factors: corporate governance and social screens generate better risk-adjusted returns whereas other screens (e.g. environmental ones) yield significantly lower returns.

Additional studies on SRI:

Socially Responsible Indexes: Composition and Performance

Statman, Meir, (January 2005)

Abstract:
One purpose of this study is to explore the characteristics that define socially responsible companies by comparing the content of the S&P 500 Index of conventional companies to the contents of four indexes of socially responsible companies, the Domini 400 Social Index (DS 400 Index), the Calvert Social Index, the Citizens Index, and the U.S. portion of the Dow Jones Sustainability Index. A second purpose of the study is to compare the returns of the four SRI indexes to those of the conventional S&P 500 Index, and to examine the tracking errors of the SRI indexes relative to the S&P 500 Index.

We find that SRI indexes vary in composition and social responsibility scores but the mean social scores of each is higher than that of the S&P 500 Index. Socially responsible indexes differ in the emphasis they place on social characteristics. For example the DS 400 Index is the strongest among all indexes on the environment while the Calvert Index is strongest on corporate governance.

We find that the returns of the DS 400 Index were higher than those of the S&P 500 Index during the overall May 1990 - April 2004 but not in every sub-period. In general, SRI indexes did better than the S&P 500 Index during the boom of the late 1990s but lagged it during the bust of the early 2000s.

The correlations between the returns of SRI indexes and those of the S&P 500 Index are high, ranging from 0.939 of the DJ Sustainability Index during January 1995 - April 2004 to the 0.985 of the DS 400 Index during September 1999 - April 2004. But tracking errors are substantial. For example, the expected difference between 12-month returns of the DS 400 Index and the S&P 500 Index, based on correlation and standard deviations during May 1990 - April 2004, was 2.84% and the realized mean difference was 2.49%.

The Religions of Social Responsibility

Statman, Meir, (July 2005)

Abstract:

Investors who follow different tenets of social responsibility and choose different socially responsible mutual funds can be described as members of different religions. Some social responsibility religions have a single tenet, such as protection of the environment, while other social responsibility religions combine several tenets, such as avoidance of tobacco, alcohol, and weapons.

The framework of the economics of religion can help us answer questions such as:

- Why do some mutual funds attract many investors while others attract few?

- What are the differences between strategies that are effective at attracting individual investors to SRI and those effective at attracting institutional ones?

- How do tenets, such as opposition to tobacco, come to the forefront or recede?

- Are government regulations aimed at fostering SRI likely to accomplish their aim or are they likely to retard SRI? And is the SRI movement likely to grow stronger in the U.S. or in Europe?

Asset Class Reader: Private Equity

2007-04-19T09:58:00.000-07:00

Investing in Private Equity Funds: A Survey
by Phalippou, Ludovic (2007)

Abstract
This literature review covers the issues faced by private equity fund investors. It shows what has currently been established in the literature and what has yet to be investigated. In particular, it shows the many important questions to be answered by future research. The survey shows that the average investor has obtained poor returns from investments in private equity funds, potentially because of excessive fees. Overall, investors need to gain familiarity with actual risk, past return, and specific features of private equity funds. Increased familiarity will improve the sustainability of this industry that plays such a central role in the economy.

Private Equity Performance: Returns, Persistence and Capital Flows
by Steve Kaplan and Antoinette Schoar (2004)

Abstract
This paper investigates the performance and capital inflows of private equity partnerships. Average fund returns (net of fees) approximately equal the S&P 500 although there is substantial heterogeneity across funds. Returns persist strongly across different funds raised by a partnership. Better performing partnerships are more likely to raise follow-on funds and larger funds. This relationship is concave so that top performing partnerships grow proportionally less than average performing partnerships. At the industry level, market entry and fund performance is cyclical; however, established funds are less sensitive to cycles than new entrants. Several of these results differ markedly from those for mutual funds.

The Performance of Private Equity Funds
by Phalippou, L., and O. Gottschalg. 2006

Abstract
Using a dataset of 1,579 mature private equity funds, the authors find that the performance estimates found in previous research and used as industry benchmark are overstated. They show that commonly used samples are biased towards better-performing funds and that accounting values reported by mature funds for nonexited investments are substantial and mostly represent “living dead” investments. After correcting for sample bias and overstated accounting values, average fund performance changes from slight overperformance to substantial underperformance. Assuming a typical fee structure, they find that gross of fees, these funds outperform by about 4 percent a year.

An Index For Venture Capital
John M. Quigley and Susan E. Woodward (2003)

Abstract
In this paper we build an index of value for venture capital. Our approach overcomes the problems of intermittent, infrequent pricing of private company deals by using a repeat valuation model to build the index, and it corrects for selection bias in the reporting of values. We use a unique data set from Sand Hill Econometrics. The index measures the return and risk for venture capital. Its covariance with other asset classes from 1987-1999 enables us to explore the role of venture capital in diversified portfolios during a period of increased importance of venture capital in the economy.

The Risk and Return of Venture Capital

John H. Cochrane (January 2001)

Abstract
This paper measures the mean, standard deviation, alpha and beta of venture capital investments, using a maximum likelihood estimate that corrects for selection bias. Since firms go public when they have achieved a good return, estimates that do not correct for selection bias are optimistic.

The selection bias correction neatly accounts for log returns. Without a selection bias correction, I find a mean log return of about 100% and a log CAPM intercept of about 90%. With the selection bias correction, I find a mean log return of about 7% with a -2% intercept. However, returns are very volatile, with standard deviation near 100%. Therefore, arithmetic average returns and intercepts are much higher than geometric averages. The selection bias correction attenuates but does not eliminate high arithmetic average returns. Without a selection bias correction, I find an arithmetic average return of around 700% and a CAPM alpha of nearly 500%. With the selection bias correction, I find arithmetic average returns of about 53% and CAPM alpha of about 45%.

Second, third, and fourth rounds of financing are less risky. They have progressively lower volatility, and therefore lower arithmetic average returns. The betas of successive rounds also decline dramatically from near 1 for the first round to near zero for fourth rounds.

The maximum likelihood estimate matches many features of the data, in particular the pattern of IPO and exit as a function of project age, and the fact that return distributions are stable across horizons.

Caveats when Venturing into the Buyout World: Is the Devil in the Details?

by Phalippou, Ludovic, (July 2007)

Abstract
This paper discusses performance of buyout funds, the contracts between funds and investors and the information contained in fund-raising prospectuses. It shows that economically significant sources of variation in fees as well as the explanation for their high level are in the 'details' of the contracts. The most striking facts are that incentive fees can be received by a fund while the rate-of-return is negative. Also, management fees are only 2% but are charged on more than capital invested. In addition, a number of economically significant fees are charged to portfolio companies by fund managers and thus indirectly to investors. Finally, several additional fees are charged and are economically sizeable.

This article then shows that most of the actual contracts may exacerbate potential conflicts of interest rather than mitigate them. The fact that those in control (fund managers) have some discretion in charging fees to portfolio companies (owned by investors) could lead to some conflicts of interest. In addition, several contract clauses provide steep incentives to exit investments too early (short horizon). Furthermore, contracts do not seem optimal as they reward shirking. I show that a buyout fund that would pursue a passive investment strategy (a closet index fund) would have received more than 6% per year of fees in the 1990s.

Finally, it shows i) how flexibility in the aggregation of fund performance offers room for exaggerating performance figures, ii) that low IRR figures are often not mentioned in fund-raising prospectuses, iii) that good track records are seen much more often by investors than inferior ones, iv) that information needed for assessing past performance is often missing, and and vi) that the lack of rule/standard for valuing on-going investments provides yet another way to inflate performance reports.

Asset Class Reader: Art

2007-04-06T02:38:00.000-07:00

Art as a Financial Investment

by Campbell, Rachel A.J. (March 2007)

Abstract
The comparatively poor performance of traditional asset classes in recent years has driven the search for greater returns via alternative asset classes. The desire to reap higher risk adjusted returns from diversification into assets which offer low and even negative correlation with equities and bonds is extremely desirable. There has been a huge growth in the traditional alternative investments such as real estate, commodity futures, private equity and hedge fund investments.

Additionally, a number of funds specialising in art have recently emerged. These also appear to offer a highly beneficial diversification strategy with extremely low correlation with traditional asset classes. It is important for investors to understand the risk and return characteristics of this new alternative asset class.

In this paper we take a closer look at art as an alternative asset, and look specifically at how this new alternative asset is expected to perform, also during bear markets, when the benefits of diversification are most needed. We look at the risk and return characteristics of art using art market indices, and the prospects for portfolio diversification in the art market using a variety of data across art market sectors, including the Old Master, European Impressionist, Modern and Contemporary art markets. Due to the low correlation of art with other asset classes, we find opportunities for portfolio diversification across art markets and across asset classes. The results hold, even allowing for the high transaction costs, which are encountered when trading art, when spread over a longer time horizon.

Art as an Investment and the Underperformance of Masterpieces

by Mei, Jianping and Moses, Michael (February 2002)

Abstract
This paper constructs a new data set of repeated sales of artworks and estimates an annual index of art prices for the period 1875-2000. Contrary to earlier studies, we find art outperforms fixed income securities as an investment, though it significantly under-performs stocks in the US. Art is also found to have lower volatility and lower correlation with other assets, making it more attractive for portfolio diversification than discovered in earlier research. There is strong evidence of underperformance of masterpieces, meaning expensive paintings tend to under-perform the art market index. The evidence is mixed on whether the "law of one price" holds in the New York auction market.

Dealers in Art

by Shubik, Martin (September 2001)

Abstract

A brief narrative and descriptive discussion of the role of private dealers in art together with some suggestive statistics is presented.

How Did Japanese Investments Influence International Art Prices?

by Hiraki, Takato, Ito, Akitoshi, Spieth, Darius Alexander and Takezawa, Naoya (2005)

Abstract

This study examines dynamics among the art, Japanese land, Japanese and U.S. stock market prices during the sample period from 1976 to 1998. We find that the Japanese land prices caused both art and Japanese stock prices to co-move during the sample period. We interpret this finding as suggesting that the accelerated appreciation of land prices in Japan stimulated Japanese investor demands for both international arts and Japanese stocks, especially, in the late 1980s. We further show that the Japanese land index as well as own art index returns are dominant factors in generating fluctuations of returns in most art indexes. We also find that an influence of the Japanese land prices on art prices was preserved and even increased in the 1990s after the burst of bubbles. We interpret this as suggesting that in the 1990s the decreasing land prices in Japan urged some Japanese investors to sell their holdings of arts at a considerable bargain.

The German Art Market

by Kraeussl, Roman, (May 2007)

Abstract:

This paper discusses various aspects of the German art market, including a brief history of German art throughout the twentieth century and the great influence of World Wars I and II. Different styles and movements, such as Expressionism (e.g. Die Brücke, Der Blaue Reiter), Neue Sachlichkeit (New Objectivity) including Dada and Bauhaus and the classification of Entartete Kunst (Degenerate Art) during the Nazi regime, will be discussed. It also elaborates on German art after World War II, including East Germany's Socialist Realism and West Germany's international influences, the influence of Conceptual Art on contemporary German art and the more recent emergence of German photography and figurative paintings of the Neue Leipziger Schule (New Leipzig School). This paper analyzes the specific characteristics of collecting and dealing as it takes place in Germany. It therefore provides a more detailed account of galleries, auction houses and art fairs, as well as a short overview of museums and exhibitions. Finally, it discusses the position of the German art market in the international market and analyses transactions and sales turnover data. It also evaluates the recent market performance of different styles and individual artists. Finally, this chapter closes with a discussion of whether art might serve as an alternative asset class, with a special focus on the first German art fund.

Asset Class Reader: Convertible Bonds

2007-03-05T01:14:00.000-08:00

Convertible Bonds As An Asset Class 1957-1992 by Ibbotsen, Scott L. Lummer PHD CFA, Mark W. Riepe CFA

Convertible bonds are an important asset class, but its risk and return performance and suitability as an asset class for different types of investors has received insufficient attention. We attempt to rectify this neglect by evaluating the unique characteristics of convertibles and documenting the convertible bond market in terms of its historical return performance. We find that convertibles allow the investor to experience the benefits from both a fixed-income and equity investment, have favorable features for issuers who are consequently motivated to price the bonds attractively, and are ideally suited for an investment in firms whose future risk is difficult to assess. With respect to performance, convertibles had a compound annual total return of 8.3 percent over the years 1957 to 1992 compared with 6.8 percent for long-term corporate bonds, 7.3 percent for intermediate-term corporate bonds, and 10.5 percent for stocks.

What Drives the Performance of Convertible Bond Funds?

Ammann, Manuel, Kind, Axel H. and Seiz, Ralf, "What Drives the Performance of Convertible Bond Funds?" (March 2007)

Abstract:
This paper examines the performance of US mutual funds investing primarily in convertible bonds. Although convertible-bond funds are popular investment vehicles, their return process is not well understood. We contribute an analysis of the complete universe of US convertible-bond funds proposing a set of multi-factor models for the return generating process. In spite of the well-known hybrid nature of convertible bonds, the return process of convertible-bond funds cannot be fully explained by factors typically related to stock and bond markets. Thus, we consider additional variables accounting for the option-like character of convertible bonds. Surprisingly, multivariate cross-sectional analyses show the existence of a significant positive relationship between fund's performance and its asset composition. We show that this result can be explained by factors related to investment opportunities in the convertible-bond market and trading strategies related to convertible arbitrage, as typically performed by hedge funds. Overall, convertible-bond funds have a performance as measured by alpha that is comparable to passive investment strategies in stocks, bonds, and convertible-bonds. This average performance is the result of weak selection skills and successful timing in trading strategies closely related to convertible arbitrage.

An Empirical Comparison of Convertible Bond Valuation Models

Zabolotnyuk, Yuriy, Jones, Robert A. and Veld, Chris H., "An Empirical Comparison of Convertible Bond Valuation Models" (June 18, 2007)

Abstract:
This paper empirically compares four convertible bond valuation models. We use an innovative approach where all model parameters are estimated by the Marquardt algorithm using a subsample of convertible bond prices. The model parameters are then used for out-of-sample forecasts of convertible bond prices. The mean absolute deviation, which is calculated as the absolute difference between the model and the market price expressed as a percentage of the market price, is 2.29% for two different versions of the Tsiveriotis-Fernandes (1998) model, 3.08% for the Brennan-Schwartz (1980) model, 3.19% for the Takahashi-Kobayashi-Nakagawa (2001) model, and 4.08% for the total default and the partial default Ayache-Forsyth-Vetzal (2003) models. For this and other measures of fit the Tsiveriotis-Fernandes model outperforms the other three models.

Vanguard Web Sites

2007-02-22T03:34:00.000-08:00

Vanguard Links

Vanguard Index Provider Links

Asset Class Reader: Nominal Bonds

2007-02-22T01:08:00.000-08:00

Explaining the Rate Spread on Corporate Bonds

EDWIN J. ELTON, MARTIN J. GRUBER, DEEPAK AGRAWAL,
and CHRISTOPHER MANN, THE JOURNAL OF FINANCE • VOL. LVI, NO. 1 • FEBRUARY 2001

ABSTRACT
The purpose of this article is to explain the spread between rates on corporate and government bonds. We show that expected default accounts for a surprisingly small fraction of the premium in corporate rates over treasuries. While state taxes explain a substantial portion of the difference, the remaining portion of the spread is closely related to the factors that we commonly accept as explaining risk premiums for common stocks. Both our time series and cross-sectional tests support the existence of a risk premium on corporate bonds

Macroeconomic Factors and the Correlation of Stock and Bond Returns

Li, Lingfeng, "Macroeconomic Factors and the Correlation of Stock and Bond Returns" (November 2002). Yale ICF Working Paper No. 02-46; AFA 2004 San Diego Meetings.

Abstract:

This paper examines the correlation between stock and bond returns. It first documents that the major trends in stock-bond correlation for G7 countries follow a similar reverting pattern in the past forty years. Next, an asset pricing model is employed to show that the correlation of stock and bond returns can be explained by their common exposure to macroeconomic factors. The link between the stock-bond correlation and macroeconomic factors is examined using three successively more realistic formulations of asset return dynamics. Empirical results indicate that the major trends in stock-bond correlation are determined primarily by uncertainty about expected inflation. Unexpected inflation and the real interest rate are significant to a lesser degree. Forecasting this stock-bond correlation using macroeconomic factors also helps improve investors' asset allocation decisions. One implication of this link between trends in stock-bond correlation and inflation risk is the Murphy's Law of Diversification: Diversification opportunities are least available when they are most needed.

Benefits of Internation al Bond Diversificatio n

Hunter, Delroy M. and Simon, David P., "Benefits of International Bond Diversification" . Journal of Fixed Income, Vol. 13, pp. 57-72, March 2004

Abstract:
This paper assesses the incremental diversification benefits to US investors from investing in international government bonds. In light of suggestions that these benefits have fallen sharply in the recent decade due to more closely synchronized business cycles, we use mean-variance spanning tests to show that currency-hedged bonds provide significant diversification benefits over the period from January 1992 to September 2002. Using a bivariate GARCH framework, we find that US bond returns have become increasingly correlated with UK and German bond returns, but have experienced declining correlations with Japanese bonds. The changing correlations are consistent with variation in the synchronization of business cycles. However, the evidence suggests that correlations have not become high enough to threaten the gains from diversification and that these gains on a currency-hedged basis are not diminished during periods of weakness or increased volatility in US or foreign bond markets. Conditional Sharpe ratios also demonstrate that risk-reward tradeoffs for each bond market vary in a predictable manner, which further underscores the potential benefits of international bond investing. Finally, we demonstrate how conditional yield betas and conditional yield beta adjusted foreign bond durations can be constructed from our model estimates.

A Conditional Assessment of the Relationships Between the Major World Bond Markets

Hunter, Delroy M. and Simon, David P., "A Conditional Assessment of the Relationships Between the Major World Bond Markets" (June 24, 2003)

Abstract:
This paper uses a bivariate GARCH framework to examine the lead-lag relations and the conditional correlations between 10-year US government bond returns and their counterparts from the UK, Germany, and Japan. We find that while mean and volatility spillovers exist between the major international bond markets, they are much weaker than those between equity markets. The results also indicate that the correlations between the US and other major bond market returns are time varying and are driven by changing macroeconomic and market conditions. However, in contrast to the finding that the benefits of international diversification in equity markets evaporate during high-stress periods, we find that the benefits of diversification across major government bond markets do not decrease during periods of extremely high bond market volatility or following extremely negative US and foreign bond returns.

Securitization and Collateralized Debt Obligations

Fabozzi, Frank J. and Kothari, Vinod, Yale ICF Working Paper No. 07-07
Lucas, Douglas J., Goodman, Laurie and Fabozzi, Frank J., . Yale ICF Working Paper No. 07-06

Classic Studies on Tax Management & Rebalancing

2007-02-21T03:21:00.000-08:00

Although slightly dated, First Quadrant, Rob Arnott's erstwhile home, produced a number of fine monographs on tax managing and rebalancing portfolios:

Tax Management, Loss Harvesting, and HIFO Accounting
Loss Harvesting:What Is It Worth To The Taxable Investor
Tax-Advantaged Investing
How Well Have Taxable Investors Been Served in the 1980's and 1990's

The Management and Mismanagement Of Taxable Assets

Rebalancing A Global Policy Benchmark: How To Profit from Necessity
Tactical Rebalancing

Money in Motion: Dynamic Portfolio Choice in Retirement

2007-02-15T09:57:00.000-08:00

A new paper from Wharton examines the role of adding immediate variable annuitizations during the decumulation stage. Partial annuitization, gradually increased over the investment time frame, is the suggested normative strategy. For additional insights into asset allocation and immediate variable annuitization, see this post linking papers by Milevsky, as well as this post addressing withdrawal rate strategies and delayed annuitizations.

Money in Motion: Dynamic Portfolio Choice in Retirement

Horneff, Wolfram J., Maurer, Raimond, Mitchell, Olivia S. and Stamos, Michael, "Money in Motion: Dynamic Portfolio Choice in Retirement" (February 2007). Pension Research Council Working Paper No. 2007-7

Abstract:

Retirees confront the difficult problem of how to manage their money in retirement so as to not outlive their funds while continuing to invest in capital markets. We posit a dynamic utility maximizer who makes both asset location and allocation decisions when managing her retirement financial wealth and annuities, and we prove that she can benefit from both the equity premium and longevity insurance in her retirement portfolio. Even without bequests, she will not fully annuitize; rather, her optimal stock allocation amounts initially to more than half of her financial wealth and declines with age. Welfare gains from this strategy can amount to 40 percent of financial wealth (depending on risk parameters and other resources). In practice, it turns out that many retirees will do almost as well by purchasing a variable annuity invested 60/40 in stocks/bonds.

SIMPLE IRA Transfer

2007-02-14T10:46:00.000-08:00

My annual trustee-to-trustee transfer of SIMPLE-IRA account accumulations has been successfully implemented. The transfer process went smoothly, although this year I received telephone calls from both investment institutions before the transfer procedure was put in motion.

Reviewing my motivation for making the transfers should be self explanatory once one tabulates the cost differentials between the two fiduciary companies managing the accounts.

My employer plan is invested in AIM mutual funds. I use the sole no-load fund offering, the money market fund, for accumulating salary deferral contributions. The expense ratio for this fund is 1.02%, and the cost per 1000 dollars (at 5% appreciation) comes to 5.16/1000. On a ten thousand dollar balance, this cost loading drains 51.60 dollars per year from investment returns. Over five years of accumulations, the cost drain would accumulate to 774.00 dollars. (If I were to choose a bond fund with AIM, I would sacrifice a 5.5% load on each investment and then endure a 5.66/1000 dollar expense drain on the residual invested balance.)

I transfer the SIMPLE balances to a Vanguard Traditional IRA. I allocate these funds into the Vanguard Inflation Protected Securities Fund. The annual expense ratio for this fund in 0.20%. The cost per 1000 dollars (at 5% appreciation) comes to 1.02/1000. On a ten thousand dollar balance, this cost loading drains 10.20 dollars per year from investment returns. Over five years of accumulations. the cost drain would accumulate to 153.00 dollars.

The differential in cost loadings continuously compounds over the lifetime holding period on the investment.

Portfolio Performance and Strategic Asset Allocation Across Different Economic Conditions

2007-02-13T02:24:00.000-08:00

Diversification often fails when needed most. The following paper examines asset classes that hedge portfolios during "bad" economic states. These assets include equity REITS; commodities and precious metals; and treasury securities.

Portfolio Performance and Strategic Asset Allocation Across Different Economic Conditions

Sa-Aadu, Jarjisu, Shilling, James D. and Tiwari, Ashish, "Portfolio Performance and Strategic Asset Allocation Across Different Economic Conditions" (March 12, 2006)

Abstract:
Motivated by the theoretical results on strategic asset allocation, we examine the gains in portfolio performance when investors diversify into different asset classes, with particular focus on the timeliness of such gains. Although the various asset classes we analyze yield significant gains in portfolio performance, even in the presence of short sales constraints, the timeliness of the gains differs considerably across the asset classes. Our key result is that commodities and precious metals, and equity REITs are the two asset classes that deliver portfolio gains when consumption growth is low and/or volatile, i.e., when investors really care for such benefits. Consistent with these results, our examination of investor portfolio allocations using a regime switching framework reveals that during the 'bad' economic state, the mean-variance optimal risky portfolio is tilted towards equity REITs, precious metals, and Treasury bonds. Our analysis highlights an important metric by which to judge the attractiveness of an asset class in a portfolio context, namely the timeliness of the gains in portfolio performance.

Asset Class Reader: Gold

2007-02-13T02:02:00.000-08:00

The diversification benefits of adding gold to a portfolio of financial assets are discussed in the following papers. Our first paper offers a comprehensive (although slightly dated) description of the global gold market. The primary diversification benefit of gold is as a hedge which performs best when needed.

The Structure and Operation of the World Gold Market

O`Callaghan, Gary, "The Structure and Operation of the World Gold Market" (December 1991). IMF Working Paper No. 91/120

Abstract:
This paper describes the structure of the world gold market, its sources of supply and demand, and how it functions. The market has three principal functions in three major locations: the New York futures market speculates on spot prices, which are largely determined in London, whereas physical gold is in large part shipped through Zurich. The market is dominated by large suppliers and gold holders, including monetary authorities. Some unique characteristics of the gold market ensure confidentiality, and as a result, there are gaps in existing knowledge and data. The paper identifies and attempts to fill these gaps.

International Portfolio Formation, Skewness and the Role of Gold

Lucey, Brian M. and Tully, Edel, "International Portfolio Formation, Skewness and the Role of Gold" (September 2003)

Abstract:
This paper examines the optimal allocation of assets in well diversified equity based portfolio where the investor is concerned not only with mean and variance but also with the skewness of the returns. Beginning with an analysis of the rationale for concerning with skewness, the paper then discusses previous attempts to model multi-objective portfolio problems. The second part of the paper outlines the attractive nature of the gold asset in equity portfolios. The paper then integrates the two elements, showing the changes in portfolio composition that arise when not only skewness but gold are concerned.

Is Gold a Zero-Beta Asset? Analysis of the Investment Potential of Precious Metals

McCown, James Ross and Zimmerman, John R., "Is Gold a Zero-Beta Asset? Analysis of the Investment Potential of Precious Metals" (July 24, 2006)

Abstract:
Gold shows the characteristics of a zero-beta asset. It has approximately the same mean return as a Treasury Bill and bears no market risk. Silver also bears no market risk but has returns inferior to Treasury Bills. Both gold and silver show evidence of inflation-hedging ability, with the case being much stronger for gold. The prices of both metals are cointegrated with consumer prices, showing additional evidence of hedging ability.

Analysis of the Investment Potential and Inflation-Hedging Ability of Precious Metals

McCown, James Ross and Zimmerman, John R., (July 23, 2007).

Abstract
Gold and silver show strong evidence of ability to hedge stock portfolios and inflation during the period from 1970 to 2006. However, negative betas are only observed for the 1970s, suggesting that it is the inflation-hedging ability that is the cause of the stock-hedging ability. Both metals show high correlation with expected future inflation as measured by the TIPS spreads, confirming Greenspan's (1993) conjecture that gold prices are an indicator of expected inflation.

Asset Allocation and Immediate Annuitization

2007-02-12T10:56:00.000-08:00

The potential benefits of combining immediate annuities to portfolio withdrawal strategies is examined in the following papers. In the first paper, Optimizing the Retirement Portfolio: Asset Allocation, Annuitization, and Risk Aversion, the authors consider the following withdrawal strategies:

Fixed dollar withdrawals
Fixed percentage withdrawals
Percentage withdrawals to longest mortality table (1/T)
The MRD withdrawal (1/E(T)
Total immediate annuitization
Partial annuitization

Optimizing the Retirement Portfolio: Asset Allocation, Annuitization, and Risk Aversion

Horneff, Wolfram J., Mitchell, Olivia S., Maurer, Raimond and Dus, Ivica, "Optimizing the Retirement Portfolio: Asset Allocation, Annuitization, and Risk Aversion" (July 2006). Pension Research Council (PRC) Working Paper

Abstract:

Retirees must draw down their accumulated assets in an orderly fashion so as not to exhaust their funds too soon. We derive the optimal retirement portfolio from a menu that includes payout annuities as well as an investment allocation and a withdrawal strategy, assuming risk aversion, stochastic capital markets, and uncertain lifetimes. The resulting portfolio allocation, when fixed as of retirement, is then compared to phased withdrawal strategies such a "self-annuitization" plan or the 401(k) "default" pattern encouraged under US tax law. Surprisingly, the fixed percentage approach proves appealing for retirees across a wide range of risk preferences, supporting financial planning advisors who often recommend this rule. We then permit the retiree to switch to an annuity later, which gives her the chance to invest in the capital market and "bet on death." As risk aversion rises, annuities first crowd out bonds in retiree portfolios; at higher risk aversion still, annuities replace equities in the portfolio. Making annuitization compulsory can also lead to substantial utility losses for less risk-averse investor.

In a second paper, Moshe Milevsky examines the economics of delayed annuitization, including the timing effects of having inflation escalating and variable account annuitization options.

Optimal Asset Allocation and The Real Option to Delay Annuitization: It’s Not Now-or-Never

Moshe A. Milevsky and Virginia R. Young
Version: 13 April 2002

Abstract:
Asset allocation and consumption towards the end of the life cycle is complicated by the uncertainty associated with the length of life. Although this risk can be hedged with life annuities, empirical evidence suggests that voluntary annuitization amongst the public is not very common, nor is it well understood. This paper develops a normative model of when, and if, one should purchase an immediate life annuity. This problem is particularly relevant given the increasing number of Defined Contribution pension plans in the U.S – for which participants must make this decision – and the corresponding trend away from Defined Benefit guarantees. Specifically, our main qualitative argument is that there is a real option – akin to the corporate finance usage of the word – embedded in the decision to annuitize. A life annuity can be viewed as a project with a positive net present value. However, quite distinct from a fixed-income bond or period certain annuity, once purchased, a life annuity can never be sold, reversed, or exchanged. Its purchase is final because of the severe moral hazard involved in trying to terminate a life-contingent claim. We use standard continuous-time technology to solve the optimal asset allocation and annuitization timing problem. We then define the value of the real option to defer annuitization (RODA) as the compensating utility loss from being unable to behave optimally. By using reasonable capital market and actuarial parameters, we estimate that the real option to defer annuitization is quite valuable until the mid-70s or mid-80s. Of course, the precise values depend on one’s gender, risk aversion, and subjective health assessment. Finally, we show that low-cost variable immediate annuities, which are currently not widely available, greatly reduce the option value to wait and create substantial welfare gains. This might explain the large number of TIAA-CREF participants who rightfully choose to annuitize their DC pension plan, as a result of the availability of both fixed and variable payments in the payout stage.

Reducing Downside Risk

2007-02-12T01:36:00.000-08:00

The following three papers provide perspective on maximizing downside risk protection in the asset allocation decision. In our first paper, Benjamin Cotton considers the effects of uncertainty on the question of asset allocation:

The Uncertain Science of Asset Allocation

Cotton, Benjamin L., "The Uncertain Science of Asset Allocation" (September 16, 1999)

Abstract:
Descriptive statistics for asset class return distributions are compared to inferential statistics produced by Monte Carlo simulations to illustrate that the assumption of normality and constant correlation can understate the risk associated with a given portfolio. Results are presented in a form accessible to students, investors, and practitioners alike. This working paper is to be part of a larger work illustrating investment uncertainty and the methods by which to deal with such uncertainty.

Factors such as skewness, kurtosis, and inconsistent asset class correlations result in downside risk roughly double that suggested by mean variance optimization. Stabilizing the portfolio with investment grade bonds can reduce this downside risk. However, Cotton notes:

"However, the table also illustrates that a 75% allocation to fixed income would be required to bring the portfolio’s worst case within the expectations set by the simulation. Even a 50/50 allocation between fixed income and equities underestimates our actual worst case by over 80% relatively. This is quite disturbing when you consider that most advisors consider a 60/40 allocation between equities and fixed income to be conservative."

A second paper, examining asset allocation under value-at-risk measures, comes to similar conclusions:

Asset Allocation in a Value-at-Risk Framework

Huisman, Ronald, Koedijk, Kees C.G. and Campbell, Rachel A.J., "Asset Allocation in a Value-at-Risk Framework" (April 27, 1999).

Abstract:

In this paper we develop an asset allocation model which allocates assets by maximising expected return subject to the constraint that the expected maximum loss should meet the Value-at-Risk limits set by the risk manager. Similar to the mean-variance approach a performance index like the Sharpe index is constructed. Furthermore it is shown that the model nests the mean-variance approach in case of normally distributed expected returns. We provide an empirical analysis using two assets: US stocks and bonds. The results highlight the influence of non-normal characteristics of the expected return distribution on the optimal asset allocation.

At the 99% confidence level mandated by Basel for commercial bank value-at-risk use, the optimal portfolio under realistic non-normal distributions consists of 23.93% stock; 35.59% bonds; and 40.68% cash.

Finally, Lingfeng Li takes a look at the macroeconomic factors driving stock and bond correlations. He finds the primary driver to be unexpected changes in inflation expectations:

Macroeconomic Factors and the Correlation of Stock and Bond Returns

Li, Lingfeng, "Macroeconomic Factors and the Correlation of Stock and Bond Returns" (November 2002). Yale ICF Working Paper No. 02-46; AFA 2004 San Diego Meetings

Abstract:

This paper examines the correlation between stock and bond returns. It first documents that the major trends in stock-bond correlation for G7 countries follow a similar reverting pattern in the past forty years. Next, an asset pricing model is employed to show that the correlation of stock and bond returns can be explained by their common exposure to macroeconomic factors. The link between the stock-bond correlation and macroeconomic factors is examined using three successively more realistic formulations of asset return dynamics. Empirical results indicate that the major trends in stock-bond correlation are determined primarily by uncertainty about expected inflation. Unexpected inflation and the real interest rate are significant to a lesser degree. Forecasting this stock-bond correlation using macroeconomic factors also helps improve investors' asset allocation decisions. One implication of this link between trends in stock-bond correlation and inflation risk is the Murphy's Law of Diversification: Diversification opportunities are least available when they are most needed.

This suggests that the fixed income portfolio allocation would be best filled by short term bonds and inflation indexed bonds, both of which are hedges against unexpected inflation.

Asset Location: Variable Annuities

2007-02-11T11:16:00.000-08:00

Household Demand for Variable Annuities

Brown, Jeffrey R. and Poterba, James M., "Household Demand for Variable Annuities" (March 2004). Boston College, Center for Retirement Research Working Paper No. 2004-08.

Abstract:

Between 1990 and 2000, total sales of variable annuities in the U.S. grew from just over $5 billion to nearly $140 billion. These products now account for approximately half of all private market annuity sales. Variable annuities resemble mutual funds, but they qualify for special tax treatment as insurance products because they provide an option to convert to a life annuity. This paper describes the tax treatment of variable annuities and presents summary information on the ownership patterns for variable annuities. It also explores the relative importance of several distinct motives for household purchase of variable annuities. We use household data from the 1998 and 2001 waves of the Survey of Consumer Finances to examine ownership patterns and to test for the importance of tax and insurance considerations in variable annuity demand. We find that variable annuity ownership is highly concentrated among high income and high net wealth sub-groups of the population, although the concentration is lower than for several other categories of financial assets. We find mixed support for the role of tax considerations in generating variable annuity demand, and we outline a set of research issues that focus on household annuity purchases.

The Titanic Option: Valuation Of The Guaranteed Minimum Death Benefit In Variable Annuities And Mutual Funds

Milevsky, Moshe and Posner, Steven E.,The Journal of Risk and Insurance, 2001, Vol. 68, No. 1, 91-126.

ABSTRACT

The authors use risk-neutral option pricing theory to value the guaranteed minimum death benefit (GMDB) in variable annuities (VAs) and some recently introduced mutual funds. A variety of death benefits, such as returnof- premium, rising floors, and “ratches,” are analyzed. Specifically, the authors compute the fair insurance risk fee, charged to assets, that funds the embedded option. The authors derive analytic option prices for a simplified exponential mortality model and robust numerical estimates in the case of a properly calibrated Gompertz model. The authors label this contingent claim a Titanic option because its payoff structure is in between European and American style but is triggered by death. The authors’ main objective is to compare theoretical estimates against a cross-section of insurance risk charges, as reported by Morningstar, Inc. The authors’ main conclusion is that a simple return-of-premium death benefit is worth between one and ten basis points, depending on gender, purchase age, and asset volatility. In contrast, the median Mortality and Expense risk charge for return-of-premium variable annuities is 115 basis points. Presumably, the remaining markup can be attributed to profits, model imperfections, or, more cynically, to an implicit payment for the tax-deferral privilege.

Variable Annuities versus Mutual Funds: A Monte Carlo Analysis of the Options

Milevsky, M.A. and Panyagometh, Kamphol, "Variable Annuities versus Mutual Funds: A Monte Carlo Analysis of the Options" (September 2001). York-Schulich-Finance Working Paper No. MM10-1.

Abstract:

This paper quantifies the impact of return uncertainty when measuring the relative benefits of mutual funds versus variable annuities by calculating the certainty equivalents of utility. This paper points out that the possibility of an investment loss endows the holder of the mutual fund with a 'real option' to harvest those losses and this 'real option' has value and must be factored into any decision in advance.

Our main practical observation is that although we find that low-cost Variable Annuities are indeed superior to low-cost Mutual Funds for investors with a long time horizon, the critical threshold is at least 10 years for typical levels of risk aversion. If, however, we ignore the embedded options, the erroneous break-even horizon drops to 5 years. The stochasticity increases the break-even horizon.

Irrational Optimism

2007-02-08T01:37:00.000-08:00

The following paper, by Dimson, Marsh, and Staunton, provides, in brief form, research and data from their superb text, Triumph of the Optimists. The results clearly indicate that a global diversified portfolio reduces investment risk.

Irrational Optimism

Dimson, Elroy, Marsh, Paul and Staunton, Mike, "Irrational Optimism" (December 2003). LBS Institute of Finance and Accounting Working Paper No. IFA397.

Abstract:
We address 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, we examine 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. We use a 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, the worldwide real return on equities averaged close to 5 percent a year (before costs, fees, and taxes). This is appreciably lower than is frequently quoted from historical averages, a difference that arises because we use a longer time frame than other studies and adopt a global focus. Prior views on the long-run safety of equities have been overly influenced by the experience of the United States. Furthermore, the US 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 US experience, we examine the histories of other countries. We find only three non-US equity markets (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. Historically, in 6 of the 16 countries, investors would need to have waited more than 50 years to be assured of a positive return.

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, and we also examine a lower return of 4 percent. The projected shortfall risk exceeds the historical risk of shortfall - partly because of the lower assumed real returns, 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 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 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.

Asset Class Reader: Alternate Fixed Income Asset Classes

2007-02-04T21:53:00.000-08:00

The primary asset allocation purpose of fixed income investments is to dilute the riskiness of volatile equity asset classes. This risk reduction function is realized by allocating short to intermediate treasury bonds, inflation indexed treasuries, or investment grade corporate or municipal bonds to the portfolio mix.

However, the fixed income market is not restricted to such high quality debt. Among the riskier and potentially higher return portions of the market are high yield bond and emerging market debt securities. Both of these asset classes possess high volatility, considerable credit risk, and correlations with equities. The following papers supply data on the returns, risks, and characteristics of these high risk asset classes. (My personal judgment on these asset classes is that, if added to the allocation mix, they should replace equity allocation and not bond allocation in the equity/bond allocation split.)

Defaults and Returns in the High Yield Bond Market: The Year 2005 in Review and Market Outlook: Altman, Edward I. and Pasternack, Brent

Credit Risk: How Much? When?: William Bernstein

Determinants of Recovery Rates on Defaulted Bonds and Loans for North American Corporate Issuers: 1983-2003

Cantor, Richard Martin and Varma, Praveen, "Determinants of Recovery Rates on Defaulted Bonds and Loans for North American Corporate Issuers: 1983-2003" . Journal of Fixed Income, December 2004

Abstract:
This paper explores the determinants of recovery rates on defaulted loans and bonds for North American corporate issuers over a period of 21 years (1983-2003). The variables it examines include seniority, security, type of initial default event, and a wide variety of firm-specific, industry-specific, and macroeconomic factors. The report estimates their influence on recovery rates both through univariate analysis, presented in a tabular form, and through multivariate regressions. Not only do our findings corroborate results on seniority, security, and macroeconomic factors found elsewhere in the literature, but we also find that recovery rates are strongly affected by 1) the type of event precipitating default, 2) the amount of debt an issuer has outstanding that is subordinate to the defaulted security, 3) the tangibility of its assets, 4) the prevailing credit spreads at the time of default, and 5) the market-to-book ratio of the firm and its industry prior to default. The results of this study show that seniority and security are the two most important factors that impact recovery rates, followed by debt-cushion, leverage and asset tangibility. Industry and macroeconomic factors are also found to be correlated with recovery rates, sometimes very strongly.

Understanding Emerging Market Bonds:Claude B. Erb, Campbell R. Harvey and Tadas E. Viskanta

Asset Class Reader: Hedge Funds

2007-02-04T21:15:00.000-08:00

Hedge Funds, with access restricted to "sophisticated, wealthy investors" and institutions, have been the recipients of large cash inflows from investors seeking to diversify "traditional" investment portfolios. Hedge Fund investment comes at a heavy price (2% of assets under management and 20% of profits is the common expense loading) as well as with complex return attributions which require a deep (and for the novice, often bewildering) statistical analysis to determine their utility as additions to a portfolio. How does one measure hedge fund returns, and how do hedge funds measure up as investments? The following series of papers examine these issues:

Understanding Alternative Investments: A Primer on Hedge Fund Evaluation

Vanguard Investment Counseling and Research

Executive summary
Sparked by the 2000–2002 equity bear market and fueled by general expectations of lower future returns for stocks and bonds, popular opinion has embraced the idea that hedge funds can deliver positive returns regardless of the direction and magnitude of stock and bond market returns. As a result, hedge funds have garnered considerable attention as a viable alternative investment. But is such enthusiasm justified? What have been the risk-adjusted returns of hedge funds? And what are the risks of hedge fund investing? This report examines the characteristics and historical performance of a common set of hedge fund strategies available to investors. While we find that most hedge funds operate in a risk-controlled framework, we caution that investing in hedge funds may not be as simple or safe as often portrayed. Indeed, this report concludes that:

• Reported hedge fund returns contain significant biases that skew conventional mean-variance and regression analysis.
• Distinct and enduring differences exist between opportunistic and non-directional strategies.
• Because of serious data limitations, quantitative analysis of hedge funds should be supplemented by qualitative judgment.

Hedge Funds: Past, Present and Future

Stulz, René M., "Hedge Funds: Past, Present and Future" . Fisher College of Business Working Paper No. 2007-03-003

Abstract:
Assets managed by hedge funds have grown faster over the last ten years than assets managed by mutual funds. Hedge funds and mutual funds perform the same economic function, but hedge funds are largely unregulated while mutual funds are tightly regulated. This paper compares the organization, performance, and risks of hedge funds and mutual funds. It then examines whether one can expect increasing convergence between these two investment vehicles and concludes that the performance gap between hedge funds and mutual funds will narrow, that regulatory developments will limit the flexibility of hedge funds, and that hedge funds will become more institutionalized.

Superstars or Average Joes? A Replication-Based Performance Evaluation of 1917 Individual Hedge Funds

Kat, Harry M. and Palaro, Helder P., "Superstars or Average Joes? A Replication-Based Performance Evaluation of 1917 Individual Hedge Funds" (February 3, 2006)

Abstract:
In this paper we use the hedge fund return replication technique recently introduced by Kat and Palaro (2005) to evaluate the net-of-fee performance of 1917 individual hedge funds. Comparing fund returns with the returns on dynamic futures trading strategies with the same risk and dependence characteristics, we find that no more than 17.7% of the hedge funds in our sample beat the benchmark. In other words, the majority of hedge funds have not provided their investors with returns, which they could not have generated themselves by mechanically trading S&P 500, T-bond and Eurodollar futures. Over time, we observe a substantial deterioration in overall hedge fund performance. In addition, we find a tendency for the performance of successful funds to deteriorate over time, which supports the hypothesis that increasing assets under management endanger future performance.

Welcome to the Dark Side: Hedge Fund Attrition and Survivorship Bias over the Period 1994-2001

Kat, Harry M. and Amin, Gaurav S., "Welcome to the Dark Side: Hedge Fund Attrition and Survivorship Bias over the Period 1994-2001" (December 11, 2001)

Abstract:
Hedge funds exhibit a high rate of attrition that has increased substantially over time. Using data over the period 1994-2001, we show that lack of size, lack of performance and an increasingly aggressive attitude of old and new fund managers alike are the main factors behind this. Although attrition is high, survivorship bias in hedge fund data is quite modest, which reflects the relatively small difference in performance between surviving and defunct funds. Concentrating on survivors only will overestimate the average hedge fund return by around 2% per annum. For small, young, and leveraged funds, however, the bias can be as high as 4-6%. We also find significant survivorship bias in estimates of the standard deviation, skewness and kurtosis of individual hedge fund returns. When not corrected for, this will lead investors to seriously overestimate the benefits of hedge funds. We find fund of funds attrition to be much lower than for hedge funds. Combined with a small difference in performance between surviving and defunct funds of funds, this yields relatively low survivorship bias estimates for funds of funds.

The Statistical Properties of Hedge Fund Index Returns and Their Implications for Investors

Kat, Harry M. and Brooks, Chris, "The Statistical Properties of Hedge Fund Index Returns and Their Implications for Investors" (October 31, 2001)

Abstract:
The monthly return distributions of many hedge fund indices exhibit highly unusual skewness and kurtosis properties as well as first-order serial correlation. This has important consequences for investors. We demonstrate that although hedge fund indices are highly attractive in mean-variance terms, this is much less the case when skewness, kurtosis and autocorrelation are taken into account. Sharpe Ratios will substantially overestimate the true risk-return performance of (portfolios containing) hedge funds. Similarly, mean-variance portfolio analysis will over-allocate to hedge funds and overestimate the attainable benefits from including hedge funds in an investment portfolio. We also find substantial differences between indices that aim to cover the same type of strategy. Investors' perceptions of hedge fund performance and value added will therefore strongly depend on the indices used.

Harry Kat, the academician who has exhaustively researched hedge funds, has posted many more papers on hedge funds and synthetic funds (which replicate hedge fund performance and risk metrics using managed futures at dramatically lower cost loadings.) You can find Dr. Kat's research at Cass Business School, City of London. Dr. Kat is also a principle in a firm he has founded to create and manage synthetic funds.

How to Evaluate a New Diversifier with 10 Simple Questions

2007-02-02T10:01:00.000-08:00

Interest in adding "alternate" asset classes such as hedge funds and commodities to the standard asset class menu has mushroomed subsequent to the early century bear market episode (2000-2002). How should an investor evaluate the addition of an asset class to the portfolio mixture? Harry Kat provides normative guidance for making such decisions in the following paper, which expands the statistical analysis of asset class performance to include skewness and co-skewness measures.

How to Evaluate a New Diversifier with 10 Simple Questions

Kat, Harry M., "How to Evaluate a New Diversifier with 10 Simple Questions" (December 1, 2006). Alternative Investment Research Centre Working Paper No. 39

Abstract:
In this paper we discuss a number of important questions to ask when analysing a new alternative diversifier from either a stand-alone, asset-only or asset-liability point of view. The framework is simple, but highly effective. Apart from the new diversifier's statistical properties, it emphasizes the importance of properly accounting for parameter uncertainty and illiquidity; two elements very often ignored by investors. It also shows the importance of taking the correct perspective when evaluating a new diversifier. What looks good from a stand-alone perspective need not look good in a portfolio context and vice versa. Application of the above framework to funds of hedge funds, commodities and synthetic funds underlines the advantages and disadvantages of these diversifiers and clearly points at synthetic funds as the most and funds of hedge funds as the least attractive of the three.

The Ten Questions To Ask

1. What risk premium is offered?
2. How volatile are the returns?
3. Are returns positively or negatively skewed or explicitly floored or capped?
4. How certain are you of the above?
5. How liquid is the investment?
6. Is the fee charged fair in relation to the above?
7. What is the correlation with the existing portfolio?
8. What is the co-skewness with the existing portfolio?
9. What is the correlation with the liabilities?
10. What is the co-skewness with the liabilities?

The Asset Allocation Debate

2007-02-01T20:18:00.000-08:00

Ever since the publication in 1986 of the oft quoted Brinson, Hood, and Beebower (BHB) study on asset allocation, debate has swirled about the validity of the study's conclusions. A sampling of available studies on the BHB controversy are rendered below:

Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?

Roger G. Ibbotson and Paul D. Kaplan

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 among funds is explained by policy, and on average about 100 percent of the return level is explained by the policy return level.

The Contribution of Asset Allocation Policy to Portfolio Performance

This study examines the total return of investment portfolios composed of mutual funds and analyzes the contributions of strategic asset allocation (investment policy), tactical timing (the periodic over- or underweighting of asset classes relative to the strategic weightings), and security selection (the selection of individual mutual funds to represent asset classes). The results of Brinson, Hood and Beebower (1986) and Brinson, Singer and Beebower (1991) are confirmed using a sample free of several data limitations in their samples. Utilizing data from five model mutual fund portfolios, covering a wide range of asset class combinations over a three year period, I demonstrate that strategic asset allocation policy explains more than 90 per cent of the variation in total portfolio return, and that tactical timing decisions and security selection may also contribute significantly to the variation in total return. I expand the existing literature by performing a pooled regression, which incorporates all portfolios together (in addition to examining each portfolio individually and averaging the results, as in Brinson et al.) I further demonstrate that the results are also valid when examining risk-adjusted return: I extend the analysis to include several types of risk measure, examining the data in terms of absolute and relative variance, and conclude the analysis with an evaluation of the portfolios in terms of riskadjusted return, demonstrating that the results obtained vis-a-vis total return also apply on a risk adjusted return basis.

Wolfgang Drobetz and Friederike Köhler

Abstract
It is well known that asset allocation policy is the major determinant of fund performance. However, there is substantial disagreement about the exact magnitude of the contribution of asset allocation. Following the approach in Ibbotson and Kaplan (2000), we use German and Swiss balanced mutual fund data to show that the correct answer depends on the specific question being asked. We find that more than 80 percent of the variability in returns of a typical fund over time is explained by asset allocation policy, roughly 60 percent of the variation among funds is explained by policy, and more than 130 percent of the return level is explained, on average, by the policy return level.

The asset allocation debate: Provocative questions, enduring realities

Vanguard Institutional Research

Ever since the 1986 “Brinson study” stated that asset allocation accounts for more than 90% of the variation in portfolio returns over time, investment professionals have been debating its implications. The opposing view, introduced by William Jahnke in 1997, counters that asset allocation alone cannot account for the variation in returns across portfolios. This report analyzes industry research surrounding this ongoing debate (including recent Vanguard studies), with an in-depth review of static versus dynamic asset allocation strategies and index versus active portfolio construction.

Another Look at the Determinants of Portfolio Performance: Return Attribution for the Individual Investor: French, Craig W.

Abstract
This study examines the total return of investment portfolios composed of mutual funds and analyzes the contributions of strategic asset allocation (investment policy), tactical timing (the periodic over- or underweighting of asset classes relative to the strategic weightings), and security selection (the selection of individual mutual funds to represent asset classes). The results of Brinson, Hood and Beebower (1986) and Brinson, Singer and Beebower (1991) are confirmed using a sample free of several data limitations in their samples. Utilizing data from five model mutual fund portfolios, covering a wide range of asset class combinations over a three year period, I demonstrate that strategic asset allocation policy explains more than 90 per cent of the variation in total portfolio return, and that tactical timing decisions and security selection may also contribute significantly to the variation in total return. I expand the existing literature by performing a pooled regression, which incorporates all portfolios together (in addition to examining each portfolio individually and averaging the results, as in Brinson et al.) I further demonstrate that the results are also valid when examining risk-adjusted return: I extend the analysis to include several types of risk measure, examining the data in terms of absolute and relative variance, and conclude the analysis with an evaluation of the portfolios in terms of riskadjusted return, demonstrating that the results obtained vis-a-vis total return also apply on a risk adjusted return basis.

The Brinson 93.6% Hoohah, or, The Fable of the Blind CFAs and the Portfolio: William Bernstein

The 93.6% Question of Financial Advisors: Meir Statman

Asset Class Reader: U.S. Stocks

2007-02-01T08:44:00.000-08:00

Asset Class Reader: U.S. Stocks

The following papers document the historical returns of U.S. stocks:

A new historical database for the NYSE 1815 to 1925: Performance and predictability: William N. Goetzmann, Roger G. Ibbotson, Liang Peng

Long-Run Stock Returns: Participating in the Real Economy: Roger G. Ibbotson and Peng Chen

The following papers deal with the equity premium for U.S Stocks:

History and the Equity Risk Premium : William N. Goetzmann and Roger G. Ibbotson

What Risk Premium is 'Normal'?: Arnott, Robert D. and Bernstein, Peter L.

The Equity Premium: Fama, Eugene F. and French, Kenneth R.

The Worldwide Equity Premium: A Smaller Puzzle: Dimson, Elroy, Marsh, Paul and Staunton, Mike

Long-Run Stock Returns: Participating in the Real Economy: Roger G. Ibbotson and Peng Chen

The following papers deal with the value and size premiums for U.S Stocks:

Characteristics, Covariances, and Average Returns: 1929-1997: Davis, James L., Fama, Eugene F. and French, Kenneth R.

The Value Premium and the CAPM: Fama, Eugene F. and French, Kenneth R.

The Anatomy of Value and Growth Stock Returns: Fama, Eugene F. and French, Kenneth R

Migration: Fama, Eugene F. and French, Kenneth R.

Factor Rotation: Bernstein, William

Asset Class Reader: International Stocks

2007-01-30T20:42:00.000-08:00

Asset Class Reader: International Stocks

The following papers analyze International and Emerging Market stocks.

International Equity Investing: Long Term Expectations and Short Term Departures: Vanguard Institutional Research

International equity: Considerations and recommendations: Vanguard Institutional Research

The Worldwide Equity Premium: A Smaller Puzzle: Dimson, Elroy, Marsh, Paul and Staunton, Mike

The Long Term Risks of Global Stock Markets: Jorion,Phillipe

Value vs. Growth: The International Evidence: Fama,Eugene and French,Kenneth R.

Factor Funds, Mean-Variance Efficiency, and the Gains From International Diversification: Eun, Cheol S., Lai, Sandy and Zhang, Zhe

Long Term Global Market Correlations: Goetzmann,William N., Li,Lingfeng and Rouwenhorst,K. Geert

Investing in Emerging Markets: Vanguard Institutional Investors

Asset Class Reader: REITS

2007-01-30T09:40:00.000-08:00

Asset Class Reader: REITS

The following papers examine the portfolio characteristics of Equity REITS as an asset class:

Commercial Real Estate: The Role of Global Listed Real Estate Equities in a Strategic Asset Allocation: Ibbotson

The case for a strategic allocation to global real estate securities: Ted Bigman and Christina Chui

Cointegration of Real Estate Stocks and REITs with Common Stocks, Bonds and Consumer Price Inflation - An International Comparison: Westerheide, Peter

International Evidence on Real Estate as a Portfolio Diversifier: Hoesli, Martin, Lekander, Jon and Witkiewicz, Witold

The Performance and Diversification Benefits of European Public Real Estate Securities: Bond, Shaun A. and Glascock, John L.

Investing for the Long-Run in European Real Estate: Fugazza, Carolina, Guidolin, Massimo and Nicodano, Giovanna

Real Estate Investing The REIT Way: Barclays Global Investors

Commercial equity real estate: A framework for analysis :Vanguard Research & Counseling

Asset Class Reader: Inflation Indexed Bonds

2007-01-30T01:45:00.000-08:00

Asset Class Reader: Inflation Indexed Bonds

Papers examining the investment characteristics and diversification benefits of Inflation Indexed Bonds:

Understanding And Using Inflation Bonds: Hammond, P. Brett

The Rationale and Design of Inflation-Indexed Bonds: Price, Robert

Diversification Benefits of Treasury Inflation Protected Securities: An Empirical Puzzle: Mamun, Abdullah and Visaltanachoti, Nuttawat

Asset Allocation With Inflation Protected Bonds: Kothari,S.P. and Shanken,Jay

Asset Class Reader: Commodities

2007-01-29T20:09:00.000-08:00

Asset Class Reader: Commodities

Papers examining the portfolio characteristics of commodity futures:

Strategic Asset Allocation and Commodities: Ibbotson Research

An Investor's Guide to Commodities: Deutsche Bank

Facts and Fantasies About Commodity Futures: Gorton,Gary and Rouwenhorst,K. Geert

The Tactical and Strategic Value of Commodity Futures: Erb,Claude B. and Harvey,Campbell

Is The Case For Investing in Commodities Really That Obvious? : Katt,Harry M.

What Every Investor Should Know About Commodities, Part I: Univariate Return Analysis: Katt, Harry M. and Oomen, Roel C.A.

What Every Investor Should Know About Commodities, Part II: Multivariate Return Analysis: Katt, Harry M. and Oomen, Roel C.A.

Understanding alternative investments: The role of commodities in a portfolio :Kimberly A. Stockton, Vanguard Investment Counseling & Research, (08/02/2007)

Tobin's Separation Theorem : The Dilution of Risk

2007-01-27T23:15:00.000-08:00

Ever since the 1957 publication of James Tobin's seminal paper on what has become known as "The Separation Theorem" (Liquidity Preference as Behavior Towards Risk for those intrepid souls willing to sample it) , investors have had the theoretical basis for modulating portfolio risk.

In essence, the Theorem postulates that an investor can control the risk of a basket of risky investments by either borrowing at the risk free rate and leveraging the portfolio (and its risk), or alternately, lending at the risk free rate and tempering risk. Since most investors are risk averse, the clear preference of most investors is to combine the risky basket of securities with risk free bonds, and thereby lower the downside risk of the portfolio. In common parlance, we would term this the stock/bond asset allocation decision.

The risk free bond allocation is usually defined as short-term treasury securities (1 to 5 year maturities), or perhaps expanded to include short term investment grade corporate paper. It is sometimes suggested that the risk free allocation should be made up of inflation indexed treasuries. (My personal individual preference is to combine both securities for risk dilution by dividing the risk free allocation between the two.)

In his excellent paper, The Long-Term Risks of Global Stock Markets, Phillipe Jorion finds that "a globally diversified portfolio would have displayed much less downside risk than any single market." The global equity portfolio is therefore a proxy for the risk basket of securities.

We can derive a notion of the downside risk for this risky basket by reference to the superb Dimson, Marsh, and Staunton paper, The Worldwide Equity Premium: A Smaller Puzzle, a table from which is reproduced in the following pdf. file.

The table rewards careful scrutiny. It covers 106 years of market history, not only for the US market, but also including four foreign markets (UK, France, Germany, and Japan) as well as the World Market and the World Market Ex-US. The table provides real rates of return for various market episodes; highest and lowest period returns; and longest runs of negative real returns. The rewards and risks of equity investment are manifestly apparent. Although future returns and economic episodes are uncertain as to limits, the historical record does demonstrate that the world equity portfolio has surrendered as much as 50% of its real value during past down market cycles.

The following table (courtesy of William Bernstein, The Intelligent Asset Allocator) puts the Separation Theorem to practical use, showing the required bond allocation for diluting the downside risk potential of equities to tolerable levels. (The choice of maximum loss preference would, of course, depend on the risk tolerance of the individual investor). One must also caution that, as the Dimson, Marsh, and Staunton paper reminds us, hyperinflation can render even risk-free assets worthless, a reminder that uncertainty is an inescapable fact of life. An allocation to commodities might be advisable to hedge this risk.

Table 1. Downside Risk Reduction
Maximum Loss
Equity Allocation
35%
80%
30%
70%
25%
60%
20%
50%
15%
40%
10%
30%
5%
20%
0%
10%

Table 1. Downside Risk Reduction
Maximum Loss	Equity Allocation
35%	80%
30%	70%
25%	60%
20%	50%
15%	40%
10%	30%
5%	20%
0%	10%

Asset Allocation: Rebalancing

2007-01-25T10:02:00.000-08:00

Rebalancing an investment portfolio to one's target policy allocation is, as asset class returns vary, often necessary to maintain a portfolio's risk characteristics. The following papers examine the intricacies of rebalancing a portfolio. (For individual investors, annual rebalancing within 5% variance bands should provide sufficient risk control, and under certain investment environments a "rebalancing bonus" in absolute return.)

The first paper, from Vanguard Institutional Investors, is geared towards the institutional investor, albeit the insights are applicable to individual investors. The conclusion is especially relevent for taxable accounts.

We include a number of papers examining the rebalancing issue from William Bernstein's Efficient Frontier. One may also find the following study in the FPA Journal to be of interest:

Rebalancing for Tax-Deferred Accounts: Just Do It—Don't Worry How" by Mark W. Riepe, CFA, and Bill Swerbenski, CFA

Portfolio Rebalancing in Theory and Practice
Executive summary
A portfolio’s asset allocation determines the portfolio’s risk and return characteristics. Over time, as different asset classes produce different returns, the portfolio’s asset allocation changes. To recapture the portfolio’s original risk and return characteristics, the portfolio must be rebalanced to its original asset allocation. This paper identifies the factors that influence a rebalancing strategy. We present a conceptual framework for developing rebalancing strategies that can accommodate changes in the financial market environment and in asset class characteristics, as well as account for an institution’s unique risk tolerance and time horizon. Our findings indicate that:

• Determining an effective rebalancing strategy is a function of the portfolio’s assets: their expected returns, their volatility, and the correlation of their returns. For example, a high correlation among the returns of a portfolio’s assets means that they tend to move together, which will tend to reduce the need for rebalancing. In addition, the investment time horizon affects the rebalancing strategy. A portfolio with a short time horizon is less likely to need rebalancing because there is less time for the portfolio to drift from the target asset allocation. In addition, such a portfolio is less likely to recover the trading costs of rebalancing. The effect of a rebalancing strategy on a portfolio depends on return patterns over time. If security prices approximately follow a random-walk pattern, then rebalancing more frequently or within tighter bands reduces a portfolio’s downside risk (absolute as well as relative to the target asset allocation). In a trending or mean-reverting market, the impact of rebalancing may be somewhat different when viewed on an absolute or relative-to-target basis.

• Additional factors to consider when implementing a rebalancing strategy include preference and costs, such as time spent, redemption fees, or trading costs. Each cost incurred will reduce the return of the portfolio. The nature and magnitude of trading costs affect the choice of rebalancing strategies.

• Due to differing risk tolerances, two institutions with identical asset allocations may prefer different rebalancing strategies.

Conclusion
To ensure that a portfolio’s risk and return characteristics remain consistent over time, a portfolio must be rebalanced. The appropriate rebalancing strategy depends on a number of factors such as the market environment and asset-class characteristics. Rebalancing achieves the goal of risk control relative to the target asset allocation in all market environments. Although market return patterns may create opportunities for tactical rebalancing, this active strategy is challenging. Based on reasonable expectations about return patterns, average returns, risk, and correlations, we conclude that for most broadly diversified stock and bond fund portfolios, annual or semiannual monitoring, with rebalancing at 5% thresholds, produces an acceptable balance between risk control and cost minimization. To the extent possible, this rebalancing strategy should be carried out by appropriately redirecting interest income, dividends, new contributions, and withdrawals.

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Efficient Frontier Articles

The Rebalancing Bonus: Theory and Practice September, 1996

When Doesn’t It Pay to Rebalance? January, 1997

Rebalancing: Practical Issues July, 1997

Case Studies in Rebalancing Winter, 2000

Rebalancing Individual National Markets Spring 2000

The 1/N Solution

2007-01-24T09:27:00.000-08:00

Individual investors rarely employ sophisticated asset allocation methodologies, such as mean variance optimization, monte-carlo simulation, or probabalistic scenario analysis in formulating and implementing investment policy. Instead, they often employ "naive" strategies, such as equally dividing the pallete of asset classes. Such "Couch potato" or "cowards" portfolios are designated "1/N Heuristic" portfolios by academia. Examples of 1/N Heuristic Portfolios, from simple to complex would take the following forms (assuming an equal 50/50 equity/fixed income division):

Two Asset Class 1/N Heuristic Portfolio

Vanguard Total Stock Market Index 50%
Vanguard Total Bond Market Index 50%

Four Asset Class 1/N Heuristic Portfolio

Vanguard Total Stock Market Index 16.7%
Vanguard Total International Index 16.7%
Vanguard REIT Index 16.7%
Vanguard Total Bond Market Index 50%

Six Asset Class 1/N Heuristic Portfolio

Vanguard Total Stock Market Index 10.0%
Vanguard Small Value Index 10.0%
Vanguard REIT Index 10.0%
Vanguard Total International Index 10.0%
Vanguard Total Bond Market Index 25.0%
Vanguard Inflation Protected Bond 25.0%

How do such naive asset allocation models stand up to academic analysis? Surprisingly well, as the following studies indicate.

The 1/n Pension Investment Puzzle

Heath Windcliff and Phelim P. Boyle

ABSTRACT
This paper examines the so-called 1/n investment puzzle that has been observed in defined contribution plans whereby some participants divide their contributions equally among the available asset classes. It has been argued that this is a very naive strategy since it contradicts the fundamental tenets of modern portfolio theory. We use simple arguments to show that this behavior is perhaps less naive than it at first appears. It is well known that the optimal portfolio weights in a mean-variance setting are extremely sensitive to estimation errors, especially those in the expected returns. We show that when we account for estimation error, the 1/n rule has some advantages in terms of robustness; we demonstrate this with numerical experiments. This rule can provide a risk-averse investor with protection against very bad outcomes.

The 1/N Heuristic in 401(k) Plans

Huberman, Gur and Jiang, Wei, "The 1/N Heuristic in 401(k) Plans" (March 15, 2004). EFA 2004 Maastricht Meetings Paper No. 2036

Abstract:
Records of more than half a million participants in more than six hundred 401(k) pension plans indicate that participants tend to use a small number of funds: The number of participants using a given number of funds peaks at three funds and declines with the number of funds for more than three funds. Participants tend to allocate their contributions evenly across the funds they use, with the tendency weakening with the number of funds used. The median number of funds used is between three and four, and is not sensitive to the number of funds offered by the plans, which ranges from 4 to 59. A participant's propensity to allocate contributions to equity funds is hardly sensitive to the fraction of equity funds among those offered by his plan. The paper also comments on limitations on inference available from experiments and from aggregate-level data analysis.

Naive Diversification Strategies in Defined Contribution Saving Plans

Shlomo Benartzi and Richard Thaler

Abstract:
There is a worldwide trend toward defined contribution saving plans and growing interest in privatized Social Security plans. In both environments, individuals are given some responsibility to make their own asset-allocation decisions, raising concerns about how well they do at this task. This paper investigates one aspect of the task, namely diversification. We show that some investors follow the “1/n strategy”: they divide their contributions evenly across the funds offered in the plan Consistent with this naive notion of diversification, we find that the proportion invested in stocks depends strongly on the proportion of stock funds in the plan.

How Inefficient are Simple Asset-Allocation Strategies?

DeMiguel, Victor, Garlappi, Lorenzo and Uppal , Raman, "How Inefficient are Simple Asset-Allocation Strategies?" (February 2005).

Abstract:
In this paper, we wish to evaluate the performance of simple asset-allocation strategies such as allocating 1/N to each of the N assets available. To do this, we compare the out-of-sample performance of such simple allocation rules to about ten models of optimal asset-allocation (including both static and dynamic models) for ten data sets. We find that the simple asset allocation rule of 1/N is not very inefficient. In fact, it performs quite well out-of-sample: it typically has a higher Sharpe ratio, a higher certainty equivalent value, and a lower turnover than the policies from the optimal asset allocation. The intuition for the good performance of the 1/N policy is that the loss from naive rather than optimal diversification is smaller than the loss arising from having to optimize using moments that have been estimated with error. Simulations show that the performance of policies from optimizing models relative to the 1/N rule improves with the length of the estimation window (which reduces estimation error) and also with N (which increases the gains from optimal diversification). But, even with an estimation window of 50 years, the difference in the performance of the 1/N policy and the policies from models of optimal asset allocation is not statistically significant.

2006 Year End Portfolio Rebalancing

2007-01-23T22:04:00.000-08:00

My portfolio rebalancings at 2006 year end simply returned my portfolio to policy weights. My rebalancing included:

Allocating my annual transfer of SIMPLE IRA accumulations over to my Traditional IRA and placing the proceeds into Inflation Indexed Bonds;
Allocating my 2007 Roth contribution into Short Term Bonds;
Rebalancing my Variable Annuity REIT Index holdings into Variable Annuity Short Term Bonds;
Rebalancing from my taxable account short term reserves into Total Stock Market Index and Tax-Managed International Fund allocations.

Asset Allocation and Asset Location

2007-01-23T21:34:00.000-08:00

The following papers examine the optimal division of asset classes between taxable and tax preferenced accounts. A fine tool for determining asset location can be found at Easy Allocator.

Maximizing Long-Term Wealth Accumulation:It’s Not Just About "What" Investments To Make,But Also "Where" To Make Them

Robert M. Dammon, Carnegie Mellon University
James Poterba, Massachusetts Institute of Technology
Chester S. Spatt, Carnegie Mellon University
Harold H. Zhang, University of Texas at Dallas

EXECUTIVE SUMMARY
Individuals who are saving for retirement are likely to know that the level of savings and the asset allocation of their savings are two very important factors affecting wealth accumulation. Another factor called asset location — which refers to the placement of certain types of assets in tax-deferred accounts and other types of assets in taxable accounts — is far less understood
The winners of the 2004 TIAA-CREF Paul A. Samuelson Award tackled this issue head-on, and concluded that equities are far better suited for taxable accounts than for tax-deferred accounts, and that bonds are far better suited for tax-deferred accounts than for taxable accounts. The reason for this preference is the different tax treatment of equity investments compared to fixed-income investments. Other research findings include:
Choosing the right asset location for a pair of asset classes is more important when the tax rate differential between the two types of assets is greater and when the rate of return on the relevant assets is high.
The relative proportions of taxable and tax-deferred wealth are an important factor in determining one’s optimal asset allocation. According to the Samuelson award-winning authors, other factors being equal, an investor’s optimal equity allocation will be higher when a larger proportion of his/her total wealth is held in taxable accounts, and that his/her optimal bond allocation will be higher if the bulk of his/her wealth is held in tax-deferred accounts.
The ideal situation occurs when the desired asset allocation is reached by investing the entire tax deferred account in bonds and the entire taxable account in equities. More often, the proportions of financial assets don’t match up neatly with the desired asset allocations, and so adjustments may be needed. The authors state that for maximum tax efficiency, individuals should not hold mixed portfolios of equities and bonds in both their taxable and tax-deferred accounts.

Ta x Efficient Saving and Investing

By William Reichenstein, Ph.D.,
TIAA-CREF Institute Fellow, Baylor University
February 2006

EXECUTIVE SUMMARY

A central component of investment advice in recent decades both for individual and institutional investors has focused on asset allocation, and rightly so since it plays a critical role in determining returns. For individual investors, tax management also plays a significant role in maximizing wealth but it typically does not receive the attention it deserves. This Trends and Issues examines four types of tax considerations that can reap benefits to investors:

• Choice of Savings Vehicle. To the degree possible, individuals should take maximum advantage of tax-favored savings vehicles, including tax-deferred accounts such as 401(k)s, 403(b)s and traditional IRAs, as well as after-tax accounts such as Roth IRAs, Roth 401(k)s, and Roth 403(b)s. All of these accounts essentially allow for tax-exempt growth on their after-tax values.
• After-Tax Asset Allocation. As noted, most individuals are aware of the importance of asset allocation but they calculate it as though assets in tax-deferred accounts are worth the same amount as those in taxable accounts. As a result, they overstate the allocation to the dominant asset class held in tax-deferred accounts. When calculating their asset allocation, they should convert all assets to after-tax values and then calculate their asset allocation using these after-tax values. For example, assets in tax-deferred accounts should be converted to after-tax funds by multiplying the pretax value by 1 minus the expected tax rate during retirement. Sometimes assets in taxable accounts also need to be converted to after-tax values, but the adjustments generally are not as large.
• Tax-Efficient Investing (Including the Role of the Stock Management Style). Examples of tax-efficient investing in one’s taxable account include: a) tax-loss harvesting, in which capital losses are realized in order to offset capital gains or ordinary income; and, 2) passive, index-type investing where unrealized gains are allowed to accumulate, thus providing tax deferral and even exemption if assets ultimately receive a step-up in basis or are donated to charity.
• Asset Location. This concept refers to appropriate location of equities and fixed income. In general, fixed income should be held in retirement accounts such as 403(b)s and Roth IRAs and equities, especially passively-managed stocks, should be held in taxable accounts. The reason for this preference is that, when held in taxable accounts, equities are generally taxed more favorably than fixed income. Equities in taxable accounts can benefit from lower capital gains tax rates, and taxation on gains can be deferred as long as the investor continues to hold the equities. Taxation on gains can even be avoided altogether if the owner holds the equities until death, at which time they receive a step-up in basis. In addition, capital losses can offset capital gains and reduce income.

Non-qualified Annuities in After Tax Optimizations

William Reichenstein, Baylor University

Abstract
This study first explains why individuals should calculate an after-tax asset allocation. This asset allocation distinguishes between pretax funds in say a 401(k) and the generally after-tax funds in a taxable account. Separately, it performs mean-variance optimizations for individual investors. It concludes that, in general, almost all investors should locate bonds in Roth IRAs and qualified retirement accounts (e.g., 401(k)) and stocks, especially passively held stocks, in taxable accounts. At lower levels of risk tolerance, investors should substitute bonds held in non-qualified annuities for stocks held in taxable accounts. At higher levels of risk tolerance, they should substitute stocks for bonds held in Roth IRAs and qualified retirement accounts. The analysis suggests that the people who should be most interested in holding stocks in annuities are those who trade too frequently to qualify for preferential capital gain tax rates. Finally, this study may be the first to demonstrate that an individual investor bears more risk when an asset is held in an annuity instead of taxable account, and it considers the implications of this conclusion for optimal asset-allocation and asset-location decisions.

Asset Allocation and Insurance Hedging

2007-01-23T20:34:00.000-08:00

The question of how to hedge risks to human capital (early in life) and indeterminate life expectancy (later in life) by broadening the asset allocation paradigm to included insurance hedging with life insurance and immediate annuities are examined in the following two papers:

Human Capital, Asset Allocation, and Life Insurance

P. Chen, R. Ibbotson, M. Milevsky and K. Zhu
Version: February 25, 2005

Abstract
Human capital should be taken into account when building portfolios for individual investors. One unique risk for an investor’s human capital is mortality risk, the loss of human capital in the unfortunate event of premature death. Life insurance hedges against mortality risk. Human capital affects both the optimal asset allocation and the optimal life insurance demand. However, asset allocation and life insurance decisions have consistently been analyzed separately in theory and practice. We develop a unified human capital based framework to help individual investors make both decisions. We investigate the impact of the size of human capital, its volatility, and its correlation with other assets; bequest preference; and subjective survival probability through five case studies. Our analysis validates some intuitive rules of thumb and provides additional results.

Merging Asset Allocation and Longevity Insurance: An Optimal Perspective on Payout Annuities

by Peng Chen, Ph.D., and Moshe A.Milevsky, Ph.D.

Although several recent papers in the Journal of Financial Planning have discussed the mechanics and importance of lifetime, or payout annuities, the industry currently lacks a coherent and formal model of how much wealth should be allocated within and between these products.This paper revisits the importance of longevity insurance—while discussing the concerns with a strategy consisting purely of fixed payout annuities—and then addresses the proper asset allocation between conventional financial assets and payout annuity products. Our focus is on maximizing a suitably defined objective function in an intuitive,comprehensible and practical manner. In addition to the usual risk and return preferences of investors, our modeling framework requires inputs on the relative strength of retirees’bequest motives, their subjective versus objective health status, and their pre-existing longevity insurance (aka pensions).To illustrate the model,we provide some brief case studies.

Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors

2007-01-23T10:28:00.000-08:00

Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors

Chhabra, Ashvin B., "Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors" . The Journal of Wealth Managment, Vol. 7, No. 4, pp 8-34, Spring 2005

Abstract:
In sharp contrast to the recommendations of Modern Portfolio Theory (MPT), a vast majority of investors are not well diversified. This neglect of diversification is seen across all wealth segments, including the affluent. This paper attempts to provide a solution to this “diversification paradox,” by expanding the Markowitz Framework of diversifying market risk to also include the concepts of Personal Risk and Aspirational Goals.

The Wealth Allocation Framework enables individual investors to construct appropriate portfolios using all their assets, such as their home, mortgage, market investments and human capital. The investor may choose to accept a slightly lower “average rate of return” in exchange for downside protection and upside potential. The resulting portfolios are designed to meet individual investors' needs and preferences, as well as to protect individuals from Personal, Market and Aspirational risk factors.

The Wealth Allocation Framework attempts to bring together MPT with aspects of Behavioral Finance through a single pragmatic Framework. A major conclusion of this work is that, for the individual investor, Risk Allocation should precede Asset Allocation.

2006 Asset Allocation Update:

2006-08-11T10:30:00.000-07:00

My portfolio remained essentially in balance during 2005 and 2006. I direct dividend distributions in the taxable account to my treasury money market fund (which is part of my emergency reserves). These funds were reinvested in short term bonds.

As my short term bond allocation was underweighted , I shifted my Roth IRA inflation indexed bond fund allocation to the short term bond index.

Rumor has it that my second job might institute a 401-k program. Since my part-time second job income is invested (in my Roth and taxable portfolio), participation in this plan will depend on:

1.) The availability of a company matching contribution
2.) The expense loading and fund selections of the plan.

My Current Asset Allocation

2005-11-28T00:57:00.000-08:00

Keeping in mind that every individual must tailor an asset allocation plan to his or her own specific circumstances, I nevertheless felt that readers might be interested, and to some degree, entitled to have me reveal my asset allocation plan.

My portfolio is divided 50% equity/50% fixed income. Wherever possible, my asset classes are either indexed, tax-managed, or defined asset class funds. Without further ado, my current Asset Allocation Plan includes the following asset classes:

Table 1. Asset Allocation
Asset Class	Portfolio Allocation
US Market	8%
US Value	6%
US Small	5%
US Small Value	6%
US Realty	6%
International EAFE	6%
International Value	3%
International Small	3%
Emerging Markets	3%
Gold	4%
Real Bonds	30%
Short Bonds	20%

My Asset Location consists of the following account structures:

Table 2. Accounts
Account	Portfolio Allocation
Taxable Account	33%
Roth IRA	25%
Traditional IRA	25%
SIMPLE IRA	2%
Variable Annuity	15%

My annual invesment contribution flows into each asset location as follows:

Table 3. Accounts
Account	Portfolio Allocation
Taxable Account	21%
Roth IRA	36%
Traditional IRA	43%
SIMPLE IRA	0%
Variable Annuity	0%

Each year I execute a trustee to trustee transfer of SIMPLE IRA asset balances to my Traditional IRA. (This is why my annual investment contribution to the SIMPLE IRA is entered as 0%; the contribution is registered in the Traditional IRA.)

The taxable account consists of my Total Market allocation, as well as tax-managed allocations in Small Cap and International EAFE allocations. I also hold Emerging Market and Gold allocations in this account. Fixed allocations consist of real bonds (I bonds) and a limited term tax exempt fund. For this account, I redirect all dividend and capital gains distributions to my cash reserves (a treasury money fund). Redirection of dividends allows me to more effectively rebalance asset classes in a tax-efficient manner, as well as simplifying tax accounting.

The Roth IRA contains my allocations to Value, Small Value, International Value, and International Small allocations. For rebalancing purposes I also hold a small allocation to an inflation-indexed bond fund in this account.

The Traditional IRA is allocated to inflation-indexed bonds. The SIMPLE IRA plan fiduciary is a high cost, scandal plagued load fund group, so I hold my plan accumulations in the fund group's no-load money fund awaiting my annual transfers to my IRA.

The no-load, low-cost, no surrender fee Variable Annuity Account is allocated among equity REITS and short term investment grade bonds.