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Asset Class Reader: Nominal Bonds

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 International Bond Diversification

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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