Reverse Asset Allocation: Alternatives At The Core,

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

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

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

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?

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

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

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

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

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

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Commercial equity real estate: A framework for analysis

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

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

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

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

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

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

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)

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

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

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

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.