Active Portfolio Management and Positive Alphas: Fact or Fantasy?
It is commonly believed that active portfolio management can generate positive alphas.This is partly based on the belief that positive alphas represent disequilibrium returns, which can exist in complex financial markets.In contradiction, this article shows that positive alphas represent arbitrage opportunities, not just disequilibrium returns.As persistent and frequent arbitrage opportunities are much rarer, even in complex markets, Jarrow argues that positive alphas are more fantasy than fact. He introduces the notion of an unobservable factor that can generate false positive alphas, and which resolves the inconsistency between common belief and the sparsity of positive alphas. More »
Signal Weighting
Signal weighting is the name commonly used for the allocation of risk between several potential sources, or themes, each of which is assumed to have some potential for adding value. The signal-weighting decision is an important facet of any investment process. Grinold presents a portfolio-based approach to the choice of signal weights in the presence of trading costs. In the absence of costs, the weights depend on the assessed strength of the signals—the correlations between the signal and the desired level of portfolio risk. In the presence of costs, the method also depends critically on the rate that new information arrives for each of the signals as well as the rate of change (trading speed) of the portfolio. The resulting model is robust and relatively simple to use. The model also forces portfolio managers to view their portfolios and their respective drivers as objects in motion. That change of perspective alone is valuable. Technical material is contained in two appendices that can be obtained from the author. More »
Thinking about Indices and "Passive" versus Active Management
Trillions of dollars are indexed to various benchmarks, which the authors refer to as paper indices. Paper indices are based on a surprisingly large number of arbitrary, active decisions that are made by the organizations that sponsor them. Fuller, Han, and Tung investigate the importance of these active decisions on benchmark returns by constructing their own paper index, allowing them to estimate the amount of shortfall relative to their index that an indexer would incur due to transaction costs related to mimicking the index. The estimated shortfall is 2 to 4 basis points a year, depending upon the assumptions made regarding transaction costs. The authors also show that traditional indexing, relative to the benchmark they constructed, can be improved—using only market value data available to any indexer—by about 25 to 30 basis points a year after transaction costs. The authors conclude that no investment strategy is passive. Although the strategy of traditional indexing has a number of attractive attributes, it is not passive in the sense that the word passive is commonly used. More »
Constraint Attribution
Constraints are now an integral part of the portfolio construction process.With constraints comes the challenge of understanding how they cause the optimal portfolio to deviate from a trade-off dictated by the forecasts of risk and return. Stubbs and Vandenbussche describe the theory and application of a technique that is able to quantify the impact of individual constraints in several different ways, including decomposing the difference between the optimal constrained and unconstrained portfolios as well as the difference between alphas and implied alphas as described in earlier work by Grinold and others. The authors also introduce a new technique that applies these decompositions on an ex post basis, thus providing an understanding of how constraints actually impact realized risk and return. More »
The Properties of Equally Weighted Risk Contribution Portfolios
Minimum-variance portfolios and equally weighted portfolios have recently prompted great interest from both academic researchers and market practitioners because their construction does not rely on expected average returns and, therefore, is assumed to be robust. In this article, the authors consider a related approach in which the risk contribution from each portfolio component is made equal, maximizing the diversification of risk, at least, on an ex ante basis. Roughly speaking, the resulting portfolio is similar to a minimum-variance portfolio subject to a diversification constraint on the weights of its components. The authors derive the theoretical properties of such a portfolio and show that its volatility is located between those of minimum-variance and equally weighted portfolios. Empirical applications confirm that ranking. Equally weighted risk contribution portfolios appear to be an attractive alternative to minimum-variance and equally weighted portfolios and, therefore, could be considered a good trade-off between the two approaches in terms of absolute risk level, risk budgeting, and diversification. More »
Inverse and Leveraged ETFs: Not Your Father's ETF
First-generation ETFs were designed as convenient, straightforward investment vehicles for earning the returns of broad market indexes. The rapid growth and competitiveness of the ETF industry has led to the development of products that bear more complicated relationships with market indexes. The first wave of these, leveraged and inverse ETFs, were engineered to meet objectives quite different from those of the traditional ETFs. This article shows how investors who used them like traditional ETFs experienced unintended consequences during the volatile markets of 2008–2009. The author explains how the daily rebalancing of leverage affects the valuation and determines the appropriate usage of such ETFs. More »
Actively Managed Exchange-Traded Funds
ETF assets have steadily grown worldwide from $310 billion in 2004 to $815.2 billion as of March 31, 2010, gathering over $100 billion in each of the last three years, which included the upheaval of 2008 and early 2009. In the United States, ETF assets grew at a compound annual growth rate of over 30% from 2000 to 2009. This growth has attracted start-up managers who are launching niche ETFs, as well as some of the industry’s most well-known managers with significant assets under management, who are incorporating ETFs into their diverse product lineups. ETFs also have a history of product innovation, and this article explores the latest innovation: actively managed ETFs. The article outlines the key features of ETFs, describes the current ETF classifications, addresses whether a mutual fund can convert to an ETF, discusses the active ETFs currently available, and analyzes the impediments to widespread adoption of active ETFs. More »
ETF Mythbuster: Tracking Down the Truth
The rising popularity of ETFs as short-term trading tools as well as longer-term investment vehicles has brought increased attention to how they perform. Tracking error is a one of the most common measures of how well index funds (and ETFs) perform. But tracking error is often misused by the media and investors when referring to ETF performance. In this article, the authors clarify some of the most common misconceptions regarding ETF performance. They also show that relative performance is, in general, far better than tracking error calculations might imply. More »
S&P ETFs: Arbitrage Opportunities and Market Forecasting
The article examines the pricing differences between two S&P 500 ETFs (ticker symbols SPY and IVV) and the underlying stock index. The author finds that, on average, both ETFs trade at a premium relative to the S&P 500; however, the level of the daily premium (and, on occasion, discount) varies between the two securities, which creates the opportunity for arbitrage. Since the passage of Regulation NMS in mid-2005, the pricing differences, as expected, have declined, implying that any current/future arbitrage opportunity will be confined to periods of high market volatility, such as 2008. Beyond issues related to arbitrage, the author finds that the relative pricing of the ETFs also provides a valuable signal of future (particularly next day) market activity. Thus, he suggests that active traders and longer-term investors may both benefit from recognition of relative ETF prices. More »
Diversification and Risk Management with Index Products During the 2008 Financial Crisis
Many U.S. institutional investors are legally required to be diversified so as to minimize the risk of large losses, but this diversification requirement recently was difficult to meet, as key benchmark indexes for nine different types of investments—real estate, U.S. large-cap stocks, U.S. small-cap stocks, international stocks, private equity, venture capital, commodities, hedge funds, and highyield debt—all experienced huge losses in and around 2008. Some losses exceeded 50% over a 16-month period.Some investors thought they were well-diversified with investments in many of the foregoing investments, but they were dismayed to learn that in 2008 the correlations of returns for many investments rose sharply and some well-regarded diversification principles did not fare well. The author found four investments that actually did rise in 2008:managed futures, gold, volatility, and Treasury bonds.The findings of this article could be useful to investors who are re-evaluating ways to diversify to minimize the risk of large losses in the future. More »
Examining the Use of Investment Policy Statements
Using a sample of Investment Policy Statements from college and university endowments, the authors examine the form and use of these important documents. Direct examination of the IPS reveals subtleties that surveys may obscure. In addition to providing statistical insights into endowment management, the authors extract what they view as best practices from the Investment Policy Statements themselves. This study provides valuable insights for individual and institutional investors and their advisors. More »
Historical Performance of Asset Location Strategies and Its Implications for Investors' Retirement Portfolios
This study investigates how two portfolios, both holding Treasury bonds and the passively managed U.S. stock market index but utilizing opposite location strategies, would have performed historically over the 1928–2009 period and finds that the relative performance of the two portfolios differs substantially during the two halves of the period. The return to full taxation of dividends at marginal income tax rates created a significant advantage for the stock-sheltered portfolio as the combination of the changes in tax legislation and high dividend payouts contributed to the consistent outperformance of the stock-sheltered portfolio until mid-1980s. During the second half of the period, which was characterized by elevated inflation, substantially higher bond returns, and shrinking dividend yields, the advantage of the stock-sheltered portfolio was gradually eliminated due to the diminished level of tax inefficiency of equities. The relative attractiveness of the stock-sheltered portfolio declines with higher risk aversion but increases with a higher share of payout distributions. The expected tax environment of 2011 combined with a modest size of the realized stock market risk premium would marginally favor the stock-sheltered portfolio. More »
Yes Virginia, Diversification Is Still a Free Lunch
Recent financial market turbulence led many analysts to question the efficacy of diversification. This article uses changing correlations to show that diversification is still the tool that enhances risk-adjusted performance. Recent economic turbulence, however, makes it necessary to include more asset classes. More »
On the Popularity of the CPPI Strategy: A Behavioral-Finance-Based Explanation and Design Recommendations
The constant proportion portfolio insurance (CPPI) strategy is frequently used on both the institutional and the retail sides of the asset management industry. While standard finance theory struggles to justify its popularity, this article attempts to explain the widespread use of the CPPI strategy by referring to elements of behavioral finance. We run bootstrap as well as Monte Carlo simulations for the CPPI strategy and for simple benchmark strategies in order to evaluate the outcomes using cumulative prospect theory. Our simulation results indicate that the CPPI strategy is the preferred strategy for a prospect theory investor. The analysis provides hints at how a CPPI-based investment product should be designed in order to meet the preferences of a prospect theory investor as well as possible. More »
Angel Investors: Who They Are and What They Do; Can I Be One, Too?
Angel investors go by many definitions. By all definitions, however, angel investors act as informal venture capitalists and collectively invest billions of dollars in thousands of entrepreneurial projects annually. Despite their importance to small businesses and entrepreneurs, angel investments have received comparatively little attention from investment managers and writers. This article describes the advantages and disadvantages of angel investing and suggests ways for investors to extract the maximum benefits—both pecuniary and nonpecuniary—from angel investing. More »
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