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"The mark of a well educated person is not necessarily
in knowing all the answers, but in knowing where to find them."
—— Douglas Everett.
Here you will find relatively brief articles and papers, each of which
focuses on a fairly narrow topic. For more broad coverage of investing
issues, see our Reading Room for Books.
We've listed herein a mix of good articles from the popular press (intended for
lay people) and highly technical academic papers. Hopefully, these
materials will elucidate more than they confuse. We've included links for the vast
majority of the entries. Note that some of the papers are quite lengthy
and may take a fair amount of time to download.
Unfortunately, some papers aren't freely available on the Internet at this
time (to the best of our knowledge). You may be able to find them at large
public libraries. You almost certainly will be able to locate them at most
business school libraries. For those papers which aren't freely available
online, we've tried to include brief summaries.
Articles written in a fashion such that laypeople can
probably understand them are colored blue
— most people should be able to
comprehend them. Technical articles and
papers intended for professionals/academics are colored red.
If you have questions or comments about any of the materials referenced here, contact us — we love
talking about this stuff!
Asset allocation refers to the division of one's investment portfolio across
the various asset classes. At the highest level, this refers to a split
between stocks and bonds. Many more finely defined sub-asset allocations
are also common. Also, see Modern
Portfolio Theory, Rebalancing and
Tax-Managed Investing.
 | Gary P. Brinson, L. Randolph Hood, and Gilbert P. Beebower, "Determinants
of Portfolio Performance," Financial Analysts Journal, July/August
1986, pp. 39-44. This was the paper which revolutionized
portfolio construction by emphasizing the importance of asset allocation.
It found that, on average, 93.6% of the total return variation of the pension funds studied
over time was due solely to asset allocation. Further, it found that active
management resulted in an annual reduction of 1.1 percentage points in total
returns.
|
| Gary P. Brinson, Brian D. Singer, and Gilbert P. Beebower, "Determinants
of Portfolio Performance II: An Update," Financial Analysts Journal,
May/June 1991, pp. 40-48. "Clearly, the contribution of
active management [which was found to be somewhat negative] is not
statistically different from zero." An update of their previous work, with similar
conclusions.
|
| John C. Bogle, "The
Riddle of Performance Attribution: Who's in Charge Here —
Asset Allocation or Cost?," a speech presented before the Financial Analysts Seminar Sponsored by
the Association for Investment Management and Research At Northwestern
University, Evanston, Illinois July 20, 1997.
Vanguard's founder concludes that, while asset allocation is very important,
controlling costs is also very important.
|
| Natalie Chieffe, "Asset Allocation, Rebalancing, and
Returns," Journal of Investing, Winter 1999, pp. 43-48.
"The results of this research show that market conditions tend not to
provide reliable information on which to base the rebalancing decision
[i.e., tactical asset allocation decisions]. Much of the advice
presented to investors during periods of unusual market activity should be
ignored. It is more important to rebalance the retirement portfolio on
the basis of a change in risk aversion, rather than on the conditions in the
financial markets."
Basically, this paper supports the idea of strategic, not tactical, asset
allocation.
|
| John H. Cochrane, "Portfolio
Advice for a multifactor world," Economic Perspectives,
XXIII (3) Third quarter 1999 (Federal Reserve Bank of Chicago), pp. 59-78
(296kb). Pragmatic advice on asset allocation.
|
| Wolfgang Drobetz and Friederike Köhler,
"The
Contribution of Asset Allocation Policy to Portfolio Performance,"
WWZ/Department of Finance Working Paper No 2/02 (115kb). "...
active management not only failed to add value above the policy benchmarks
[but] it destroyed a significant portion of investors' value." This
paper concludes that asset allocation accounts for about 134 percent of the
level of portfolio performance (implying that active management accounts for
about minus 25%).
|
| Eugene F. Fama and G. William Schwert, "Asset
Returns and Inflation," Journal of Financial Economics, November
1978, pp. 115-146 (1.49mb). For a smaller file version, see
here (749kb).
This paper studies the relative efficacy of various asset classes as inflation
hedges. It finds that treasury bonds are a complete hedge against
expected inflation. It also finds that private residential real estate
is a complete hedge against both expected and unexpected inflation.
|
| Roger C. Gibson, "A
Timely Reminder: The recent market tumult offers a perfect opportunity to
remember the advantages of a diversified, balanced portfolio,"
Financial Planning, October 2001. An excerpt from Mr.
Gibson's outstanding book,
Asset Allocation: Balancing Financial Risk (McGraw-Hill, 2000).
|
| Sherman Hannah and Peng Chen, "Subjective
and Objective Risk Tolerance: Implications for Optimal Portfolios,"
Financial Counseling and Planning Journal, Vol 8 No 1 1997, pp. 17-26.
"For a typical investor under the age of 50, a retirement savings portfolio
should be 100% in stocks." This paper attempts to make suggestions
primarily based on need and ability to bear risk ("objective risk"), but not
very much on willingness to bear risk ("subjective risk"). In
general, we do not agree with the 100% stock asset allocation recommendation
except in cases where there is a very high willingness and ability to tolerate
risk.
|
| Steven Horan,
"After-Tax
Valuation of Tax-Sheltered Assets," Financial Services
Review, 11 2002, pp. 253-275. This study builds on
Reichenstein and Sibley papers below.
|
| Jeffrey T. Hoernemann, Dean A. Junkans, and Carmen
M. Zarate, "Strategic Asset Allocation and Other Determinants of Portfolio
Returns," Journal of Wealth Management, Winter 2005, pp. 26-38.
This study reviews and revises the Brinson studies above. This study
concludes that strategic asset allocation only explains about 77.5% of the
variability of portfolio returns, not 90+% as suggested by Brinson et. al.
|
| Kwok Ho, Moshe Arye Milevsky, and Chris Robinson,
"Asset Allocation, Life Expectancy, and Shortfall," Financial Services
Review, 3(2) 1994, pp. 109-126. Also
here. This study suggests that, in
order to minimize shortfall risk, it may be appropriate for investors to
maintain 100% stock allocations well into their retirements (i.e., as late as
age 75 for men and 80 for women). In general, we do not agree that most
retirees should use such a high stock allocation unless they have a very high
willingness and ability to tolerate risk.
|
| Roger G. Ibbotson and Paul D. Kaplan, "Does
Asset Allocation Policy Explain 40, 90, or 100% of Performance?,"
Ibbotson Associates (97kb). Also
here. The
full article appeared in
Financial Analysts Journal, January/February 2000 (244kb). An
analysis of criticisms of the two "Determinants of Portfolio Performance"
papers.
|
| Scott L. Lummer and Mark W. Riepe, "The
Role of Asset Allocation in Portfolio Management," Ibbotson Associates
(40kb). Also
here. This paper also appeared in
Global Asset Allocation: Techniques for Optimizing Portfolio Management
(John Wiley & Sons, 1994).
|
| David Nawrocki, "The
Problems with Monte Carlo Simulation," Journal of Financial Planning,
November 2001, pp. 92-106. Also
here. This excellent article puts Monte
Carlo simulations into perspective. Consumers are increasingly being led
to believe that use of a Monte Carlo simulator accurately projects the
probability of meeting their financial goals. The article correctly
exposes this fraud. We believe that Monte Carlo simulators may be useful
in educating clients about the nature of risk and return tradeoffs, but they
certainly shouldn't be counted on to determine one's asset allocation.
The principal problem with them is that the entire analysis depends solely on
the validity of the data inputs as predictors of the future.
Unfortunately, there is only one thing we know for certain about those inputs,
whatever they might be: they are wrong. We don't know how wrong they are
or whether they overstate or understate the future, but we are 100% certain that they
are wrong. Good bibliography at the end and good sidebar by John
Kingston.
|
| John Nuttall, "The
Importance of Asset Allocation." A harsh, but very valid,
critique of the "Determinants of Portfolio Performance" papers.
|
| André F. Perold and
William F. Sharpe, "Dynamic Strategies for Asset Allocation," Financial
Analysts Journal, January/February 1988, pp. 16-27. This
paper studies three dynamic asset allocation strategies: Buy-and-hold,
portfolio insurance (both constant proportion and options-based), and
constant-mix. The paper concludes that each might be most appropriate in
certain market conditions or for certain clients. We believe that the
constant-mix strategy is most appropriate for most individual investors in
that it controls the amount of risk in the portfolio. Controlling risk
not only controls expected return, but it tends to preclude investors from
allowing well-documented psychological phenomena
to influence them to do
things which are adverse to their financial well-being.
|
| William Reichenstein, "Calculating
Asset Allocation," Journal of Wealth Management, Fall 2000 (54kb).
A similar article, "Rethinking
the Family's Asset Allocation," appeared in Journal of Financial
Planning, May 2001, pp. 102-109. Another similar paper, "Asset
Allocation and Asset Location Decisions Revisited," appeared in the
Journal of Wealth Management, Summer 2001. Yet another similar paper, "Calculating
the family's asset mix," appeared in the Financial Services Review,
Volume 7 Number 3 1998 (1.49mb).
This paper suggests that asset allocation should be calculated on the basis of
post-tax values of your portfolio. For example, $100,000 in a Roth IRA
is worth much more than $100,000 in a 401(k) due to eventual tax effects.
|
| William Reichenstein, "10 Lessons You Should Learn
from Recent Market History," AAII Journal, February 2003.
Here are the ten lessons referred to in the title:
 | Mixing bonds and stocks moderates portfolio risk; |
| Portfolio risk rises disproportionately slowly as stocks are added to
the portfolio; |
| An all-bonds portfolio is not the lowest-risk portfolio; |
| Portfolio returns rise disproportionately quickly as stocks are added to
the portfolio; |
| An often-overlooked risk for the long-run investor is the risk of having
a too-conservative portfolio; |
| By rebalancing once a year, you maintain a stable risk exposure; |
| A balanced portfolio avoids market timing; |
| Due to rebalancing, if an asset class becomes overvalued, you will be
selling it as it rises; and, if an asset class becomes undervalued, you will
be buying it as it falls; |
| Rebalancing provides a discipline that helps investors overcome inertia; |
| A fixed-weight strategy takes little time and it can save time at tax
time.
|
|
| L. Jacobo Rodriguez, "Core
Equity: An Integrated Portfolio Solution," Institute for Fiduciary
Education, 2005.
This paper describes a somewhat novel approach to designing a portfolio.
Rather than developing your asset allocation and then implementing it with
several highly specialized funds, you would instead build all (or most) of the
allocation preferences into a single fund. DFA has done this with their
"Core Equity" funds, of which they have five. The idea is that you'd
combine one or more of those funds together, with other Core Equity funds or
other funds, to get the overall portfolio factor exposure that you desire.
|
| Paul A. Samuelson, "The Long-Term Case for
Equities: and how it can be oversold," Journal of Portfolio Management, Fall 1994, pp.
15-24.
This paper, written by a Nobel prize winner, warns against market timing,
warns against active management, and generally supports the prudence of
strategic asset allocation.
|
| Paul A. Samuelson, "Asset allocation could be
dangerous to your health: Pitfalls in across-time diversification," Journal
of Portfolio Management, Spring 1990, pp. 5-8. This paper,
written by a Nobel prize winner, warns against tactical asset
allocation (and is consistent with the prudence of strategic asset
allocation).
|
| Mike Sibley, "On
the Valuation of Tax-Advantaged Retirement Accounts," Financial
Services Review, 11 (2002), pp. 233-251 (726kb). An excellent discussion of
how to get an after-tax valuation for a retirement account. Due to the
assumption made that the taxable equivalent investment is perfectly tax
inefficient, the equations' applicability is limited only to valuing bond
investments.
|
| Steve Strongin and Melanie Petsch, "Protecting
A Portfolio Against Inflation Risk," Investment Policy, July/August
1997, pp. 63-82 (439kb). An excellent discussion of how to hedge
against various types of inflation risk. It suggests that international
diversification, inflation-indexed bonds, and commodities are the best hedges
against inflation.
|
| Ronald J. Surz, Dale Stevens, and Mark Wimer, , "The
Importance of Investment Policy,"
Journal of Investing, Winter 1999, pp. 80-85. "We find that, on average, policy [a.k.a., asset
allocation] explains approximately 100% of investment returns. If a manager
succeeds in adding value, this can drop to as low as 85% when risk is not
incorporated, and even to 75% on a risk-adjusted basis. If the manager fails to add value, policy can explain as much as 135% of
return unadjusted for risk, or 165% risk-adjusted; the difference between
these percentages and 100% is explained by manager value reduced through
market timing, selection, and/or costs. In other words, if a manager
neither adds nor reduces value, policy explains 100% of performance."
|
| Ronald J. Surz, Dale Stevens, and Mark Wimer, "The
Importance of Investment Policy: A Simple Answer to A Contentious Question,"
PPCA. "We find that, on average, policy [a.k.a., asset
allocation] explains approximately 100% of investment returns. If a manager
succeeds in adding value, this can decrease to as low as 85% when risk is not
incorporated, and even further to 75% on a risk-adjusted basis. On the other
hand, if the manager fails to add value, policy can explain as much as 135% of
return unadjusted for risk, or 165% risk-adjusted ..."
|
| Ronald J. Surz, Dale Stevens, and Mark Wimer, "Investment
Policy Explains All," Journal of Performance
Measurement, Summer 1999, pp. 43-47 (22kb) This paper also appeared
in Journal of Investing, Winter 1999, pp. 80-86. Another
critique of the two Determinants of Portfolio Performance papers.
|
| Yesim Tokat, "The
Asset Allocation Debate: Provocative Questions, Enduring Realities,"
Investment Research and Counseling /ANALYSIS, April 2005. A
summary of the issues. "Unless there is a strong belief in the
ability to select active managers who will deliver higher risk-adjusted net
returns, investors’ focus should be on the asset allocation choice and its
implementation using broadly diversified, low-cost portfolios with limited
market-timing."
|
| Yesim Tokat, Nelson Wicas, and Francis M. Kinniry, "The
Asset Allocation Debate: A Review and Reconciliation,"
Journal of Financial Planning, October 2006, pp. 52-63. A
summary of the issues. "Unless there is a strong belief in the
ability to select active managers who will deliver higher risk-adjusted net
returns, investors’ focus should be on the asset allocation choice and its
implementation using broadly diversified, low-cost portfolios with limited
market-timing."
|
| R. Douglas Van Eaton and James A. Conover, “Equity
Allocations and the Investment Horizon: A Total Portfolio Approach,”
Financial Services Review, 11(2) Summer 2002, pp. 117-133 (1.65mb).
Also here.
This article provides support for the idea that an investor's equity exposure
should be somewhat proportional to their time horizon (actually it should be
somewhat proportional to the ratio of existing assets to future savings). |
All securities bought or sold on exchanges have a bid-ask spread. This
is the difference between the security's selling price and its buying price.
The difference covers the costs and profits of the market maker. Whenever
you buy or sell a security on an exchange, you implicitly incur one-half of the
bid-ask spread as a transaction cost. Also, see
Illiquidity Premium.
| Kidwell, Blackwell, Peterson, and Whidbee, "Financial
Institutions, Markets, and Money," John Wiley & Sons. This
slide presentation summarizes Chapter 10 of the referenced book. The
highlight as it applies to this topic: In general, bid-ask spreads:
| are proportionately higher for low-priced stocks due to fixed costs of
operations. |
| are higher for trades of a few shares. |
| are higher for a large block trade; a liquidity service is performed. |
| are narrower with more frequent trading, where the costs of providing
liquidity are less. |
| are wider with traders with insider information, where the dealer may
have to incur the cost of price discovery, or buying high, selling low!
|
|
| Jinbaek Kim, "A
Study on the Bid-Ask Spread," U.C. Berkeley
Working Paper. The appendices here
are outstanding. They summarize the important existing research on the
bid-ask spread.
|
| Richard Roll, "A
Simple Implicit Measure of the Bid-Ask Spread in an Efficient Market,"
Journal of Finance, September 1984, pp. 1127-1139(342kb). This
paper suggests a simple formula for the effective Bid-Ask spread in an
efficient market.
|
| Hans Stoll, "Inferring the Components of the Bid-Ask
Spread: Theory and Empirical Tests," Journal of Finance, March 1989,
pp. 115-134. See
here for
a good discussion of this paper. This paper finds that serial
return covariances are strongly negatively correlated with the square of the
bid-ask spread. Further, the paper finds that the bid-ask spread can be
broken down empirically into the following components:
| Adverse Information Costs: 43%. |
| Inventory Holding Costs: 10%. |
| Order Processing Costs: 47%.
|
|
|
"Empirical Market Microstructure Research." A good summary of the
important existing research on the bid-ask spread.
|
Fixed income assets (e.g., bonds) are often added to a portfolio to lessen
its volatility. Another benefit from including bonds in a (otherwise all
equity) portfolio is the improved risk/return characteristics resulting from the
less than perfect correlation of bonds with equities and other assets.
Also, see Inflation-Indexed Bonds and
High-Yield Bonds (Junk Bonds).
| David A. Plecha, "Fixed
Income," Dimensional Fund Advisors. Details the rationale
behind DFA's fixed income strategies. An excellent, very readable
article.
|
| Vance Anthony, Martha Mahan Haines, and Murat
Aydogyu, "Report
on Transactions in Municipal Securities," United States Securities and
Exchange Commission, July 1 2004 (2.3mb). This excellent study
quantifies the extent of typical bid-ask spreads for individual municipal
bonds (they're big). The bid-ask spread is effectively a transaction
cost. Effectively, any time you buy or sell a municipal bond, you pay
one-half of the bid-ask spread as a transaction cost, perhaps in addition to a
brokerage commission. For a good discussion of this study, see the Zweig
article below.
|
| Manoj V. Athavale and Terry L. Zivney, "Now
is Always the Best Time to Buy Bonds,"
Journal of Financial Planning, August 2005, pp. 56-61. This
outstanding paper suggests that it makes sense to buy bonds when you need
them, even if that happens to be in a rising interest rate environment.
"... financial planners would better serve their clients by helping them
define their investment time frame and helping them understand the role of
bonds in their portfolio, and discouraging speculation on the direction and
magnitude of interest rate changes."
|
| Thomas J. Berger, "Global Bonds and
Emerging Debt: Worth Considering or Worth Forgetting?,"
Institute for Fiduciary Education, October 1 1999 (140kb). This
paper points out the diversification benefits of investing a portion of your
fixed income portfolio overseas.
|
| Donald G. Bennyhoff, "Municipal
Bond Funds and Individual Bonds,"
The Vanguard Group, July 2004. Also
here. This
paper looks at the pros and cons of using muni bond funds vs. using individual
bonds.
|
| Christopher R. Blake, Edwin J. Elton, Martin J.
Gruber, "The Performance of Bond Mutual Funds," Journal of Business,
July 1993, pp. 371-403. This study concludes, "Overall and
for subcategories of bond funds, we found that bond funds underperformed
relevant indexes. ... this underperformance was approximately equal to
the average management fees ..." "... on average, a percentage point
increase in expense leads to a percentage point decrease in returns ..."
This paper strongly supports the prudence of a strategy of selecting bond
funds by cost (i.e., choosing no-load funds with the lowest expense ratios).
|
| James L. Davis, "The
Information in the Term Structure: An Update," Dimensional Fund Advisors,
October 2000. Details the empirical support for DFA's "variable
maturity" strategy.
|
| Dale L. Domian and William Reichenstein, "Performance
and Persistence in Money Market Fund Returns," Financial Services
Review, 1997 Vol 6, pp. 169-183. This paper confirms strong persistence in money
market mutual funds due principally to the almost perfect negative correlation of expenses
and performance. The paper strongly supports the prudence of a strategy
of selecting money market funds by cost (i.e., choosing no-load funds with
the lowest expense ratios).
|
| Dale L. Domian, Terry S. Maness, and William
Reichenstein, "Rewards to Extending Maturity: Implications for investors,"
Journal of Portfolio Management, Spring 1998, pp. 77-92. This
paper confirms that short term bonds offer superior risk-adjusted returns to
those offered by longer term bonds. "The average term premium appears
to rise very sharply as maturity lengthens through about one year, continues
to rise through about three years, remains essentially flat from. about three
through fifteen years, and falls thereafter." "The greatest reward to
risk is realized for extending maturity through the shortest end of the bond
market. In fact, most of the average reward to extending maturity probably
occurs by the time maturity reaches one year."
|
| Dale L. Domian and William Reichenstein, "Predicting
Municipal Bond Fund Returns," Journal of Investing, Fall 2002, pp.
53-65. This paper confirms persistence in municipal bond mutual
funds due principally to the almost perfect negative correlation of expenses
and performance. The paper strongly supports the prudence of a strategy
of selecting municipal bond funds by cost (i.e., choosing no-load funds with
the lowest expense ratios).
|
| Scott J. Donaldson, "Taxable
Bond Investing: Bond Funds or Individual Bonds," Vanguard Investment
Counseling & Research/ANALYSIS, March 2005 (662kb). Also
here. An excellent
paper which compares and contrasts the pros and cons of buying individual
bonds vs. using low-cost bond mutual funds.
|
| Edwin J. Elton, Martin J. Gruber, Deepak Agrawal,
and Christopher Mann, "Explaining
the Rate Spread on Corporate Bonds," Journal of Finance, February
2001, pp. 247-278 (219kb). This paper studies the factors which
influence the difference between returns on corporate bonds and government
bonds. They found that the possibility of default for corporates
explains about 18% of the difference. They also found that the
tax-exempt treatment of government bonds at the state and local level explains
about 36% of the difference. Of the remaining effects, about 85% is
explained by factors which are commonly used to explain common stock returns.
|
| Cheol S. Eun and Bruce G. Resnick, "International
Diversification of Investment Portfolios: U.S. and Japanese Perspectives,"
Management Science, January 1994, pp. 140-161. "For U.S.
investors, the international bond diversification with exchange risk hedging
offers a superior risk-return trade-off than the international stock
diversification, with or without hedging." This paper supports the
prudence of hedging the currency risk on foreign bond investments.
|
| Eugene F. Fama, "Update
of the Research Underlying Dimensional's Bond Strategies,"
Dimensional Fund Advisors, September
2003. Updates the empirical support for DFA's "variable
maturity" strategy.
|
| Eugene F. Fama and Robert R. Bliss, "The Information
in Long-Maturity Forward Rates," American Economic Review, September
1987, pp. 680-692. This paper suggests that long forward interest
rates have significant power in predicting future spot interest rates.
"The 1-year forward rate calculated from the prices of 4- and 5-year bonds
explains 48 percent of the variance of the change in the 1-year interest rate
4 years ahead." In other words, the market is fairly efficient at
anticipating future interest rates.
|
| Walter V. Gerasimowicz, "Diversification
from a U.S.$ perspective," J.P. Morgan Securities Inc., March 8 1995.
A good discussion of the benefits of diversifying bond investments into
foreign bonds.
|
| Roberto C. Gutierrez, Jr., "Book-to-Market,
Equity, Size, and the Segmentation of the Stock and Bond Markets," Texas
A&M Working Paper, April 11 2001 (85kb). This paper suggests that
book-to-market ratio and market capitalization have explanatory power for the
cross section of corporate bond returns, just as they do for stocks.
|
| Eric E. Haas, "Corporate
Bond Fund or Individual Treasuries: Which is Better?," Altruist
Financial Advisors LLC Working Paper, May 4 2005. This paper
quantitatively answers the question, "Which is better for an individual
investor: A bond fund or individual bonds?" As you might imagine, the
answer ultimately is, "It depends." But basically, this paper suggests
that, over the period studied (85-02), a short-term investment grade corporate
bond fund would have outperformed, on a risk-adjusted basis, a portfolio of
individual treasury bonds, if the difference in its fees were less than about
0.71 percentage points. Since such funds are generally available (e.g.,
the Vanguard Short-Term Investment Grade Fund (VFSTX)), it seems prudent for
most individual investors to go the bond fund route.
|
| Delroy Hunter and David P. Simon, "Benefits
of International Bond Diversification," Journal of Fixed Income,
March 2004, pp. 57-68 (1mb).
This paper finds that, during the period 1992 to 2002, there was benefit to
diversifying a bond portfolio overseas, but only if you hedged the currency
risk.
|
| Antti Ilmanen, "Does
Duration Extension Enhance Long-Term Returns?," Journal of Fixed
Income, September 1996, pp.
23-36. "The main conclusion is that duration extension does
increase expected returns at the front end of the [yield] curve ... and
for durations longer than two years, no conclusive evidence exists of rising
expected returns."
|
| Antti Ilmanen, Rory Byrne, Heinz Gunasekera, and
Robert Minikin, "Which
Risks Have Been Best Rewarded?: Duration, equity market, and short-dated
credit risk," Journal of Portfolio Management, Winter 2004, pp.
53-57. This outstanding paper looks at what return
enhancing strategies are most "worthwhile" for bond investors: extending
duration, changing from bonds to stocks, and decreasing credit quality.
It finds that the highest increase in risk adjusted returns comes from
extending duration from treasury money market to the 1 to 3 year range, and
from increasing credit risk from zero (Treasuries) to investment-grade corporates. This paper supports a strategy of using short-term
investment grade corporate bonds as the (non-inflation indexed) bond component in your
portfolio.
|
| Haim Levy and Zvi Lerman, "The Benefits of
International Diversification in Bonds," Financial Analysts Journal,
September/October 1988, pp. 56-64. "There appears to be a very
large potential for international diversification in stocks and bonds, even if
we qualify the expectation of possible gains by recognizing the possible extra
costs associated with holding foreign investments."
|
| Burton G. Malkiel, "Expectations, Bond Prices,
and the Term Structure of Interest Rates,"
Quarterly Journal of Economics, May 1962, pp. 197-218.
This seminal paper laid out clearly some of the principal phenomena affecting bond
pricing.
|
| Craig McCauley, "The Case for Global Fixed Income,"
Global Investor, October 1996, pp. 29-31. "...
presents a compelling case for US investors to
substantially increase their exposures to international fixed income markets
(on a fully hedged or unhedged basis), and to maintain a permanent exposure to
this asset class."
|
| Robert C. Merton, "On
the Pricing of Corporate Debt: The Risk Structure of Interest Rates,"
Journal of Finance,
May 1974, pp. 449-470 (1.58mb). This paper suggests that
corporate bonds can be modeled as riskless bonds (i.e., Treasury bonds) plus a
put (i.e., an option to sell the stock) that bondholders issue to the owners
of the company’s stock. As the company's prospects become better, the
stock's price increases, which causes the value of the put to decrease (which
is good for the bondholders who issue the virtual puts), which causes the
value of the bond to increase, which causes the yield on the bond to decrease.
On a separate line of thought, as the company becomes riskier, the value of
the put increases (which is bad for the bondholders who issue the virtual
puts), which causes the value of the bond to decrease, which causes the yield
on the bond to increase. This is how high-yield bonds get to be
high-yield bonds!
|
| Frederick S. Mishkin, "The Information in the Term
Structure: Some Further Results," Journal of Applied Econometrics,
Oct-Dec 1988, pp. 307-314. "The term structure does help predict
spot interest rate movements several months into the future." This
paper provides additional support for the prudence of DFA's "variable
maturity" strategy.
|
| Alejandro Murguía and Dean T. Umemoto, "Analyzing
Fixed-Income Securities and Strategies," Journal of Financial Planning,
November 2005, pp. 80-90. A good discussion of issues
around investing in bonds.
|
| Eugene A. Pilotte and Frederick Sterbenz, "Sharpe
and Treynor Ratios on Treasury Bonds," Journal of Business,
January 2006. "Most
striking is our finding that reward-to-risk ratios vary inversely with
maturity and are incredibly high for short-term bills. Apparently investors
would do much better engaging in highly leveraged investments in bills instead
of purchasing long maturity bonds or common stocks." This
paper provides additional support for the prudence of keeping bond durations
short.
|
| Tom Potts and William Reichenstein, "Predictability
of Fixed Income Fund Returns," Journal
of Financial Planning, November 2004. This paper finds
that relative bond fund returns are somewhat predictable. For funds with
similar duration and credit worthiness, the difference in returns is likely to
be similar to the difference in expense ratio. The gross returns for
Intermediate-Term bond funds were consistent (over five year periods, but less
so for shorter periods) with the yield on five year treasuries at the
beginning of the period. The gross returns for Long-Term bond funds were
consistent (over ten to twenty year periods, but less so for shorter periods)
with the yield on twenty year treasuries at the beginning of the period.
|
| William Reichenstein, "Bond
Fund Returns and Expenses: A Study of Bond Market Efficiency," Journal
of Investing, Winter 1999, pp. 8-16 (488kb). This paper finds
a strong persistence in bond fund performance. It suggests this is due
to the strong negative correlation between a bond fund's expenses and its
performance. In other words, this paper suggests that selecting bond
funds by price (i.e., no-load funds with the lowest expense ratios) is an
extremely prudent strategy.
|
| V. Vance Roley and Gordon H. Sellon, Jr., "Monetary
Policy Actions and Long-Term Interest Rates," The Federal Reserve
Bank of Kansas City Economic Review, Fourth Quarter 1995, pp. 73-89
(142kb). This excellent paper describes, theoretically, how bond
yields respond to changes in the Federal Funds Target rate
— and why.
|
| Sandeep Singh and William H. Dresnack, "Market
Knowledge in Managed Municipal Bond Portfolios," Financial Services
Review, 6(3), pp. 185-196. "This study provides further
support in favor of indexing." "When state income taxes are considered
significant, for example, in states like New York and California, it is
beneficial for the individual investor to buy into state-specific municipal
bond funds." The paper found that state-specific muni-bond funds were
riskier than national funds, but they offered superior risk-adjusted after-tax
returns.
|
| Jason Zweig, "The
dark side of the muni: Municipal bonds seem safe, but buying or selling them
is fraught with peril. Protect yourself," Money, August
20 2004. This article discusses the high transaction costs of
buying and selling municipal bonds, as well as market inefficiencies of the
municipal bond market, at least from the perspective of an individual
investor. The study discusses the Anthony/Haines/Aydogyu study above.
|
| "Global
Bond Observations: A Realistic View of the Excess Return of Corporates,"
Bridgewater Associates (572kb). This excellent paper points out that,
while it may be true that corporate bonds are expected in the long run to have
higher returns than treasuries, it is due to higher riskiness. It
suggests that you'd have to wait about 26 years to have a 90 percent
probability of the added riskiness paying off in higher returns.
|
| "Global
Bond Observations: The Rationale for Investing in Global Bonds: A Brief
Overview," Bridgewater Associates, February 2000 (114kb). Also
here. This
excellent paper suggests that hedged foreign bonds can be expected to
outperform similar US bonds by about 0.5 percentage points per year with less
volatility. |
Broker/Dealers are involved with selling financial products and executing
brokerage transactions (as opposed to
providing objective advice as a fiduciary). Sadly, the public is
ill-informed about the conflicts of interest exhibited by Broker/Dealers and
subsequently tend to accept sales-pitches masquerading as objective financial
advice as such objective financial advice.
| Daylian M. Cain, George Lowenstein, and Don A.
Moore, "The
Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest,"
Journal of Legal Studies, Vol 34 (2005), p 1.
This outstanding study shows that even if Broker/Dealers plainly disclose
their inherent conflict of interest, the consumer might actually be worse off
than if the disclosure didn't happen. This study confirms the prudence
of requiring fiduciaries to avoid, rather than merely disclosing, conflicts of
interest. "Conflicts
of interest can lead experts to give biased advice. While disclosure has been
proposed as a potential solution to this, we show that disclosure can have
perverse effects, and might even increase bias. Disclosure may increase bias
because advisors feel morally licensed and strategically encouraged to
exaggerate their advice even further from the truth. As for those receiving
the advice, proper use of the disclosure depends on understanding how the
conflict of interest biased the advice and how that advice impacted them.
Because people lack this understanding, disclosure can fail to solve the
problems created by conflicts of interest."
|
| Eric E. Haas,
Comment to
the SEC on Broker/Dealer exemption to the Advisers Act of 1940, August 23
2004. A frank discussion of the principal issues surrounding the SEC's proposed exemption of
Broker/Dealers from the requirements of the Investment Adviser's Act of 1940.
|
| Eric E. Haas,
Comment to
the SEC on Broker/Dealer exemption to the Advisers Act of 1940, January 25
2005. Another brief comment on the principal issues surrounding the SEC's proposed exemption of
Broker/Dealers from the requirements of the Investment Adviser's Act of 1940.
|
| Duane R. Thompson,
Letter to the SEC commenting on Broker/Dealer exemption to the Advisers Act of
1940, February 7 2005. An excellent
discussion of the issues surrounding the SEC's proposed exemption of
Broker/Dealers from the requirements of the Investment Adviser's Act of 1940. |
The Capital Asset Pricing Model was developed in the mid-60s by William
Sharpe, John Lintner, and Jan Mossin (independently). Some believe that
its utility has largely been eclipsed by the introduction of the
Fama/French Three-Factor Model.
| Frank Armstrong, "Capital
Asset Pricing Model," Investor Solutions, 2002. An excellent
introduction to the CAPM.
|
| Eugene F. Fama and Kenneth R. French, "The
Capital Asset Pricing Model: Theory and Evidence," CRSP Working Paper 550,
January 2004 (105kb). Also
here.
This excellent paper discusses some of the major problems with the CAPM.
"The problems are serious enough to invalidate most applications of the
CAPM" "... despite its seductive simplicity, the CAPM's empirical
problems probably invalidate its use in applications."
|
| Eugene F. Fama and Kenneth R. French, "Disagreement,
Tastes, and Asset Prices," CRSP Working Paper 552, February 2004 (89kb).
Also here.
This paper discusses the implications of one of the assumptions of the CAPM
—
that there is complete agreement among investors about probability
distributions of future payoffs on assets.
|
| William N. Goetzmann, "An
Introduction to Investment Theory," Yale School of Management.
This is from a college course. It is an excellent introduction to the
CAPM.
|
| William F. Sharpe, "Capital
Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,"
Journal of Finance, September 1964, pp. 425-442 (1.17mb). Also
here.
This is the paper that basically defined the CAPM and won Dr. Sharpe the Nobel
Prize. |
Charitable Giving has several benefits. First, of course, it is good
for the soul. But many don't realize how it can have enormously beneficial
tax effects as well. For example, if, instead of donating cash, you donate
highly appreciated securities, you can avoid paying capital gains taxes on those
securities (and the charity wouldn't have to pay them either). This is in
addition, of course, to the benefit of the tax-deduction you get for charitable
gifts of any kind.
There are at least two means for implementing a long-term giving program:
Donor-Advised Funds and Charitable Remainder Trusts. Of the two,
Donor-Advised Funds are the simplest to set up and administer.
The Vanguard Charitable Endowment
Program and the Fidelity Charitable
Gift Fund are generally the most preferred DAFs due to their exceptionally low
fees. Investors who want a bigger, better selection of investments to
choose from might choose The American
Endowment Foundation, which has a
tiered fee scale.
Also, see Estate Planning.
| Roccy DeFrancesco, "Gifts
That Keep Giving," Financial Planning, July 2004, pp. 89-92.
A good article which goes into detail about one way to use a Charitable Gift
Annuity in conjunction with a Donor-Advised Fund and a Irrevocable Life
Insurance Trust.
|
| Elfrena Foord, "Philanthropy
101: Donor-Advised Funds," Journal of Financial Planning,
November 2003, pp. 66-73.
A good article which compares Donor-Advised Funds to Private Foundations.
|
| Lawrence C. Phillips and Thomas R. Robinson, "Charitable
Remainder Trust: A Powerful Financial Planning Tool," Journal of Financial Planning, August
1997, pp. 70-76 (980kb).
A good primer on Charitable Remainder Trusts.
|
| Eric Lee Smith, "Donor-Advised
Funds: A Well Kept Secret," The CPA Journal, September 2001, pp.
62-63. A good discussion of Donor-Advised Funds.
|
| Eric Lee Smith, "An
Introduction to Donor-Advised Funds," from The ePhilanthropy
Foundation's Guide to Success Online, 2001. This interesting
article (a chapter from a book) is geared towards organizations who might be
considering starting a Donor-Advised Fund.
|
| "Gifting
Assets? Here's What's to Know," The Vanguard Group, November 16
2005. A good discussion of the various options for gifting
assets.
|
Closed End Funds are mutual funds which are bought and sold on exchanges
(i.e., like you buy and sell stocks). Interestingly, the share price,
determined by the market, can dramatically differ from the share price
determined by the current value of the securities a closed end fund holds (i.e.,
its NAV). This gives an investor the opportunity to get exposure to
securities at a deep discount. Whether or not it is prudent to do so is a
different story. Before going out and buying discounted closed-end funds,
be sure to read the Pontiff and Reichert/Timmons papers below.
| Dominic Gasbarro, Richard D. Johnson, and J. Kenton
Zumwalt, "Evidence on the Mean-Reverting Tendencies of Closed-End Fund
Discounts,"
The Financial Review, May 2003, pp. 273-291. This paper
examines the "mean-reverting" tendency of closed-end funds.
Specifically, it examines the hypothesis that funds sold at a discount to NAV
tend to have their discount narrow (i.e., the fund share price tends to
increase towards NAV over time). The truth of this hypothesis is
important for investors who desire to engage in closed-end fund arbitrage.
|
| Burton G. Malkiel, "The Valuation of Closed-End
Investment Company Shares,"
Journal of Finance, June 1977, pp. 847-859. This paper
suggested that it seemed possible to get significant abnormal positive returns
through investing in deeply discounted closed-end funds. Specifically,
this paper found at least two reasons to consider deeply discounted closed-end
funds:
| The expected returns on a deeply discounted closed-end fund are much
higher than the expected returns on a similar portfolio of the underlying
securities. Even if the discount doesn't narrow, you get all of the
income from the underlying securities with a fraction of the up-front
investment. |
| Fund discounts seem to narrow when the market falls and increase when the
market rises. This suggests that closed end funds might make good
diversifiers, all else being equal.
|
|
| Jeffrey Pontiff, "Excess Volatility and Closed-End
Funds,"
The American Economic Review, March 2003, pp. 155-169. This interesting
paper finds that the prices of closed end funds are about 64 percent more
volatile than the assets they hold. This is yet another reason to think
twice before attempting a closed end fund arbitrage strategy.
|
| Carolyn Reichert and J. Douglas Timmons, "Closed-End
Investment Companies: Historic Returns and Investment Strategies,"
The Financial Review, May 2003, pp. 273-291. This interesting
paper models the results of a simple investment strategy designed to take
advantage of the presumed tendency of a closed-end fund (which is trading at a
discount) to have its discount lessen over time. Specifically, this paper
analyzes a strategy of buying the closed-end funds with the greatest discount,
holding them for one year, then replacing them with the funds which a year
later are available at the greatest discount. This paper's conclusion: "The
results do not support the use of a simple mechanical strategy. Even
when marginally significant before-tax returns are available, transaction
costs and taxes erode the benefits. Excess returns are not possible for
investors lacking the time or resources to actively trade in the marketplace.
Small investors following simple trading rules with a minimum of rebalancing
are unlikely to earn the abnormal returns documented in earlier studies.
This should serve as a warning to investors lured by the promise of excess
returns from CEIC [Closed-End Investment Company] funds selling at
discounts. It is important for small investors to be aware of the need
for additional monitoring, more frequent trading, larger initial investments,
or short selling if they want to use CEIC funds to outperform the market.
Investors wanting to avoid these complications should consider alternative
investments."
|
| Rex Thompson, "The information content of discounts
and premiums on closed-end funds," Journal of Financial Economics, 6,
pp. 151-186. Thompson finds that a relatively simple trading rule
(based on discounts for closed-end funds) earned statistically significant
abnormal returns of about 4% per year over the period 1940-1971. In addition,
the results are quite uniform throughout the period.
|
There are several tax-advantaged means of saving for college. For most
people, 529 savings plans are the best choice. If your state offers
tax-deductions for contributions to your state's plan, you should consider (the
direct purchased version of) that plan (i.e., don't buy it through a financial
adviser). Otherwise, you should consider one of the low cost alternatives:
Colorado,
Iowa,
Michigan,
Minnesota, Missouri,
Nebraska,
Nevada (Vanguard), New York,
Ohio,
Utah or
Virginia (note that Nebraska's
and New York's plans offer significantly greater investing flexibility than the others).
Utah's plan is definitely the least expensive of
the bunch, followed closely by Ohio's
and
Virginia's. Note that
West Virginia's SMART529 Select plan,
while not being among the lowest cost plans, has the best investment choices and
may be the best value, especially for very young beneficiaries (for information
on what makes a "good" investing choice, see here). For information on all 529 plans,
see SavingforCollege.com.
Note that, if you choose another state's plan, it may be necessary to transfer
it back to your state's plan immediately before college in order to avoid
taxation of withdrawals by your state.
| Ramon P. DeGennaro, "Asset
Allocation and Section 529 Plans," Federal Reserve Bank of Atlanta Working
Paper 2003-1 (70kb). Also
here. A good discussion of these issues.
|
| Susan M. Dynarski, "Who Benefits from the Education
Savings Incentives? Income, Educational Expectations, and the Value of
the 529 and Coverdell," NBER Working paper W10470, May 2004. This
excellent paper finds that the advantages of the 529 and Coverdell ESA rise
sharply with income. While they still make sense for low income people,
529 and Coverdell plans are a dramatically better "deal" for high-income
savers. Also, see the discussion of this paper
here.
|
| Susan M. Dynarski, "Tax
Policy and Education Policy: Collision or Coordination? A case study of
529 and Coverdell Savings Vehicles," NBER Working paper W10357, March 2004
(434kb).
|
| Jennifer Ma and Douglas Fore, "Saving
for College: A Comparison of Section 529 Plans with Other Options: An Update,"
TIAA-CREF Institute research dialogue, January 2002, pp. 1-20.
An excellent comparison of 529 plans to other savings vehicles.
|
| Jennifer Ma, "The
Impact of the 2003 Tax Law on College Savings Option," TIAA-CREF
Institute, July 31 2003. This note studies the impact of the 2003
tax law on college savings. It finds that Coverdell ESAs and 529 plans
still tend to be the optimal choice for most investors.
|
| Barry Marks and William Reichenstein, "Tax
Strategies for Financing Higher Education," Journal of Financial
Planning, May 2000. The authors survey the various means of
saving for college education. Note that this article preceded the vast
tax law changes enacted in 2001.
|
| Mark C. Neath, "Section
529 Prepaid Tuition Plans: A Low Risk Investment with Surprising Applications,"
Journal of Financial Planning, April 2002, pp. 92-98. "In
short, Section 529 plans promise to become an important tool for financial
planners, not only for college savings, but for a wide range of asset
protection, estate planning and other financial planning goals."
|
| Lynn O'Shaughnessy, "Avoiding
Fee Pitfalls as College Savings Climb," New York Times, July 13
2003. Also
here. A discussion of 529 plans, emphasizing the importance of
fees when choosing a plan.
|
| John J. Spitzer and Sandeep Singh, "The
Fallacy of Cookie Cutter Asset Allocation: Some Evidence from 'New York's
College Savings Program'," Financial Services
Review, Volume 10(4) 2001. This study was done before
529 plan qualified withdrawals were made tax-free, which somewhat affects the
conclusions, but it is an interesting analysis nonetheless (especially since
the cur | |
