Altruist Financial Advisors LLC
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Financial Planning and Portfolio Management
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Altruist Financial Advisors LLC
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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."
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 AllocationAsset 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.
Bid-Ask SpreadsAll 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.
BondsFixed 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).
Broker/DealersBroker/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.
Capital Asset Pricing Model (CAPM)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.
Charitable GivingCharitable 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, the iShares Charitable Giving 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.
Closed-End FundsClosed 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.
College PlanningThere 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.
Commodity FuturesCommodities refers to real assets such as energy, agriculture, livestock, industrial metals, and precious metals. The below papers make a compelling case for the diversification benefits of collateralized commodities index futures contracts (i.e., they have a very low correlation with other asset classes). Unfortunately, there are few practical means for retail investors to prudently expose themselves to this asset class. We currently recommend the PIMCO CommodityRealReturn Strategy Fund (PCRIX) as the preferred means of implementing this asset class. If you don't have access to the institutional shares thereof (Altruist clients do), you might consider the D-class shares (PCRDX). In general, we would recommend only a fairly small fraction of any portfolio be allocated to this asset class. Further, since futures contracts (and derivatives thereof) tend to be quite tax-inefficient, these investments are best held in tax-exempt accounts.
Currency HedgingWhen investing in foreign investments, an investor subjects herself to currency risk (i.e., the changes in the value of the investment due solely to changes in the exchange rate between the investor's native currency and that of the country where the investment is domiciled). Some investors choose to hedge (i.e., eliminate) this risk by buying currency futures for the investment's currency. Also, see Foreign Investing.
Data MiningData Mining (a.k.a., "Data Snooping") refers to the practice of searching through data looking for patterns. Of course, there isn't anything wrong with that, in general. However, many make the mistake of finding apparent patterns in the sample (which may be due to chance) and inappropriately extrapolating them from the sample to the data universe. That's a fancy way of saying that if you find a pattern in past financial data, it may be that the pattern existed solely due to chance, even if it strongly appears otherwise.
Defined Benefit Pension PlansThis section addresses issues related to use of Defined Benefit Pension Plans. Also, see Retirement Investing, Defined Contribution Pension Plan Design, and Pension Fund Management.
Defined Contribution Pension Plan DesignThis section addresses issues related to design of defined contribution pension plans (e.g., 401(k), 403(b), etc.). Also, see Retirement Investing and Pension Fund Management.
Dimensional Fund Advisors (DFA)Many of our recommended mutual funds come from DFA. However, you may never have heard of them because they do no advertising to the public. Here are some good articles on DFA.
DiversificationDiversification refers to the idea that your investments ought to be spread out amongst many investments. On average, a diversified portfolio will have the same expected return (but less risk/volatility) as a less diversified portfolio with similar characteristics. When put that way, it is easy to see why diversification is beneficial — why have a more risky portfolio if you can't expect higher returns in exchange for taking on that additional risk? Also, see the section on Modern Portfolio Theory. "Diversification is your buddy."
— Merton Miller, winner of the Nobel Memorial Prize in
Economic Sciences, 1990
Diversification of Concentrated PositionsFor various reasons, many investors find themselves overconcentrated in a single stock (or very few stocks). Most often, this is the stock of their employer. What can such a person do to prudently diversify? In addition to the articles listed here, see the articles on NUA by Bradley and by Herbers in the "Retirement Investing" section below.
DividendsWith the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003, certain stock dividends are taxed at the same low rate as long-term capital gains. Some see this as making dividend paying stocks preferred to non-dividend paying stocks. In fact, nothing can be further from the truth. Also see Tax-Managed Investing.
Dollar Cost AveragingDollar Cost Averaging refers to a procedure whereby an equal amount is invested
each period on an ongoing basis. For the purpose of deploying a stream of
cash-flows (e.g., the residue of your take-home pay after subtracting expenses),
this basically just means investing what you have to invest when you have it
available to invest. There are few other good choices in such a situation.
However, for those who are making changes in their portfolios, this might mean
spreading out the change over a period of time rather than making the change all
at once. The below articles address this aspect of Dollar Cost Averaging.
Also see Market Timing.
Efficient Market Hypothesis |
 | Eugene F. Fama, "Random Walks in Stock Market Prices,"
Chicago School of Business Selected Paper Series, Paper #16 (102kb).
Also available
here (102kb).
This paper also appeared in Financial
Analysts Journal, September/October 1965, pp. 55-59. Reprinted in
Financial
Analysts Journal, January/February 1995, pp. 75-80. This
paper is a non-technical version of Dr. Fama's doctoral dissertation below. This is
the seminal paper where Dr. Fama coined the term "Efficient Market."
"In an efficient market, competition among the many
intelligent participants leads to a situation where, at any point in time,
actual prices of individual securities already reflect the effects of
information based both on events that have already occurred and on events
which, as of now, the market expects to take place in the future. In other
words, in an efficient market at any point in time the actual price of a
security will be a good estimate of its intrinsic value." |
| Eugene F. Fama, "The
Behavior of Stock Market Prices,"
Journal of Business, January 1965, pp. 34-105 (8.52mb). This
paper is the technical version of Dr. Fama's doctoral dissertation summarized
above. |
|
Ray Ball, "The Development, Accomplishments and
Limitations of the Theory of Stock Market Efficiency," Managerial Finance,
20 (2,3) 1994, pp. 3-48. A good summary of the research into
stock market efficiency. See
here for an excellent discussion of this paper. |
|
Elroy
Dimson and Massoud Mussavian, "A
brief history of market efficiency," European Financial Management,
March 1998, pp. 91-193 (60kb). An excellent, highly readable
history of the efficient market hypothesis. |
|
"The
Efficient Market Hypothesis and Random Walk Theory,"
Investor Home, 1999. An outstanding summary of the subject
matter. |
|
Eugene F.
Fama, "Market Efficiency, Long-Term Returns, and Behavioral Finance,"
Journal of Financial Economics, September 1998, pp. 283-306 (135kb).
This paper is also available
here. |
|
Eugene F.
Fama, "Efficient
Capital Markets: A Review of Theory and Empirical Work,"
Journal of Finance, May, 1970, pp. 383-417 (4.4mb). Also
here. A
comprehensive review of the literature on this topic. |
|
Eugene F.
Fama, "Efficient Capital Markets: II," Journal of Finance, December
1991, pp. 1575-1617 (5.4mb).
Here's a good summary. A (somewhat less comprehensive) review of
the literature twenty years after his first review. |
|
Burton G. Malkiel, "The
Efficient Market Hypothesis and its Critics", Journal of Economic
Perspectives, 2003 17(1), pp. 59-82 (523kb). "This survey
examines the attacks on the efficient-market hypothesis and the relationship
between predictability and efficiency. I conclude that our stock
markets are more efficient and less predictable than many recent academic
papers would have us believe." |
|
Burton G. Malkiel, "Reflections
on the Efficient Markets Hypothesis: 30 Years Later", The
Financial Review, February 2005, pp. 1-9 (401kb). "The evidence is
overwhelming that active equity management is, in the words of Ellis (1998), a
'loser’s game.' Switching from security to security accomplishes nothing but
to increase transactions costs and harm performance. Thus, even if markets are
less than fully efficient, indexing is likely to produce higher rates of
return than active portfolio management. Both individual and institutional
investors will be well served to employ indexing ..." |
|
"Is
That a $100 Bill Lying on the Ground? Two Views of Market Efficiency,"
Wharton School of Business, 2002. Highlights of a debate between two influential
academics, Burton Malkiel and Richard Thaler. You may need to register
(for free) in order to view this. |
| Martin Sewell, "Efficient Markets Hypothesis Bibliography," University College London. An excellent bibliography of this topic. |
Emerging markets refers to stock markets of economies which are developing (e.g., China, Russia, Argentina, Mexico, etc.). Investing in emerging markets is often done with a small portion of one's portfolio in order to get the diversification benefits offered by this asset class. Also, see Foreign Investing and Currency Hedging. Also, see Frontier Markets.
| Steven L. Beach, "Why
Emerging Market Equities Belong in a Diversified Investment Portfolio,"
Journal of Investing,
Winter 2006, pp. 12-18. "Historical evidence, including
analysis of downside risk, provides ample proof that emerging market equities
have provided returns sufficient to compensate for their risk. ... investing
in a broad emerging-market index fund can provide significant return
opportunities, without the country-specific risks. In summary, diversified
investment portfolios should contain both developed international and emerging
market equities." |
| William J. Bernstein, "Rebalancing
Individual National Markets," Efficient Frontier,
Spring 2000. Discusses the benefits of an emerging markets
fund equal-weighted across countries (i.e., like DFA's Emerging Markets funds
used to be). |
| David G. Booth, "Active
Management's Failure to Deliver in Emerging Markets: A View from the New
Economy," Institute for Fiduciary Education, July 1 2000 (156kb).
This article points out that, compared with passively managed funds, actively
managed funds haven't faired particularly well in emerging markets. This
is contrary to the conventional wisdom, which suggests that less efficient
markets are more amenable to active management. |
| Campbell R. Harvey, "Predictable
Risk and Returns in Emerging Markets," Review of Financial Studies,
Fall 1995, pp. 773-816 (3.4mb). "... inclusion of emerging market
assets in a mean-variance efficient portfolio will reduce portfolio volatility
and increase expected returns." |
| Asani Sarkar and Kai li, "Should
US Investors Hold Foreign Stocks?," SSRN abstract #319754, January 2002
(47kb). This paper finds that, if short selling is not allowed,
there is no diversification benefit for US investors to diversify in foreign
developed markets. However, diversification into Emerging Markets
remains beneficial under this constraint. |
| J.D. Steinhilber, "Emerging
Markets Rebounding," IndexFunds.com, September 10 2003.
Discusses the iShares MSCI Emerging Markets Index Fund ETF (EEM). |
| Yesim Tokat, "International
Equity Investing: Investing in Emerging Markets," Investment Counseling
& Research/ ANALYSIS, July 2004 (755kb). A good discussion of
issues surrounding investing in emerging markets. |
| Yesim Tokat and Nelson Wicas, "Investing in
Emerging Markets," Journal of Wealth Management, Fall 2004, pp.
68-80. A good discussion of
issues surrounding investing in emerging markets. |
| Karen Umland, "Emerging
Markets: Managing Risks," Institute for Fiduciary Education, 2003
(313kb).
A good discussion of the risks associated with investing in emerging markets. |
| "Emerging Markets iShares," ETFZone.com, June 1 2003. Discusses the iShares MSCI Emerging Markets Index Fund ETF (EEM). |
Also, see Pension Fund Management.
| Bala Arshanapalli, Edmond D´Ouville,
and William Nelson, "A
New Endowment Distribution Plan: How to Insure Current Spending While Growing
the Fund Corpus," Journal of Wealth Management, Spring 2004, pp.
24-28 (91kb). An interesting idea. They suggest that
endowments ensure the current funding continues uninterrupted by splitting the
endowment and buying a long-term commercial annuity with a portion, while
investing the other portion in stocks for growth. |
| James P. Garland, "A Market Yield Spending Rule
for Endowments and Trusts," Financial Analysts Journal,
July/August 1989, pp. 50-60. This paper proposes a rule for
calculating how much to spend annually from an endowment. |
| Catherine D. Gordon, "Investment
Committees: Vanguard's View of Best Practices," The Vanguard Group,
June 2004. A good discussion of best practices in investment
committees. |
| Robert C. Merton, "Optimal
Investment Strategies for University Endowment Funds," NBER Working Paper
# 3820, August 1991 (1.1mb). |
| Moshe A. Milevsky, "A
New Perspective on Endowments," IFID Working Paper, March 10 2003. An excellent
article discussing spending policies for endowments. |
The "Equity Premium" refers to how much stock returns are higher than bond returns. There are many good reasons to believe that the equity premium in the future will be much less than the equity premium in the recent past. It is prudent to have realistic expectations of what stock returns are likely to be in the future. Therefore, macroscopic estimates thereof are quite important for investors.
| William Reichenstein, "The
Investment Implications of Lower Stock Return Prospects," AAII Journal,
October 2001, pp. 4-7. An excellent, readable article with very
pragmatic advice. |
| William Reichenstein, "What
Do Past Stock Market Returns Tell Us About the Future?,"
Journal of Financial Planning, July 2002, pp. 72-83. This
may be the best summary of recent studies in this area. |
| Robert D. Arnott and Ronald J. Ryan, "The
Death of the Risk Premium," Journal of Portfolio Management, Summer
2001, pp. 61-74 (198kb). |
| Robert D. Arnott and Peter L. Bernstein, "What
Risk Premium is 'Normal'?," SSRN Abstract No. 296854 (573 kb).
This
paper also appeared in Financial Analysts Journal, March/April 2002,
pp. 64-85. |
| Clifford S. Asness, "Stocks
versus Bonds: Explaining the Equity Risk Premium," Financial Analysts
Journal, March/April 2000, pp. 96-113 (187kb). This paper
presents a model for long term stock dividend yield which suggests that the
difference between stock yields and bond yields is driven by the long-run
difference in volatility between stocks and bonds. |
| Peter L. Bernstein, "What
Rate of Return Can You Reasonably Expect ... or What Can the Long Run Tell Us
about the Short Run?," Financial Analysts Journal, March/April
1997. "A strange and unexpected conclusion emerges. Stocks are
fundamentally less risky than bonds, not only because their returns have been
consistently higher than those of bonds over the long run but also because
less uncertainty surrounds the long-term return investors can expect on the
basis of past history. Equity investors have at least some notion of what the
long run has provided to owners of equities and at least a few hints as to
whether stocks are high or low relative to their long-run performance.
Investors in the bond market, even with 195 years of history to look back on,
can make no statement at all about a basic return; they can make no judgments
beyond the duration of the particular instrument they happen to be holding at
any given moment." |
| William J. Bernstein, "What's
Expected? What's Cheap?," Efficient Frontier, Summer 2001. |
| Peter Coy, "How
Risky Is the Risk Premium?," Business Week,
December 25 2000, p. 122. |
| Elroy Dimson, Paul Marsh, and Mike Staunton, "Risk
and Return in the 20th and 21st Centuries," Business Strategy
Review, Summer 2000, pp. 1-18. This is basically a longer
version of the short article below. |
| Elroy Dimson, Paul Marsh, and Mike Staunton, "New
evidence puts risk premium in context," Corporate Finance, March
2003, pp. 8-10 (61kb). "Our work results in a set of forward-looking,
geometric risk premia for the United States, United Kingdom, and for the world
of around 2.5 to 4.0 per cent." "... this corresponds to arithmetic mean
risk premia of around 3.5 to 5.25 per cent." |
| Elroy Dimson, Paul Marsh, and Mike Staunton, "Global
Evidence on the Equity Risk Premium," Journal of Applied Corporate
Finance, Fall 2003, pp. 27-38 (210kb). |
| Eugene F. Fama and Kenneth R. French, "The
Equity Premium," CRSP Working Paper No. 522, April
2001 (131kb).
This paper also appeared in Journal of Finance,
April 2001, pp. 637-659. |
| Amit Goyal and Ivo Welch, "A
Comprehensive Look the the Empirical Performance of Equity Premium Prediction,"
National Bureau of Economic Research Working Paper No w10483, May 2004.
This paper tests whether various empirical means of predicting near-term
equity premiums have been useful in the past. "... we find that, for all
practical purposes, the equity premium has not been predictable, and any
belief about whether the stock market is now too high or too low has to be
based on theoretical prior, not on the empirically [sic] variables we have
explored." |
| Lacy H. Hunt and David M. Hoisington, "Estimating
the Stock/Bond Risk Premium: An alternative approach," Journal of
Portfolio Management, Winter 2003, pp. 28-34 (317). This
paper's findings are consistent with most others, forecasting an equity premium
significantly below historical norms over the next one to two decades. |
| Roger G. Ibbotson and Peng Chen, "The
Supply of Stock Market Returns," Ibbotson
Associates. June 2001 (129 kb). |
| Antti Ilmanen, "Expected
Returns on Stocks and Bonds: Investors must moderate their expectations,"
Journal of Portfolio Management, Winter 2003 (2.3mb). A
survey of the issues affecting expected returns. |
| Ravi Jagannathan, Ellen R. McGrattan, and Anna
Scherbina, "The
Declining U.S. Equity Premium," Federal Reserve Bank of Minneapolis
Quarterly Review, Fall 2000, pp. 3-19 (150kb). A good
discussion of this issue. |
| Mimi Lord, "Is
Equity Risk Premium Still Thriving, or a Thing of the Past?," Journal
of Financial Planning, April 2002, pp. 62-70. Ms. Lord
interviews Roger Ibbotson and Robert Arnott. |
| Ellen R. McGrattan and Edward C. Prescott, "Average
Debt and Equity Returns: Puzzling?," Federal
Reserve Bank of Minneapolis Research Dept Staff Report 313, January 2003
(232kb).
An interesting look at the "equity premium puzzle" (i.e., why have returns on
equity in the US been so much higher than predicted?). After correcting
for taxes, regulatory constraints, and diversification costs, and focusing on
long-term rather than short-term savings instruments, they find that there
really is no equity premium puzzle. |
| Ivo Welch, "Views
of Financial Economists on the Equity Premium and on Professional
Controversies," Journal of Business, 2000, pp. 501-537
(794kb). |
| Ivo Welch, "The
Equity Premium Consensus Forecast Revisited," Cowles Foundation Discussion
Paper No. 1325, September 2001 (166kb). An update to his earlier
work, using a survey taken three years after the first. |
| "Great
Expectations," The Economist, July 15 2000,
p. 76. Explains the Fama/French paper's conclusions in layman's
terms. |
| "Equity
Risk Premium Forum," November 8, 2001 (2mb). The record of an
outstanding discussion led by several preeminent academics. |
| Bibliography on Equity Risk Premium, November 8 2001. An excellent bibliography on this topic |
Estate planning is extremely important for wealthy individuals who wish to maximize the amount of assets passed on to heirs. In general, it is important that estate planning be done by an expert — usually a lawyer who specializes in this area. The below articles discuss investment aspects of estate planning. Also, see Charitable Giving.
| Robert M. Dammon, Chester S. Spatt, and Harold H.
Zhang, "Taxes,
Estate Planning and Financial Theory: New Insights and Perspectives,"
Carnegie Mellon Working Paper, March 15 2004 (57kb). A good
discussion of some relevant investing issues pertaining to 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. |
| Jay S. Goldenberg, "The
Living Trust for Estate and Financial Planning," Journal of Financial Planning,
Summer 1980, pp. 217-227 (619kb). Also
here.
A good primer on Revocable Living Trusts and trusts in general. |
| Lynn Hopewell, "Advantages
of Revocable Trusts," Journal of Financial Planning, April
1994, pp. 87-91 (645kb).
A good primer on Revocable Living Trusts. |
| 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. |
| Gary Underwood, "Preserving
the Legacy," Investment Advisor, May 2005, pp. 84-88.
A good summary of twelve estate planning techniques. |
|
Deferring
Capital Gains Taxes With The Premier VI Private Annuity/Trust, National
Association of Financial and Estate Planning. Describes an
approach using a Private Annuity Trust when you have a highly appreciated
asset whose value you which to preserve for heirs. |
|
Estate Planning
Basics, National Association of Financial and Estate Planning.
A good basic discussion of many estate planning issues. |
|
Estate
Planning: An Overview, Legal Information Institute. A great
on-line bibliography on the topic, from a legal perspective. |
Exchange Traded Funds are similar to conventional index mutual funds, but they are purchased like a stock. The largest selection of ETFs are the iShares offered by Barclay's Global Investors.
| William J. Bernstein, "The
ETF vs. Open-End Index-Fund Shootout," Efficient Frontier, Fall
2001. |
| William J. Bernstein, "It's
the Execution, Stupid!," Efficient Frontier, Winter 2004.
This article finds that the best index funds have tended to outperform
"equivalent" ETFs even without considering the costs of bid-ask spreads and
commissions which apply to ETFs, but not index funds. |
| Wilfred L. Dellva, "Exchange-Traded
Funds Not for Everyone," Journal of Financial Planning, April 2001,
pp. 110-124. Also
here.
Also
here. An excellent paper which compares ETFs with the best
index mutual funds. |
| Edwin J. Elton, Martin J. Gruber, George Comer, and
Kai Li, "Spiders: Where are the Bugs," Journal of Business, July 2002,
pp. 453-472. This paper analyzes the performance of one of the
first Exchange Traded Funds, the S&P 500 SPDR. It finds that this ETF
underperforms similar low cost index mutual funds by 0.18 percentage points
per year. This underperformance is principally due to the fact that
SPDRs (unlike most more modern ETFs) are required to hold dividends received
from their underlying stocks in cash until distribution to shareholders. |
| Robert Engle and Debojyoti Sarkar, "Pricing
Exchange Traded Funds," NYU Stern Working Paper, May 2002 (172kb).
An interesting paper. |
| Gary L. Gastineau, "Exchange Traded Funds: An
Introduction," Journal of Portfolio Management, Spring 2001, pp. 88-96.
An introduction to ETFs. |
| Eric E. Haas, "ETFs vs. Index
Mutual Funds," Altruist Financial Advisors LLC, 2004. Pros
and cons of ETFs as compared with conventional index mutual funds. |
| Leonard Kostovetsky, "Index Mutual Funds and
Exchange-Traded Funds," Journal of Portfolio Management, Summer 2003,
pp. 80-92. A good comparison of ETFs with index funds. |
| James L. Novakoff, "Exchange
Traded Funds: A White Paper," Indexfunds.com, February 24 2000.
A good history and overview of ETFs. |
| Jim Novakoff, "Diamonds
in the Rough: The 10 Keys To Building Sound ETF-Based Portfolios,"
Journal of Indexes, Third Quarter 2002. |
| Scott Rasmussen, "Going
Long with Baskets: A cost-comparison of exchange-traded funds," Stanford
University Honors Thesis, December 9 2002 (1.38mb). An
interesting paper comparing ETFs to conventional index mutual funds. |
| Steven Schoenfeld, J. Lisa Chen, and Binu George, "ETFs
offer the World to Investors," A Guide to Exchange-Traded Funds,
Fall 2001, pp. 111-118. "Index based strategies are the most
efficient way to gain international exposure, and should outperform the
average actively managed fund." |
| John Spence, "New
Study Examines Domestic, International ETF Premiums and Discounts,"
Indexfunds.com, February 14 2002. This article discusses a study
which quantifies the bid-ask spreads and market premiums for ETFs. |
| John Spence, "Joined
at the Hip – Vanguard’s VIPERS and index funds," IndexUniverse.com,
November 11 2003. This excellent article discusses why Vanguard's
ETFs may have a slight advantage over other ETFs. You may have to
register (for free) to view this article (also, see
this article
in the Journal of Indexes). |
| Jim Wiandt, "How
ETFs Manage a Tax-Efficiency Edge over Traditional Mutual Funds,"
Indexfunds.com, September 28 2001. |
| Brad Zigler, "ETFs
finish in first place: Exchange-traded funds appear to be living up to their
promise," Financial Planning, May 1 2002. |
| "Another
Look at ETF Premium/Discounts and Spreads," Indexfunds.com, April 3 2002. |
| "ETF
Liquidity Myth Dispelled," ETFZone.com, November 6 2003.
Good discussion of what drives bid-ask spreads of ETFs. |
| ETFZone.com.
An excellent web site with a great deal of information on ETFs. |
| Exchangetradedfunds.com.
A good place for quotes on ETFs. |
These papers explore the intellectual underpinnings for the idea that tilting a stock portfolio towards small and value stocks will tend to result in higher long-term expected returns (at the expense of somewhat higher short-term volatility).
| Eugene F. Fama and Kenneth R. French, "The
Cross-Section of Expected Stock Returns," Journal of Finance, Vol
XLVII No 2 June 1992, pp. 427-465 (3.82mb). Also
here. Also
here (3.9mb). Also
here. This is the seminal
paper that first provided proof that exposure to market risk, market
capitalization, and book to price ratio almost completely explained
(variations in) the level
of stock returns. |
| Eugene F. Fama and Kenneth R. French, "Common
risk factors in the returns on stocks and bonds," Journal of Financial
Economics, 33 1993, pp. 3-56 (4.82mb). Also
here. This paper extends the three factor model, which
explains variation in stock returns, to five factors, which also explain
variation in bond returns (the additional factors, only applicable to bonds,
are default risk and term risk (i.e., maturity/duration)). Note that
explanatory power for the two risk factors are only applicable to high-quality
bonds. Lower quality bonds are also affected by the equity factors. |
| Frank Armstrong, "Fama
French Three Factor Model," Investor Solutions, 2001. An
outstanding, very readable introduction to the three factor model. |
| Bala Arshanapalli, T. Daniel Coggin, John Doukas,
and H. David Shea, "The Dimensions of International Equity Style," Journal
of Investing, Spring 1998, pp. 15-30. A look at 1975 to 1996
international returns data confirms that both the value effect and the small
effect exist abroad. |
| Rolf W. Banz, "The Relationship Between Return
and Market Value of Common Stocks,"
Journal of Financial Economics, 9 (1981), pp. 3-18. "It is
found that smaller firms have had higher risk adjusted returns , on average,
than larger firms. This 'size effect' has been in existence for at least
forty years and is evidence that the capital asset pricing model is
misspecified. The size effect is not linear in the market value; the
main effect occurs for very small firms while there is little difference in
return between average sized and large firms." This paper probably
originated the idea of a size premium. |
| Christopher B. Barry, Elizabeth Goldreyer, Larry
Lockwood, Mauricio Rodriguez, "Size
and Book-to-Market Effects: Evidence from Emerging Equity Markets,"
Emerging Markets Review, 3, pp. 1-30 (233kb). This paper finds a value premium in
emerging markets. It finds much less evidence in support of a small
premium. |
| Sanjoy Basu, "The Relationship Between
Earnings' Yield, Market Value, and Return for NYSE Common Stocks,"
Journal of Financial Economics, 12 (1983), pp. 129-156. "The
results confirm that the common stock of high E/P firms earn, on average,
higher risk-adjusted returns than the common stock of low E/P firms and that
this effect is clearly significant ..." This paper confirmed the
existence of a value premium. |
| Sanjoy Basu, "Investment Performance of Common Stocks in
Relation to their Price-Earnings Ratios: A Test of the Efficient Market
Hypothesis," Journal of Finance, June 1977, pp. 663-682.
This paper finds that stocks with low price-earnings ratios (i.e., value
stocks) have higher risk-adjusted returns than stocks with high price-earnings
ratios (i.e., growth stocks). |
| William J. Bernstein, "The
Cross-Section of Expected Stock Returns: A Tenth Anniversary Reflection,"
Efficient Frontier, Summer 2002. A very readable
retrospective ten years after the original Fama/French paper on the subject. |
| Carlo Capaul, Ian Rowley, and William F. Sharpe, "International Value and
Growth Stock Returns," Financial Analysts Journal, January/February
1993. A look at 1981 to 1992 international returns data confirms that the
value effect exists abroad. |
| Louis K. C. Chan and Josef Lakonishok, "Value
and Growth Investing: A Review and Update," Financial Analysts
Journal, January/February 2004, pp. 71-86
(85kb). "The evidence suggests that ... value investing generates
superior returns. Common measures of risk do not support the argument
that the return differential is due to the higher riskiness of value stocks.
Instead, behavioral considerations and the agency costs of delegated
investment management lie at the root of the value-growth spread." |
| John Chisholm, "The
Risks of Value: Examining the Risk Budget Impact of an International Value
Style," Institute for Fiduciary Education,
October 1999 (171kb). Examines the value premium overseas. |
| Truman A. Clark, "The
Dimensions of Stock Returns: 2002 Update," Dimensional Fund Advisors,
April 2002. |
| James L. Davis, Eugene F. Fama, and Kenneth R. French, "Characteristics,
Covariances, and Average Returns: 1929-1997," February 1999, Center for
Research in Security Prices Working Paper No. 471 (227kb).
This paper also appeared in Journal of Finance,
February 2000 Vol 55, pp. 389-406. This paper more than
doubles the sample size of returns analyzed, with the same conclusions as the
original Fama/French paper (the original paper only used data from 1962-1989). |
| James L. Davis, "Is
There Still Value in the Book-to-Market Ratio?," Dimensional Fund
Advisors, January 2001. Addresses whether BTM ratio has been
superceded by other measures of value, such as Price/Earnings ratio and
others. The bottom line is that BTM remains in several pragmatic ways
the optimal measure of the "value-ness" of a stock. |
| James L. Davis, "Explaining
Stock Returns: A Literature Survey," Dimensional Fund Advisors, December
2001. An excellent survey of literature on this subject. |
| Elroy Dimson, Stefan Nagel, and Garrett Quigley, "Capturing
the Value Premium in the U.K. 1955-2001," Financial Analysts Journal,
November/December 2003, pp. 35-45. Also
here. "... we find a strong value premium in the UK for the
period 1955-2001. The value premium exists within the small-cap as well
as the large-cap universe." "However, managers attempting to capture the
value premium in the small-cap segment should pay particular attention to
rebalancing-induced portfolio turnover and market illiquidity in small-value
stocks. Compared to the U.S., the U.K. market for small-cap stocks is
relatively illiquid. Trading costs are therefore an even more crucial
determinant of overall performance. This is likely to be the case in
other non-U.S. markets as well." This suggests that it is important to
implement strategies that sacrifice tracking accuracy in favor of reducing
trading needs and lowering trading costs. |
| Eugene F. Fama and Kenneth R. French, “Value vs. Growth: The International
Evidence,” Journal of Finance, December 1998 Vol
53, pp. 1975-1999 (2.38mb).
This paper also
was SSRN Working Paper 2358 (54kb). This paper examines non-US markets for
the "value premium" and finds it in nearly every other country studied. |
| Eugene F. Fama and Kenneth R. French, "Size and
Book-to-Market Factors in Earnings and Returns," Journal of Finance,
March 1995, pp. 131-155. "The evidence presented here shows that
size and BE/ME [book to market ratio] are related to profitability."
"Firms with high BE/ME (a low stock price relative to book value) tend to be
persistently distressed." This helps explain why small stocks and value
stocks tend to be have higher returns — because they are
"riskier" than larger and more "growthy" companies. |
| Eugene Fama, Jr., "Engineering
Portfolios for Better Returns," Senior Consultant, May 1998.
Dr. Fama's son discusses the practical implications of the Fama/French
Three-Factor model. |
| Sherman Hannah and Peng Chen, "Small
Stocks vs. Large: It's How Long You Hold That Counts,"
Journal of American Association of Individual Investors, July 1999.
This paper concludes that small cap stocks have tended to outperform large cap
stocks in the US for holding periods of greater than 15 years. |
| Bob Hansen, "Risk
and Return: Professor Ken French on the Cross Section of Expected Returns,"
Tuck Today, Winter 2004, pp. 3-9.
An outstanding interview with Professor Ken French. |
| Gabriel Hawawini and Donald B. Keim, "The
CrossSection of Common Stock Returns: A Review of the Evidence and Some New
Findings," The Wharton School of the University of Pennsylvania, 1998
(560kb). Also
here. This paper also appeared in
Security Market Imperfections in
World Wide Equity Markets, Eds. D.B. Keim and W.T. Ziemba (Prentice Hall,
2000). |
| Roger G. Ibbotson and Mark W. Riepe, "Growth
Vs. Value Investing: And the Winner Is...," Journal of Financial
Planning, June 1997, pp. 64-71 (1,337kb). Also
here. |
| Jeffrey Jaffe, Donald B. Keim, and Randolph
Westerfield, "Earnings Yields, Market Values, and Stock Returns," Journal
of Finance, March 1989, pp. 135-148. "Our research finds
significant E/P and size effects when estimated across all months during the
1951-1986 period." |
| Josef Lokonishok, Andrei Shleifer, and Robert W.
Vishny, "Contrarian Investment, Extrapolation, and Risk,"
NBER Working Paper number W4360. This paper also appeared in Journal of
Finance, Vol XLIX No 5, December 1994, pp. 1541-1578 (4.3mb). |
| Richard C. Marston, "White
Paper on Value and Growth Investing,"
Lincoln Financial Group, Dec 2004. An
excellent basic discussion of the value premium. |
| Nicholas Molodovsky, "Recent Studies of P/E Ratios,"
Financial Analysts Journal, May-June 1967, pp. 101-108. An
excellent summary of the earliest academic studies which detected a value premium. |
| S. Francis Nicholson, "Price Ratios in relation to
Investment Results," Financial Analysts Journal, January-February 1968,
pp. 105-109. Nicholson, who might rightfully be called the "father
of the value premium", concludes that stocks with low price-earnings ratios
(i.e., value stocks) tend to have dramatically higher subsequent returns than
stocks with high price-earnings ratios (i.e., growth stocks). His
explanation is similar to what Benjamin Graham might have offered
— that value stocks are,
effectively, "on sale." |
| Marc R. Reinganum, "Abnormal Returns in Small Firm
Portfolios,"
Financial Analysts Journal, March/April 1981, pp. 52-56.
This paper was among the first to demonstrate the "small" premium. |
| Barr Rosenberg, Kenneth Reid, and Ronald Lanstein, "Persuasive
Evidence of Market Inefficiency,"
Journal of Portfolio Management, Spring 1985, pp. 9-17.
This paper demonstrated the efficacy of a strategy of investing in value
stocks and shorting growth stocks. In other words, it validated the
existence of a value premium. |
| "What Has Worked In Investing," Tweedy, Browne Company, 1992 (289kb). An interesting pamphlet from a small value-oriented mutual fund company. |
Investing internationally with a portion of one's portfolio is often recommended in order to achieve diversification benefits. Also, see Emerging Markets and Currency Hedging.
| Scott Aiello and Natalie Chieffe, "International
Index Funds and the Investment Portfolio," Financial Services Review, 8
1999, pp. 27-35. "This study urges caution for those investors
who seek to maximize returns. However, it does suggest that the
diversification one can gain from international index funds is significant and
important." Basically, this study is consistent with the conclusions of Sinquefield (1996) below. Internationally diversifying one's otherwise
domestic equity portfolio yielded a reduction in risk/volatility, but also a
reduction in returns during the period studied. | ||||
| Marianne Baxter and Urban J. Jermann, "The
International Diversification Puzzle is Worse than you Think,"
American Economic Review, March 1997, pp. 170-180.
Appendix A of
this paper is here. Also NBER Working
paper 5019, February 1995. This interesting paper looks at the
degree of international diversification justified when taking into account
an investor's "human capital." This is the present value of a person's future
earnings. It finds that human capital is highly correlated with an
investor's domestic market. When you take that into account, the natural
tendency to overweight one's own country in their portfolio becomes
dramatically amplified. In fact it suggests not only increasing foreign
investment, but increasing it to the
point of actually shorting domestic investments. This paper, therefore, supports
a significant investment overseas for most individual investors. | ||||
| Marianne Baxter, Urban J. Jermann, and Robert J.
King, "Nontraded
Goods, nontraded factors, and international non-diversification,"
Journal of International Economics, April 1998, pp. 211-229.
This paper's conclusions are consistent with those of the one above. | ||||
| Eric Brandhorst, "International
Diversification," State Street Global Advisors, July 15 2002.
"International diversification works. Over the past 30 years, portfolios
comprising both U.S. and non-U.S. equities have experienced higher returns and
lower levels of overall risk. Risk reduction was the dominant effect for those
who invested internationally during the past decade." | ||||
| Robin Brooks and Marco Del Negro, "The
Rise in Comovement across National Stock Markets: Market Integration or IT
Bubble?," Federal Reserve Bank of Atlanta, September 2002 (301kb).
This study suggests that the recent trend of industry diversification becoming
more important than country diversification in international investing appears
to be a temporary phenomena related to the IT bubble of the late 1990s. | ||||
| Stephen E. Christophe and Richard W. McEnally, "U.S.
Multinationals as Vehicles for International Diversification," Journal of
Investing, Winter 2000, pp. 67-75. This paper debunks the
myth that an inexpensive way of getting international exposure is to buy
multinational companies headquartered in the US. The paper finds that
stocks of multinational companies tend to be strongly correlated with the US
stock market, regardless of the location and extent of their foreign
operations. | ||||
| Philip L. Cooley, Carl M. Hubbard, and Daniel T.
Walz, "Does International Diversification Increase the Sustainable Withdrawal
Rates from Retirement Portfolios?," Journal of Financial Planning,
January 2003, pp. 74-80. Also
here. This study shows that over the period
studied (1970-July 2001), international diversification would have provided almost
no benefit to typical US investors. This is consistent with the
Sinquefield study (1996) below. If the higher costs of foreign mutual
funds were taken into account, the international diversification benefit would
have been worse yet. | ||||
| Ian Cooper, "An open and shut case for portfolio
diversification," The Financial Times, July 16 2001, p. 4.
"Twenty years or less from now the challenge will be not 'the case for global
investing' but 'why deviate from a globally diversified equity portfolio.'" | ||||
| Claude B. Erb, Campbell R. Harvey, and Tadas E.
Viskanta, "Do
World Markets Still Serve as a Hedge?," Journal of Investing, Fall
1995, pp. 23-46 (2.1mb). "Do world markets still serve as a
hedge? The answer is affirmative." | ||||
| 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. | ||||
| Jason T. Greene and Charles W. Hodges, "The
dilution impact of daily fund flows on open-end mutual funds," Journal
of Financial Economics, July 2002, pp. 131-158 (101kb). This
paper measures the effect of a certain kind of day trading that allows some
active traders of mutual funds to earn significant abnormal returns at the
expense of long-term investors in those funds. It concludes that the
effect detracts about 0.5% annually from foreign mutual funds subject to this
effect. Note that the foreign mutual funds Altruist recommends aren't
subject to this effect: those of DFA (their distribution method precludes "day
trading"), Vanguard (they instituted contingent fees in 2003 which
significantly discourage the practice), and certain foreign stock ETFs (they
aren't subject to this effect by their very nature). The paper suggests
that investors may be prudent in avoiding mutual funds which are subject to
manipulation in this manner (i.e., those which haven't taken steps to avoid
this effect). | ||||
| Herbert G. Grubel, "Internationally Diversified
Portfolios: Welfare Gains and Capital Flows," American Economic Review,
December 1968, pp. 1299-1314. "... recent experience with
foreign investment returns would have given rise to substantial gains in
welfare to wealth holders. If past experiences are considered to be
indicative of future developments, then these data suggest that future
international diversification of portfolios is profitable and that more of it
will take place." | ||||
| Michael E. Hannah, Joseph P. McCormack, and Grady
Perdue, "International
Diversification with Market Indexes," Academy of Accounting and
Financial Studies Journal, 4(2) 2000, pp. 96-104. "In
theory an investor's portfolio may benefit by being invested in the U.S.
market and another market that is less than perfectly correlated with the U.S.
market. Diversification typically reduces risk significantly at the cost of a
small reduction in return. However, during the decade of the 1990s, U.S.
investors were not rewarded for international diversification. They would have
experienced small reductions in risk coupled with large reductions in return." | ||||
| Steven L. Heston and K. Geert Rouwenhorst, "Industry
and Country Effects in International Stock Returns," Journal of Portfolio
Management, Spring 1995, pp. 53-58. "... the performance of
international portfolios is largely country-driven, and international
portfolio managers should pay more attention to the geographical composition
than to the industrial composition of their portfolios." | ||||
| Kwok Ho, Moshe, Arye Milevsky, and Chris Robinson,
"International Equity Diversification and Shortfall Risk," Financial
Services Review, 8 1999, pp. 11-25. Also
here. "... [International
Equity Diversification] does not appear to benefit Americans materially,
because their equity portfolio is already closely-related to the international
equity portfolio." This paper's conclusions are consistent with those of Sinquefield (1996) below. | ||||
| John E. Hunter and T. Daniel Coggin, "An analysis of
the diversification benefit from international equity investment," Journal
of Portfolio Management, Fall 1990, pp. 33-36. "[during the
period studied (1970-1986)], ... international diversification would have
reduced investment risk (defined by variance of return) to about 56% of the
level that could have been achieved using only national diversification.
Hence, while there is a limit on international diversification benefit, the
potential gain is sizable indeed." | ||||
| Dušan Isakov and Frédéric
Sonney, "On the
relative importance of industrial factors in international stock returns,"
University of Geneva, January 2002 (99kb). This study analyzes
whether international diversification across countries or across industries
gives more diversification benefit. It concludes that, on average, the
country effect continued to dominate during the period studied. However,
the industry effect is increasing in importance and may dominate the country
effect now. It remains to be seen if this is a temporary or permanent
effect. | ||||
| Sarkis Joseph Khoury, "Country
Risk and International Portfolio Diversification for the Individual Investor,"
Financial Services Review, 2003, pp. 73-93 (2.44mb).
"... the paper finds no excuse for an investor to ignore international
diversification." | ||||
| John D. Kuethe, "Chapter
One: International Diversification in the 2000s — Stay the
Course," Ennis Knupp + Associates, September 2001 (338kb).
This paper notes that international diversification seemed to hurt US
investors in the late 1990s. It concludes that, going forward, it
probably still makes sense to diversify internationally. | ||||
| David S. Laster, "Measuring Gains from International
Equity Diversification: The Bootstrap Approach," Journal of Investing,
Fall 1998, pp. 52-60. This paper concludes that "... raising the
equity allocation to foreign stocks from zero to 20% reduces the probability
of realizing negative returns over a 5 year period by about a third. It also
documents the near certainty of reducing portfolio risk by raising the equity
allocation to foreign stocks above conventional levels." The optimal
allocation seems to be 60/40 domestic/foreign during the period studied
(1970-1996). Such an allocation would have increased risk-adjusted
returns by about 0.65 percentage points annually over that of a purely
domestic equity portfolio during the period studied, through reduction of
risk/volatility (which would also allow an increased allocation to equities,
which would further boost long-term returns). | ||||
| Haim Levy and Marshall Sarnat, "International
Diversification of Investment Portfolios," American Economic Review,
September 1970, pp. 668-675. This paper discusses the
risk-adjusted return benefits of diversifying internationally. | ||||
| Steven L. Heston and K. Geert Rouwenhorst, "Does
Industrial Structure Explain the Benefits of International Diversification?,"
Journal of Financial Economics,
August 1994, pp. 3-27. This paper concludes that diversifying
overseas by country makes more sense than diversifying overseas by industry.
"We find that industrial structure explains
very little of the cross-sectional difference in country return volatility,
and that the low correlation between country indices is almost completely due
to country-specific sources of return variation. Diversification across
countries within an industry is a much more effective tool for risk reduction
than industry diversification within a country." | ||||
| Jean-Francois L'Her, Oumar Sy, and Mohamed Yassine
Tnani, "Country, Industry, and Risk Factor Loadings in Portfolio Management,"
Journal of Portfolio Management, Summer 2002, pp. 70-79.
"... on average, country effects dominated industry effects ...
diversification across countries was more efficient than diversification
across industries." While the study reinforced the supremacy of country
diversification over the nine year period studied, it noted that industry
diversification is becoming an increasingly important factor to consider in
attempting to gain maximal benefits from international diversification. | ||||
| Jeff Madura and Thomas J. O'Brian, "International
Diversification for the Individual: A Review," Financial Services Review,
1991-1992, pp. 159-175. An excellent review of early work in this
area. "... individual investors can benefit from international
diversification, in effect increasing the efficiency of their portfolios, but
as over time the world market continues to integrate, the benefits may
decline." | ||||
| Richard O. Michaud, Gary L. Bergstrom, Ronald D.
Frashure, and Brian K. Wolahan, "Twenty years of international equity
investing: still a route to higher returns and lower risks?," Journal of
Portfolio Management, Fall 1996, pp. 9-22 (2.45mb). "... thoughtful
international equity diversification can improve the risk/return
characteristics of investors' portfolios." "Globally diversified
portfolios hold out the very real promise of less risk for the same level of
expected return ... than can be achieved with domestic portfolios." An
outstanding paper. | ||||
| Patrick Odier and Bruno Solnik, "Lessons for International Asset
Allocation," Financial Analysts Journal, March/April 1993, pp. 63-77.
"Clearly, foreign asset classes provide attractive risk diversification and
profit opportunities." "The risk and return advantages of international
diversification are very large for investors in all the major countries." | ||||
| Sandeep Patel and Asani Sarkar, "Stock
Market Crises in Developed and Emerging Markets," Financial
Analysts Journal, November/December 1998, pp. 50-61. This
paper finds that, while foreign stocks tend to become less good diversifiers
during severe bear markets (i.e., when you most want their diversification
benefits), the effect only occurs at very short time horizons. For
longer time horizons, their diversification benefit remains intact. "We
confirm the often-held belief that correlations between U.S. and emerging
markets tend to become higher in times of market decline. However, this is
only true for investors who hold stocks for short periods of time---for less
than one year, in the case of Asian stocks. For longer-horizon investors the
correlations remain very small even when markets fall. For these investors,
emerging market [and developed market] stocks continue to provide
important diversification benefits even during periods of significant market
declines." | ||||
| Mattias Persson, "Long-Term Investing and
International Diversification," SSRN Abstract #302682, March 2002
(110kb).
This paper finds that "investors gain more from internationally diversified
portfolios if the investment horizon is longer, that is, the [optimal] weight
in the international assets are significantly higher for long investment
horizons compared to the one-year horizon." | ||||
| Christopher B. Phillips, "International
Equity: Considerations and Recommendations," Vanguard Investment
Counseling & Research, November 24 2006. "We weigh these risks
against the potential benefits and conclude that:
| ||||
| Garrett Quigley, "Investing
in International Small Company Stocks," Institute for Fiduciary Education,
July 8 2001 (38kb). | ||||
| Kenneth S. Reinker and Ed Tower, "Predicting
Equity Returns for 37 Countries: Tweaking the Gordon Formula," Duke
University Working Paper, July 12 2002 (243kb). This paper shows
that there is good reason to believe that equity returns outside the US in the
near future may be somewhat higher than domestic returns. | ||||
| Judson W. Russell, "The
International Diversification Fallacy of Exchange-Listed Securities,"
Financial Services Review, Volume 7 Number 2 1998, pp. 95-106 (999kb).
This paper assesses the diversification benefit of international equities
traded on US markets (i.e., ADRs, closed-end country funds, and stocks of
multinational corporations). It concludes that "... the U.S.
exchange-listed securities included in this study behave more like the host
exchange than their home exchange. This result suggests that these U.S.
exchange-listed securities, on average, do not perform an international
diversification role for U.S. investors." This finding is consistent
with a strategy of using conventional (open-end) mutual funds in order to
achieve whatever international diversification is desired. | ||||
| Asani Sarkar and Kai li, "Should
US Investors Hold Foreign Stocks?," Federal Reserve Bank of New
York Current Issues In Economics and Finance, March 2002, pp. 1-6.
Also here (47kb).
This paper finds that, if short selling is not allowed, there is no
diversification benefit for US investors to diversify in foreign developed
markets. However, diversification into Emerging Markets remains
beneficial under this constraint. | ||||
| Steven Schoenfeld, J. Lisa Chen, and Binu George, "ETFs
offer the World to Investors," A Guide to Exchange-Traded Funds,
Fall 2001, pp. 111-118. "Index based strategies are the most
efficient way to gain international exposure, and should outperform the
average actively managed fund." | ||||
| Rex A. Sinquefield, "Where are the Gains from International
Diversification?," Financial Analysts Journal, January/February 1996,
pp. 8-14. This paper argues that international value and small stocks
are much better portfolio diversifiers than international large cap (e.g., MSCI EAFE)
during the period studied (1975-1994). | ||||
| Bruno Solnik, "Why not
diversify internationally rather than domestically?," Financial Analysts
Journal, July/August 1974, pp. 48-54. Reprinted in Financial Analysts
Journal, January/February 1995, pp. 89-94. This
paper is often cited as being among the first to lay out a convincing case for international
diversification of equity portfolios. | ||||
| Bruno Solnik,
Cyril Boucelle, and Yann Le Fur, "International Market Correlation and
Volatility," Financial Analysts Journal, September/October 1996, pp.
17-34. "Thus, a passive
international diversification strategy of investing 20 percent abroad is still
beneficial from a risk viewpoint. The risk diversification benefits could be
enhanced by ... including emerging markets, which are less correlated with the
U.S. market than developed markets." "The
benefits of international risk reduction are still robust, but the case for
international diversification may be overstated ..." | ||||
| Bruno
Solnik, "The
View After a Quarter Century," Investment Policy,
May/June 1998, pp. 9-12. A 25 year retrospective after the
1974 paper. "... the risk-diversification benefits of investing
internationally are clear ... overweighting one's home country stocks has a
cost in terms of risk." | ||||
| Meir Statman and Jonathan Scheid, "Global
Diversification," Journal of Investing Management,
forthcoming (524kb). It suggests that dispersion of returns is a
better measure of the diversification benefit of an asset class than is
correlation. "Dispersion of returns is a better measure of the benefits
of diversification because it accounts for the effects of both correlation and
standard deviation and because it provides an intuitive measure of the
benefits of diversification." | ||||
| Yesim Tokat, "International
Equity Investing: Long-Term Expectations and Short-Term Departures," Investment Counseling
& Research/ ANALYSIS, May 2004. A good discussion of
issues surrounding investing internationally, including rational reasons to
weight foreign equities somewhat less than theory might suggest. "...
this paper shows that a portfolio diversified into non-U.S. stocks has
typically provided higher returns or lower volatility than a U.S.-only
portfolio over such periods. However, we contend that behavioral and practical
considerations call for a smaller allocation than standard theory may suggest.". | ||||
| Jim Wiandt, "Diversifying Internationally — Safe and Sensible," Indexfunds.com, July 25 2000. |
Frontier Markets are countries that aren't developed enough to be considered "Emerging Markets." Conceptually, whatever makes Emerging Markets desirable (e.g., low correlation with other stuff) should apply even moreso with Frontier Markets. At the moment, there is a paucity of viable investing options in this asset class, the most viable perhaps being the The Claymore/BNY Mellon Frontier Markets ETF (FRN). It has an expense ratio of 0.65%, but it is quite new, quite concentrated in just three countries, and somewhat thinly traded at present. Also, see Emerging Markets.
| Lawrence Speidell and Axel Krohne, "The Case
for Frontier Equity Markets," Journal of Investing,
Fall 2007, pp. 12-22. This paper argues for the benefits of
investing in frontier markets. |
| Karen Umland, "Frontier
Markets: New Investment Opportunities and Risks," Institute for
Fiduciary Education, 2008 (95kb). A good primer on frontier
markets. |
Some very wealthy investors invest in Hedge Funds. Hedge Funds are similar to mutual funds, but they are more risky, less regulated, less liquid, and dramatically more expensive (not only do they have annual expense ratios of about 2%, but they typically take 20% or more of all gains as well). We discourage use of Hedge Funds because they are so very expensive and because virtually all of them are actively managed.
"If you want to waste your money, it's a good way to do it." "If you want to invest in something where they steal your money and don't tell you what they're doing, be my guest." — Dr. Eugene Fama, commenting on the prudence of investing in hedge funds
"If there's a license to steal, it's in the hedge fund arena." — Dr. Burton Malkiel, commenting on the high costs of hedge funds
"It takes about 35 years of returns to say with any statistical confidence that stocks have a higher expected return than the risk-free rate. Think about a hedge fund that has equity-like volatility. If the manager’s alpha was as large as the market risk premium — which would be huge — it would also take about 35 years to be confident the manager has any value added — and that’s before his fees of '2 and 20.' Even if that phenomenal manager is out there, is he likely to stick around long enough for us to be able to figure out he wasn’t just lucky?" — Dr. Kenneth French, commenting on the probability of being able to determine that any particular hedge fund manager had ANY skill
| Vikas Agarwal and Narayan Y. Naik, "Multi-Period
Performance Persistence Analysis of Hedge Funds," London Business School
Working Paper, February 2000 (95kb). This study concludes that
there may be some very short term persistence, but it is primarily the poor
performers whose performance appears to persist — persistence among good
performers is dramatically less. This suggests that it may not make
sense to pick a Hedge Fund based on past performance (but it may make sense to
avoid those with particularly poor past performance). If it doesn't make sense to choose a hedge fund based on past performance, how would one do it? By minimizing fees? Virtually all hedge funds have fees ranging from "much too high" to "truly outrageous." |
| Clifford Asness, Robert Krail, and John Liew, "Do
Hedge Funds Hedge?," Journal of Portfolio Management, Fall 2001,
pp. 6-19 (242kb). Also
here. This excellent paper looks at the risk-adjusted
performance of Hedge Funds. It notes that illiquidity of underlying
investments, among other effects, tends to distort performance numbers.
Specifically, it notes that hedge fund performance tends to lag the
performance of the market. After taking that effect into account, it doesn't
appear that Hedge Funds are very good at "hedging". |
| Chris Brooks and Harry M. Kat, "The
Statistical Properties of Hedge Funds Index Returns and Their Implications for
Investors," The University of Reading, October 31 2000 (108kb).
"Sharpe Ratios will substantially overestimate the true risk-return
performance of (portfolios containing) hedge funds. Similarly,
mean-variance analysis will over-allocate to hedge funds and overestimate the
attainable benefits from including hedge funds in an investment portfolio." |
| Bernard Condon, "Hedge
Fund Investing For Dummies," Forbes, May 14 2004.
"Warning to hedge fund investors: You would do better giving your money to a
monkey." You may have to register (for free) to read this article. |
| Richard M. Ennis and Michael D. Sebastian, "A
Critical Look at the Case for Hedge Funds: Lessons from the Bubble,"
The Journal of Portfolio Management, Summer 2003, pp. 103-112 (235kb).
"Notwithstanding evident market timing skill — at least
during the extraordinary period covered here — the performance of hedge funds
has not been good enough to warrant their inclusion in balanced portfolios.
The high cost of investing in funds of funds contributed to this result.
Many practitioners believe markets are imperfectly efficient, providing astute
investors an opportunity to exploit security mispricing. This may well
be true. One wonders, though, how realistic it is to expect funds of
hedge funds to realize competitive returns for their investors after costs
upward of 5% per year." |
| David Harper, "Introduction
to Hedge Funds - Part Two: Advantages and Questions," Investopedia.com,
December 10 2003. A good discussion of Hedge Funds for laypeople. |
| William Jahnke, "Hedge
Funds Aren't Beautiful," Journal of Financial Planning, February
2004, pp. 22-25. Also
here. "Hedge funds are a great product for the hedge
fund industry and its support apparatchik ... but are likely, on average, to
produce a negative return contribution relative to a benchmark consisting of
stocks, bonds, and cash." A scathing review of the utility (or lack
thereof) which hedge funds might have for investors. |
| Burton Malkiel and Atanu Saha, "Hedge
Funds: Risk and Return," Financial Analysts Journal,
November/December
2005, pp. 80-88. Also
here. "We
conclude that hedge funds are far riskier and provide much lower returns than
is commonly supposed." |
| Alejandro Murguía and Dean T. Umemoto, "An
Alternative Look at Hedge Funds," Journal of Financial Planning,
January 2004, pp. 42-49. Also
here. An outstanding, frank discussion of
hedge funds. "Advisors relying on simple return data and traditional
evaluation measures presented in many hedge fund tear sheets will be
vulnerable to inaccurate conclusions and possibly expose their clients’
investments to an inappropriate amount of risk." "Although
this [hedge fund] manager may seem to be providing excess returns, a
multifactor model that incorporates the dynamic trading strategy of the fund
will indicate that the fund manager is essentially creating these returns by
taking on more risk through the specific trading strategy and not necessarily
through alpha." "Until further advances are made [in empirical research on what drives hedge fund returns], advisors may be better served by diversifying their clients’ portfolios with other un-represented asset classes traded on major exchanges such as emerging markets or international small cap stocks. These different asset classes have traditionally been very effective portfolio diversifiers. Additionally they allow advisors a degree of liquidity and transparency not currently present in hedge funds." |
| Michael W. Peskin, Michael S. Urias, Satish I.
Anjilvel, and Bryan E. Boudreau, "Why
Hedge Funds Make Sense," Morgan Stanley Dean Witter, November 2000
(820kb). This often-cited paper concludes that Hedge Funds are
beneficial for institutional investors. However, before going out and
buying any Hedge Funds, be sure to view the other studies listed here. |
| Christopher B. Philips, "Understanding
Alternative Investments: A Primer on Hedge Fund Evaluation," The Vanguard
Group, January 2005.
A good primer on Hedge Funds. |
| Nolke Posthuma and Pieter Jelle Van Der Sluis, "A
Reality Check on Hedge Funds Returns," Working Paper, July 8 2003 (218kb).
This paper finds that backfill bias causes Hedge Fund return databases to
systematically overstate actual realized returns by about four percent per
annum. This brings into serious question any and all studies which might
conclude that hedge funds are beneficial. |
| William Reichenstein, "What
are you Really Getting When You Invest in a Hedge Fund?," AAII
Journal, July 2004. "... a review of the historical
returns of hedge funds and other alleged advantages finds them suspect." |
| Thomas Schneeweis, Hossein Kazemi, and George
Martin, "Understanding
Hedge Fund Performance: Research Results and Rules of Thumb for the
Institutional Investor, "Center for International Securities and
Derivatives Markets, University of Massachusetts,
November 2001 (1.2mb). An outstanding discussion of various
topics surrounding Hedge Funds. |
| Neil Weinberg and Bernard Cohen, "The
Sleaziest Show On Earth," Forbes, May 24 2004. "Hedge
funds will suck in $100 billion this year from an ever-broader swath of
investors. Pretty good for a business rife with exorbitant fees, phony numbers
and outright thievery." You may have to register (for free) to read this
article. |
| Andrew B. Weisman and Jerome D. Abernathy, "The
Dangers of Historical Hedge Fund Data." (62kb) This paper
presents a means of describing performance characteristics of Hedge Fund
managers. It also points out two troubling biases which tend to be
present in the data. It calls these biases "Short-Volatility Bias" and
"Illiquidity Bias." These biases tend to cause Hedge Fund performance
data to understate the actual risk/volatility of the funds (and therefore
overstate risk-adjusted performance). |
| Andrew B. Weisman, "Informationless investing and
hedge fund performance measurement bias: dangerous attractions," Journal of
Portfolio Management, Summer 2002, pp. 80-91. This paper
describes how three phenomena typical of hedge funds each conspire to
overstate the risk-adjusted performance of Hedge Funds (and understate their
correlation with other assets). The result is that most hedge fund
database data is significantly biased, calling into question any conclusions
based on them. |
| Martin Sewell's Hedge Fund Bibliography. An excellent bibliography of relevant papers on this topic — most with full text! |
High-yield bonds (a.k.a., "junk bonds") are any bonds issued by companies which are judged to be poor credit risks (i.e., they may default on their debt). Because the value of these bonds is so dependent on the likelihood of default (which in turn is linked with the well-being of the company), they behave both like conventional investment-grade bonds and like stocks. If you must invest in High-Yield bonds, we suggest one of the following selections: the Vanguard High-Yield Corporate Fund (VWEHX), the TIAA-CREF High-Yield Bond Fund (TCHYX), the iShares iBoxx $ High Yield Corporate Bond Fund (HYG), the PowerShares High Yield Portfolio (PHB), or the SPDR Barclays High Yield Bond ETF (JNK). Also, see Bonds.
| Marshall E. Blume, Donald B. Keim, and Sandeep A.
Patel, "Returns and Volatility of Low-Grade Bonds 1977-1989," Journal of
Finance, March 1991, pp. 49-74. This paper found that:
| ||||||
| Bradford Cornell and Kevin Green, "The Investment
Performance of Low-grade Bond Funds," Journal of Finance, March 1991,
pp. 29-48. "When adjusted for risk ... the returns on low-grade
bond funds are not statistically different from the returns on high-grade
bonds." | ||||||
| Christopher C. Finger, Vladimir Finkelstein,
Jean-Pierre Lardy, George Pan, Thomas Ta, and John Tierney, "CreditGrades
Technical Document," RiskMetrics Group, May 2002 (723kb).
This document describes an approach for quantifying credit/default risk of
bond issuers. Quantitative assessments of default risks using this
approach are available free here. | ||||||
| Martin S. Fridson, "Do High-Yield Bonds Have an
Equity Component?," Financial Management, Summer 1994, pp. 82-84.
"Correlation coefficients consistently show that straight noninvestment-grade
bonds trade nearly as much like stocks as pure debt instruments. The
case for an equity component in high-yield bonds is buttressed by theory.
In effect, a corporate bond is a combination of a pure interest rate
investment and a short position on the issuer's equity. For a highly
rated company, the put is well out of the money. In the case of a
noninvestment-grade bond, however, default is a realistic enough prospect to
enable the equity put to affect the bond's price materially. Empirical
research has confirmed the equity effect." | ||||||
| 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 (i.e., more
volatile), 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! | ||||||
| "Papers about Credit Pricing and Credit Spreads," DefaultRisk.com. An excellent bibliography on this topic. |
There is reason to believe that investing in relatively illiquid investments will, in the long run and on average, yield higher expected returns than a more liquid investment of similar risk. If this weren't true, then nobody would buy them, which would tend to drive down their price, which would tend to increase the expected returns until it was true. Also, see Bid-Ask Spreads and Private Equity.
| Viral V. Acharya and Lasse Heje Pedersen, "Asset
Pricing with Liquidity Risk," NYU Stern School Working Paper, July 17 2003
(416kb). Also
here. "It is shown that a security's return depends on its
expected illiquidity and on the covariances of its own return and illiquidity
with market return and market illiquidity." |
| Yakov Amihud and Haim Mendelson, "Liquidity and
Stock Returns," Financial Analysts Journal, May/June 1986, pp. 43-48.
This paper documents an illiquidity premium for stocks (i.e., the higher the
bid-ask spread (a proxy for illiquidity), the higher the expected return). |
| Yakov Amihud and Haim Mendelson, "Liquidity and
Asset Prices: Financial Management Implications," Financial Management,
Spring 1988, pp. 5-16. Another excellent discussion of this
topic. |
| Yakov Amihud and Haim Mendelson, "The Effects of
Beta, Bid-Ask Spread, Residual Risk, and Size, on Stock Returns," Journal
of Finance, June 1989, pp. 479-486. Another excellent
discussion of this topic. |
| Yakov Amihud and Haim Mendelson, "Liquidity,
Maturity, and the Yields on U.S. Treasury Securities," Journal of Finance,
September 1991, pp. 1411-1425. This paper confirms the existence
of the illiquidity premium in bonds as well as stocks. |
| Yakov Amihud and Haim Mendelson, "Liquidity, Asset
Prices and Financial Policy," Financial Analysts Journal,
November/December 1991, pp. 56-66. "When designing an investment
portfolio, a portfolio manager should consider not only the client's risk
aversion, but also its investment horizon. A short horizon calls for
investing in liquid assets, whereas a long investment horizon enables the
investor to earn higher net returns by investing in illiquid assets." |
| S. Brown, M.A. Milevsky, and T.S. Salisbury, "Asset
Allocation and the Liquidity Premium for Illiquid Annuities," Journal
of Risk & Insurance, Volume 70 Number 3 (345kb).
Here's an
earlier version. "...the required liquidity premium is an
increasing function of the holding period restriction, the subjective return
from the market, and is quite sensitive to the individual's endowed
(preexisting) portfolio." |
| Elroy Dimson and Bernd Hanke, "The
Expected Illiquidity Premium: Evidence from Equity Index-Linked Bonds,"
London Business School Working Paper, December 18 2002 (289kb). This paper found that:
"There is an economically significant expected return premium associated with
illiquidity." |
| Robert Novy-Marx, "On
the Excess Returns to Illiqidity," CRSP Working Paper # 5555, April 8 2004
(85.1kb). This paper argues that the high expected returns
observed on illiquid assets should be expected theoretically, but are not
actually a premium for illiquidity, per se. Instead, illiquidity, like size,
is a proxy for any unobserved risk. Liquidity should therefore have
explanatory power in any asset pricing model that is not perfectly specified,
with low measured liquidity forecasting high expected returns. |
Index weighting refers to how a securities index weights the constituent securities in its index. Virtually all indexes weight their constituent securities by market capitalization (notable exception: the Dow Jones Industrial Average). This makes a certain amount of sense. For example, if you assume that the market in aggregate is capable of optimizing its allocation, then a market-cap weighted index makes sense. However, some have pointed out that the market doesn't price ANYTHING "right" all the time. Some securities end up being overpriced and some being underpriced at all times. Unfortunately, the ones that are most overpriced would tend to be the largest constituents of market-cap-weighted indexes, while the ones that are most underpriced would tend to be the smallest constituents. Of course, if you could, you would prefer to concentrate your investments in those securities which are underpriced, rather than those that are overpriced. This is the qualitative argument for considering alternative weighting schemes. Note that equal weighting is perhaps the simplest of the infinitely many possible alternative (i.e., non-market-cap) weighting schemes.
| Robert D. Arnott, Jason C. Hsu, and Philip Moore, "Fundamental
Indexation," Financial Analysts Journal, March/April 2005, pp.
83-99. This was the paper that most spurred interest in this
topic. "In this paper, we examine a series of equity
market indexes weighted by fundamental metrics of size, rather than market
capitalization. We find that these indexes deliver consistent and significant
benefits relative to standard capitalization-weighted market indexes." |
| André F. Perold, "Fundamentally
Flawed Indexing," Financial Analysts Journal, November/December
2007, pp.
31-37. This paper fairly
definitively debunks the idea that alternative weighting schemes can
systematically outperform without a "value effect." "Holding a stock
in proportion to its capitalization weight does not change the likelihood that
the stock is overvalued or undervalued. The notion that capitalization
weighting imposes an intrinsic drag on performance is, accordingly, false.
Fundamental indexing is a strategy of active security selection through
investing in value stocks. It is a strategy not everyone can follow. Investors
who have no skill in evaluating value tilts and other active strategies should
hold the cap-weighted market portfolio." |
| William J. Bernstein, "Fundamental
Indexing and the Three-Factor Model," Efficient Frontier, May 2006.
"Fundamental indexing is a promising technique, but its advantage over more
conventional cap-weighted value-oriented schemes, to the extent that it exists
at all, is relatively small." "Even assuming that fundamental
indexation produces returns in excess of its factor exposure, caution should
be used in the practical application of this methodology. Differences in the
expenses, fees, and transactional costs incurred in the design and execution
of real-world portfolios can easily overwhelm the relatively small marginal
benefits of any one value-oriented approach. The prospective shareholder needs
to consider not only the selection paradigm used, but just who is executing
it." |
| Eric Brandhorst, "Fundamentals-Weighted
Indexing Offers New Insight on Value Investing," State Street Global
Advisors, December 22 2005. A good discussion of the topic. |
| Srikant Dash, "Unveiling
the next generation of Style Indexing," Standard & Poor's, September 20
2005. This white paper performs some comparison analysis on the
Standard & Poor's "True Style" indexes. These indexes are the first
widely available indexes to use a fundamentals-weighting paradigm. |
| Matthew Hougan, "Quieting
The Noise," Journal of Indexing, September/October 2007, pp.
22-23, 46. This article discusses the (then) unpublished working
paper by Harvard Business School professor André Perold which debunks the idea
that non-cap weighting can be expected to give better results than cap
weighting solely because overvaluing of stocks tends to bias a cap-weighted
portfolio towards being overvalued. The paper quantitatively proves that
this is not true. The qualitative explanation is apparently that even
the largest stocks, by market cap, are just as likely to be undervalued as
they are to be overvalued. So, while weighting by market cap does bias
you towards large market cap companies, those large market cap companies may
either be overvalued or undervalued. So the portfolio is NOT necessarily
biased towards overvalued companies (because some/many of the largest
constituents may, in fact, be undervalued). |
| Jason C. Hsu, "Cap-Weighted
Portfolios are Sub-Optimal Portfolios," Social Science Research Network
paper #647001, December 2004. This working paper was the
unpublished predecessor to the important Arnott/Hsu/Moore paper above. |
| Jason C. Hsu and Carmen Campollo, "New
Frontiers in Index Investing," Journal of Indexes, January/February
2006, pp. 32-37, 58. Makes a compelling case for weighting based
on fundamentals. |
| Jack Treynor, "Perspectives: Why
Market-Valuation-Indifferent Indexing Works," Financial Analysts Journal,
September/October 2005, pp. 65-69. A good discussion of this
issue by one of the great minds of financial economics. |
| Marcelle Arak and Stuart Robinson, "I
Bonds versus TIPS: Should individual investors prefer one to the other?,"
Financial Services Review, Volume 15 (2006), pp. 265-280. "Despite
I Bonds’ less attractive real rate, they have several features that add to
their value. They may be redeemed before maturity, at par value plus accrued
interest, eliminating price risk. In addition, taxes may be deferred until
redemption. We estimate the value of these two features, and find that they
are substantial and could potentially offset the lower real rate of I Bonds." |
| Zvi Bodie, "TIPS
for 401(k) Plans," Pensions & Investments, April 29 2002, p. 12.
Makes a compelling case for using TIPS in tax-exempt portfolios. |
| Peng Chen and Matt Terrien, "TIPS
as an Asset Class," Ibbotson Associates, 1999 (104kb). Also
here. This paper also appeared in Journal of Investing, Summer
2001, pp. 73-81. Makes a compelling case for the diversification benefits
of TIPS. |
| Scott Grannis, "Why
Are TIPS So Cheap?," Investment Policy,
September/October 1999, pp. 73-80 (584kb). |
| P. Brett Hammond, "Understanding
and Using Inflation Bonds," TIAA-CREF Institute research dialogue,
September 2002, pp.1-18. A good summary of issues surrounding
TIPS. |
| Scott E. Hein and Jeffrey M. Mercer, "Are
TIPS Really Tax Disadvantaged? Rethinking the tax treatment of U.S.
Treasury Inflation Indexed Securities," Texas Tech University Working
paper, May 2003. Also
here. This paper argues that, contrary to conventional
wisdom, the taxation of TIPS is very similar to the taxation of conventional
treasuries. Thus TIPS are no more and no less tax disadvantaged than
conventional treasuries. |
| Douglas R. Kahl and Jerry L. Stevens, "Inflation-Indexed
Treasury Bonds: Cash Flows, Taxes, and Simulated Returns," Journal of
Financial Planning, April 1999. |
| S.P. Kothari and Jay Shanken, "Asset
Allocation with Inflation-Protected Bonds,"
Financial Analysts Journal, January/February 2004, pp. 54-70 (100kb). "... the
measures of [risk-adjusted] portfolio performance ... increase by about 15%
with indexed bonds, as compared to conventional bonds." "These
observations suggest an important role for indexed bonds in a diversified
investment portfolio. The risk-reduction benefits of indexed bonds
reflect fundamental economic relations and are likely to persist in the
future, though the magnitude of those benefits will vary with the inflationary
environment." |
| R. McFall Lamm Jr., "Asset Allocation Implications
of Inflation Protection," Journal of Portfolio Management, Summer 1998,
pp. 93-100. This paper concludes that efficient frontier
portfolios almost always contain substantial quantities of TIPS. |
| Gerald Lucas and Timothy Quek, "A Portfolio Approach
to TIPS," Journal of Fixed Income, December 1998, pp. 75-84.
"We do believe that TIPS can and should be an integral part of most investors
fixed-income portfolios because of their favorable risk/reward profile." |
| Stan Luxenberg, "Best of Breed: Vanguard Inflation
Protected Securities Fund Provides Protection Against Turbulence,"
Bloomberg Wealth Manager, April 2003, pp. 78-80. Discusses
the premier TIPS mutual fund. |
| Richard Roll, "Empirical
TIPS," Financial Analysts Journal, January/February 2004 (927kb).
"Given plausible assumptions about future expected returns, an investment
portfolio diversified across equities and nominal bonds would be improved by
the addition of TIPS." |
| Sue Stevens, "Using
Inflation-Indexed Bonds in Your Portfolio," Morningstar, February
22 2001. An excellent description of TIPS and I-Bonds. You
may have to register (for free) in order to view this article. |
| Anne Tergesen, "TIPS
for Your Portfolio: Inflation-indexed bonds look smart," Business Week,
May 26 2003. |
| "TIPS:
A long-term investment, a short-term unknown," The Vanguard Group,
August 30 2004. An excellent discussion of rational short-term
return expectations for TIPS. |
| "Investing
in Treasury Inflation Protected Securities," Vanguard Investment
Counseling & Research,
October 2 2006. "TIPS make sense for many investors, as their
characteristics offer some advantages over those of conventional Treasury
bonds." |
| "Inflation
Linked Bonds: US Inflation-Indexed Bonds," Bridgewater Associates, 1996
(216kb). An excellent primer on TIPS. |
| US Department of the Treasury I-Bonds web site. |
There are many well-documented behavioral phenomena which often conspire to rob investors of investment performance. Being aware of them may help you to steer clear of them.
| H. Kent Baker and John F. Nofsinger, "Psychological
Biases of Investors," Financial Services Review, 11(2) Summer 2002, pp.
97-116. A survey of these issues. |
| Brad M. Barber and Terrance Odean, “Trading is Hazardous to your Wealth: The
Common Stock Investment Performance of Individual Investors,” Journal
of Finance, April 2000 Vol 60 No 2, pp. 773-806 (262kb).
Also
SSRN Working Paper 219228 (263kb). |
| Brad M. Barber, Terrance Odean, and Lu Zheng, "The
Behavior of Mutual Fund Investors," September 2000 (227kb). |
| Brad M. Barber and Terrance Odean, "The
Courage of Misguided Convictions: The Trading Behavior of Individual Investors,"
Financial Analysts Journal, November/December 1999, pp. 41-55 (208kb).
Also
SSRN Working Paper 219175 (143kb). |
| Nicholas Barberis and Richard Thaler, "A
Survey of Behavioral Finance," forthcoming in Handbook of the
Economics of Finance, September 2002 (720kb). |
| Shlomo Benertzi and Richard H. Thaler, "Myopic
Loss Aversion and the Equity Premium Puzzle,"
Quarterly Journal of Economics, February 1995, pp. 73-92 (1.82mb).
Also
here (1.82mb). This paper coined
the term "myopic loss aversion." It refers to the tendency to be
unusually sensitive to short term losses, relative to short term gains. |
| Werner F. M. De Bondt and Richard H. Thaler, "Does
the Stock Market Overreact?," Journal of
Finance, July 1985, pp. 793-805 (1.5mb). |
| Justin Fox, "Is
the Market Rational?," Fortune, December 9 2002. A
good even-handed discussion of the Efficient Market vs. Behavioral debate. |
| Russell J. Fuller, "Behavioral
Finance and the Sources of Alpha," Journal of Pension Plan
Investing, Winter 1998 (51kb). |
| Uri Gneezy, Arie Kapteyn, and Jan Potters, "Evaluation
Periods and Asset Prices in a Market Experiment," Journal of Finance,
April 2003, pp. 821-838 (181kb). This experiment confirms the earlier work of Thaler/Tversky/Kahneman/Schwartz
below: investors who look at their account balances more often tend to lessen
the riskiness of their portfolios more, which tends to lessen their long-term
returns. Thus, it tends to pay to ignore your periodic investment
account statements. |
| David A. Hirshleifer, "Investor
Psychology and Asset Pricing," Journal of Finance, Vol. 56 2001,
pp. 1533-1597 (568kb). "This survey sketches a framework for
understanding decision biases, evaluates the a priori arguments and the
capital market evidence bearing on the importance of investor psychology for
security prices, and reviews recent models." |
| Daniel Kahneman and Mark W. Riepe, "Aspects
of Investor Psychology: Beliefs, preferences, and biases investment advisors
should know about," Journal of Portfolio Management, Vol 24 No.
4 Summer 1998 (71kb). Kahneman is a Nobel Prize winner. |
| Daniel Kahneman and Amos Tversky, "Prospect
Theory: An Analysis of Decision under Risk,"
Econometrica, March 1979, pp. 263-292 (2.9mb). This paper
is one of the cornerstones of behavioral finance. Kahneman is a Nobel
Prize winner. |
| Martin
Sewell, "Behavioural
Finance Bibliography," University College London.
An excellent bibliography of this topic. |
| Robert J. Shiller, "Human
Behavior and the Efficiency of the Financial System," Cowles Foundation
for Research in Economics at Yale University, 1997. An
outstanding survey of behavioral finance topics. |
| Robert J. Shiller, "From
Efficient Market Theory to Behavioral Finance," Journal of
Economic Perspectives, Volume 17(1) 2003. Also, Cowles Foundation
Discussion paper number 1385, 2002 (153kb). |
| Livio Stracca, "Behavioural
finance and aggregate market behaviour: where do we stand?," May 2002
(119kb). A survey of the subject area. |
| Larry Swedroe, "The
Most Important Determinant of Investment Returns,"
Indexfunds.com, August 23 2002. |
| Richard H. Thaler, "The
End of Behavioral Finance," Financial Analysts Journal,
November/December 1999, pp. 12-17 (95kb). |
| Richard H. Thaler, Amos Tversky, Daniel Kahneman,
and Alan Schwartz, "The Effect of Myopia and Loss Aversion on Risk Taking: An
Experimental Test," Quarterly Journal of Economics, May 1997, pp.
647-661. This outstanding paper shows that investors who look at
their account balances more often tend to lessen the riskiness of their
portfolios more, which tends to lessen their long-term returns. Thus, it
tends to pay to ignore your periodic investment account statements. |
| Richard H. Thaler,
published papers. A list (with links to full text!) to
published papers (since 1995) from one of Behavioral Finance's leading
researchers. |
| Jason Zweig, "Do
You Sabotage Yourself?," Money, May 2001, p. 74. A great look
at the pioneering work of Kahneman and Tversky. |
| "Psychology and Behavioral
Finance," Investor Home, 1999. An excellent survey of this
subject area. |
| "DALBAR
Issues 2001 Update to 'Quantitative Analysis of Investor Behavior' Report:
More Proof that Market Timing Doesn't Work for the Majority of Investors,"
Dalbar, Inc. A press release announcing the 2001 update to their
annual study. The study concludes that the average fund investor
dramatically underperforms the market, presumedly due to excessive fees,
failed attempts at market timing, and general lack of investing discipline. |
|
Undiscovered Managers Behavioral Finance Research Library. An
excellent bibliography (with links!) on this topic. |
| Robert J. Carney and Lise Graham, "A Current Look at
the Debate: Whole Life Insurance Versus Buy Term and Invest the Difference,"
Managerial Finance, Vol 24 Number 12 1998, pp. 25-44. This
paper quantitatively compares a routine of "Buy Term and Invest the
Difference" with buying a whole life policy. "In terms of
terminal wealth at age 65, a 'buy term and invest the difference strategy'
outperforms variable universal life insurance [a type of whole life
policy] in almost every instance." |
| Jagadeesh Gokhale and Lawrence J. Kotlikoff, "The
Adequacy of Life Insurance," TIAA-CREF Institute research dialogue,
July 2002. This article describes a preferred means of
determining life insurance need and compares it with several "conventional"
approaches. |
| Eric E. Haas, "Life Insurance," Altruist Financial Advisors, 2004. |
| Michael D. Everett, Murray S. Anthony, and Gary
Burkette, "Long-Term
Care Insurance: Benefits, Costs, and Computer Models," Journal of
Financial Planning, February 2005, pp. 56-68. A good
discussion of the issue. |
| "Do You Need Long-Term Care Insurance?," Consumer
Reports, November 2003, pp. 20-24.
See this summary rating. Good objective advice on this issue. |
| "A
Shopper's Guide to Long-Term Care Insurance," National Association
of Insurance Commissioners, 2003 (727kb). Also available
here (6.4mb) and
here
(573kb, 1999 version). |
| The Federal Long
Term Care Insurance Program. This non-subsidized,
individually underwritten program probably should be included when shopping
around if you are eligible for it. |
Market timing refers to an attempt to time investing decisions so as to invest in assets which are expected to go up in the near term and divest from assets which are expected to go down in the near term. The most simple implementation may be to shift one's assets between cash and stocks generically in order to take advantage of anticipated stock market movements. As you can see from the below studies, attempts at market timing are only likely to work spuriously, due to occasional good fortune. We strongly advocate against market timing in all its various forms. Also, see Dollar Cost Averaging.
"The long, sad history of market timing is clear: Virtually nobody gets it right even half the time. And the cost of getting it wrong wipes out the occasional gain of getting it right. So the average investor's experience with market timing is costly. Remember, every time you decide to get out of the market (or get in), the investors you buy from and sell to are the best of the big professionals. (Of course, they're not always right, but how confident are you that you will be 'more right' more often than they will be?) What's more, you will incur trading costs or mutual fund sales charges with each move—and, unless you are managing a tax-sheltered retirement account, you will have to pay taxes every time you take a profit." — Charles Ellis, Winning the Loser's Game
"The mathematical expectation of the speculator is zero. ... The expectation of an operation can be positive or negative only if a price fluctuation occurs — a priori it is zero." — Louis Bachelier, Theory of Speculation, 1900
| William F.
Sharpe, "Likely Gains from Market Timing," Financial Analysts
Journal, March-April 1975, pp. 60-69. "... unless a manager
can predict whether the market will be good or bad each year with considerable
accuracy, (e.g., be right at least seven times out of ten), he probably should
avoid attempts to time the market altogether." Written by a Nobel
Prize winner. Also, see the QuickMBA summary below. |
| Robert H. Jeffrey, "The folly of stock market
timing: no one can predict the market's ups and downs over a long period, and
the risks of trying outweigh the rewards," Harvard Business Review,
July-August 1984, pp. 102-110. "... no one can
predict the market's ups and downs over a long period, and the risks of trying
outweigh the rewards." "... only a few wrong [market timing]
decisions ... deflate the long-term results produced by market timers to the
point where the timers would be just as well off out of the stock market
entirely." Also, see the update/summary by Rothery
below. |
| Kirt C. Butler, Dale L. Domian, and Richard R.
Simonds, "International Portfolio Diversification and the Magnitude of the
Market Timer's Penalty," Journal of International Financial Management and
Accounting, 6(3) 1995. This excellent study looks at the
magnitude of the "market timer's penalty." Basically, the market timer
of this study desires to move assets from one country's stock market to
another, presumedly in order to increase risk-adjusted returns. This
study compares a random timer (i.e., a market timer known to have no timing
skill) with a buy-and-hold investor. It finds that the timer's portfolio
is 26.2 percent more risky with the same expected return as that of the buy
and hold investor. Equivalently,
at the same level of risk, the unskilled market timer gives up 20.8% of the
buy-and-hold investor's expected return over the risk-free rate. The
study correctly notes that the potential benefits of market timing are
greatest when correlation between assets is lowest. But this is also
precisely the time when the "market timer's penalty" is the greatest. A
market timer without skill should clearly get out of the market timing business. |
| Jess H. Chua, Richard S. Woodward, and Eric C. To,
"Potential Gains from Stock Market Timing in Canada," Financial Analysts
Journal, September/October 1987, pp. 50-56. This interesting
paper finds that it is more important to correctly predict bull markets than
bear markets. And buy-and-hold investors effectively have a 100%
accuracy in correctly forecasting bull markets. "If the investor has
only a 50% chance of correctly forecasting bull markets, then he should not
practice market timing at all. His average return will be less than a
buy-and-hold strategy even if he can forecast bear markets perfectly [which is an extremely heroic assumption]."
|
| William G. Droms, "Market Timing as an Investment
Policy," Financial Analysts Journal, January/February 1989, pp. 73-77.
"Gains from market timing over the long run require forecast accuracies that
are likely to be beyond the reach of most managers. More frequent
forecasting increases the potential return available and reduces the level of
accuracy required to outperform the market, but the transaction costs incurred
in more frequent switching reduce the advantage." Note that the study
ignored the largest transaction cost for taxable accounts: short-term capital
gains taxes. If taken into consideration, this would have dramatically
lessened the attractiveness of market timing as a strategy even more.
Note also that prediction becomes much harder as the time period of the
predictions becomes shorter. |
| John R. Graham and Campbell R. Harvey, "Market
timing ability and volatility implied in investment newsletters' market timing
recommendations," Journal of Financial Economics, December 1996, pp.
397-421 (2.2mb). This excellent paper examines whether investing
newsletters exhibit market timing ability. "We find no evidence that
letters systematically increase equity weights before market rises or decrease
weights before market declines." |
| Roy D. Henriksson, "Market Timing and Mutual Fund
Performance: An Empirical Investigation," Journal of Business, January
1984, pp. 73-96 (4.55mb). This paper investigated whether mutual funds
exhibited market timing ability. "The empirical results ... do not
support the hypothesis that mutual fund managers are able to follow an
investment strategy that successfully times the return on the market
portfolio." |
| Burton G. Malkiel, "Models
of Stock Market Predictability," Journal of Financial Research,
Winter 2004, pp. 445-459 (159kb). This study finds that, while
there appears to exist some reversion to the mean behavior, "... there is
no evidence of any systematic inefficiency that would enable investors to earn
excess returns." In other words, market timing models aren't likely
to be fruitful. |
| Mario Levis and
Manolis Liodakis, "The
Profitability of Style Rotation Strategies in the United Kingdom,"
Journal of Portfolio Management, Fall 1999, pp. 73-86 (131kb).
This paper looks at the feasibility of market timing between growth and value
stocks, and between large and small stocks, in the United Kingdom (i.e., if
you wanted to tactically switch between growth and value, or between large and
small, how accurate would your forecasting need to be in order to beat a buy
and hold strategy?). "Our simulation results suggest that forecasting
the size spread with a 65%-70% accuracy rate may be sufficient to outperform a
long-term small-cap strategy. Beating a long-term value strategy, however, is
markedly more difficult; it requires more than 80% forecasting accuracy." |
| Stephen L.
Nesbitt, "Buy High, Sell Low: Timing Errors in Mutual Fund Allocations,"
Journal of Portfolio Management, Fall 1995, pp. 57-60.
"Our finding is that market-timing activity by mutual fund investors costs
over 1% per year in return performance versus what mutual funds actually
report their performance to be." |
| Austin Pryor, "Timing
isn't as Significant as You Might Expect," Sound Mind Investing,
July 2003. An excellent article pointing out
that even perfect timing doesn't do much better than essentially random timing
(actually, it compares a perfect timing of deposits routine with a dollar cost
averaging routine). |
| S P Umamaheswar
Rao, "Market Timing and Mutual Fund Performance," American Business Review,
June 2000, pp. 75-79. "The empirical results
do not support the hypothesis that mutual fund managers are able to follow an
investment strategy that successfully times the return on the market
portfolio." Note that if highly paid, highly educated, highly
experienced mutual fund managers can't successfully time the market with the
assistance of large support staffs of brilliant analysts, it seems imprudent
to think that any particular layperson can expect do so. |
| Norman Rothery, "Timing
Disaster," Stingy Investor. An update to
(and summary of) the Jeffrey article above. |
| Robert Sheard, "Market-Timing
Futility," Motley Fool, July 1 1998.
This article supports disciplined periodic investment. It suggests that,
since the long-term return difference between making periodic investments with
perfect timing and with perfectly imperfect timing is small, the important
thing is to be making the periodic investments, not to try to time the
markets. "...for a genuine long-term investor/saver ... it makes
precious little difference when you invest." |
| John D.
Stowe, "A Market Timing Myth," Journal of Investing, Winter 2000, pp.
55-59. This paper points out that the often cited reason for
avoiding market timing isn't a valid reason. Many articles suggest that,
because the majority of the stock market's gains are confined to a small
number of days or weeks or months, imperfect market timing is likely to
result in missing those runups, with catastrophic results. This article
argues that the same rationale might suggest that the market timer is just as
likely to miss the few worst days, weeks or months, which would tend to
increase returns. Both results would likely be due to luck. Market
timing still seems imprudent, but this isn't the reason why. |
| Jack L. Treynor
and Kay K. Mazuy, "Can Mutual Funds Outguess the Market?," Harvard Business
Review, July-August 1966, pp. 131-136.
"Are mutual fund managers successfully anticipating major turns in the stock
market? ... [the study] shows no statistical evidence that the
investment managers of the 57 funds have successfully outguessed the market." |
| "Market
Timing," QuickMBA. This excellent article
summarizes the Sharpe paper above. |
Modern Portfolio Theory refers to the idea that each investment ought to be selected in consideration of how it will interact with other assets in one's portfolio. Modern Portfolio Theory is the basis for Mean Variance Optimization.
You should also read about Modern Portfolio Theory Using Downside Risk, which is a definite improvement on traditional MPT. Also, see the sections on Asset Allocation and Diversification.
| Harry Markowitz, "Portfolio
Selection," Journal of Finance, March 1952 Vol 7, pp. 77-91
(603kb). Also here. This paper laid the groundwork for Modern Portfolio Theory,
which earned Dr. Markowitz a Nobel Prize. The paper suggests that,
instead of asking the question, "What is a good investment?", you ought to be
asking, "What is a good investment for my portfolio?" It turns
out that the answer is heavily dependent on what else happens to be in your
portfolio. All else being equal, it is more beneficial (from the
standpoint of maximizing your risk-adjusted return) to take on an
investment which is likely to have low correlations with other elements of
your portfolio than to take on an investment which is likely to have high
correlations with other elements of your portfolio. Thus, investment
selection should involve getting maximum diversification benefit (with respect
to the rest of the portfolio) from each
investment. |
|
James S.
Ang, Jess H. Chua, and Anand S. Desai, "Efficient Portfolios versus
Efficient Market," Journal of Financial Research, Fall 1980, pp.
309-319. This paper tested whether constructing "efficient
frontier" portfolios based on past information resulted in superior
performance. The conclusion was that it did not, thus confirming the
weak form of the Efficient Market Hypothesis (note the two different uses of
the word "efficient"). This also proves the imprudence of blindly
using a Mean Variance Optimizer (using historical data as inputs) to construct a portfolio
based on past data. |
| William J. Bernstein, "The
Appropriate Use of the Mean Variance Optimizer," Efficient Frontier,
January 1998. An excellent discussion of how this tool can be
used and (as is more usual) misused. "Can you use an MVO to help you
shape your portfolio? Yes, but you've got to be very careful. An MVO is like a
chainsaw. Used appropriately, it is a powerful tool for clearing your
backyard. Used inappropriately it will send your local surgeon's kids to
college. Same thing with MVOs. Want to wind up in the financial version of
intensive care? Just throw in some historical (or even plausible) returns and
believe what comes out the other end." "So, what use is the thing? Well,
first and foremost an MVO is a superb teaching tool. Play around with one for
a few hours and you will begin to acquire a grasp of the rather
counterintuitive way in which real portfolios behave." "... you have to
realize that the chances of your allocation, no matter how skillfully chosen,
winding up exactly on the future efficient frontier are zero." |
| David G. Booth and Eugene F. Fama, "Diversification
Returns and Asset Contributions," Financial Analysts Journal, May/June
1992, pp. 26-32. This paper provides a means for estimating the
compound return contribution of a particular asset to a portfolio containing
it. Basically, it suggests subtracting one half of the asset's
covariance (with the portfolio) from the asset's arithmetic mean return.
The resulting compound return contribution can then be weighted with those of
other assets in the portfolio to obtain the portfolio's compound return.
This takes into account the asset's diversification benefit to the portfolio. |
| Gregory Curtis, "Modern
Portfolio Theory and Quantum Mechanics," Journal of Wealth Management,
Fall 2002, pp. 7-13 (536kb). An interesting discussion of the
limits of MPT. |
| Frank J. Fabozzi, Francis Gupta, and Harry M.
Markowitz, "The
Legacy of Modern Portfolio Theory," Journal of Investing, Fall
2002, pp. 7-20. A good discussion of the impact of MPT. |
| Paula H. Hogan, "Portfolio
Theory Creates New Investment Opportunities," Journal of Financial
Planning, January 1994, pp. 35-37. A very basic summary of
MPT. |
| Malcolm Mitchell, "Is
MPT the Solution — or the Problem?," Investment
Policy, July 2002. A bit long,
but this paper is a very readable critique of Modern Portfolio Theory. |
| John Rekenthaler, "Strategic
Asset Allocation: Make Love, Not War," Journal of Financial Planning,
September 1999, pp. 32-34. Also
here. This article criticizes blindly
following Mean Variance Optimizer (MVO) outputs during strategic asset
allocation decision-making. We agree with the criticism. MVO is an
interesting tool, but the results are extremely sensitive to the inputs.
The inputs are either guesses about the future or facts about the past.
Either way, we know that the data inputs are extremely imperfect predictors of
the future, which causes decision-making based on them to be significantly
less optimal than may appear to be the case. Dr Eugene Fama on
optimizers: "They're junk. You're wasting your time with an optimizer,
but if you have a lot of time to waste, go ahead." |
This refers to an improvement on Modern Portfolio Theory. MPT suggests using volatility as the measure of an investment's risk. The problem is that this suggests that abnormally high returns are as much "risk" as abnormally low returns. Most investors welcome high returns and are only sensitive to low returns. This inspires the idea of considering risk only to be related to abnormal low returns and ignoring abnormal high returns. The most useful such measure of risk would be to consider only abnormal returns below some customized "minimum acceptable return" to be "risk." This section contains papers which develop this idea.
While traditional MPT suggests optimizing a portfolio on two statistics -- return and volatility, this "Improved" Modern Portfolio Theory suggests optimizing a portfolio on return and some measure of downside risk. Also, see the sections on Asset Allocation, Diversification, Risk Measures, and especially, Modern Portfolio Theory.
| Vijay S. Bawa and Eric B. Lindenberg, "Capital
Market Equilibrium in a Mean-Lower Partial Moment Framework," Journal of
Financial Economics, November 1977, pp. 189-200. This paper
derived a version of the Capital Asset Pricing Model which
embraced Lower Partial Moment (a fancy term for downside risk) as the measure
of risk. This model is a more generalized version of the more
traditional CAPM. |
| W. Van Harlow, "Asset Allocation in a Downside-Risk
Framework," Financial Analysts Journal, September/October 1992, pp.
28-40. An outstanding article on use of downside risk measures
(e.g., downside variance or downside deviation). Downside risk turns out
to be a superior risk measure (i.e., better than standard deviation) in
circumstances where the return distribution is not symmetrical and/or a
"Minimal Acceptable Return" can be defined. |
| James C.T. Mao, "Survey of Capital Budgeting,"
Journal of Finance, May 1970, pp. 349-360. This paper is
among the earliest to point out the superiority of a downside risk measure to
the standard volatility measures of risk. This paper addresses the
question from the perspective of an executive and notes that the concept of
"risk" held by many financial decision makers is better described by downside
risk measures than by volatility. "Variance is the generally accepted
measure of investment risk in current capital budgeting theory. There are
theoretical reasons for preferring semivariance and the evidence is more
consistent with semi-variance than variance." |
| David N. Nawrocki, "Market
Theory and the use of Downside Risk Measures," Working Paper,
1996. A good discussion of the issues. |
| David N. Nawrocki, "The
Case for Relevancy of Downside Risk Measures," Working Paper,
1999. Also here.
Also
here.
"We need downside risk measures because they are a closer match to how
investors actually behave in investment situations." |
| David N. Nawrocki, "A
Brief History of Downside Risk Measures," Journal of Investing,
Fall 1999, pp. 9-25 (135kb). Also
Here.
Also
Here. A comprehensive discussion of
downside risk measures. Downside risk turns out to be a superior risk
measure (i.e., better than standard deviation) in circumstances where the
return distribution is not symmetrical and/or a "Minimal Acceptable Return"
can be defined. |
| Brian M. Rom, "Using
Downside Risk to Improve Performance Measurement," Presentation,
Investment Technologies. A good summary of issues surrounding use
of downside risk measures. |
| A.D. Roy, "Safety First and the Holding of Assets,"
Econometrica, July 1952, pp. 431-450. This may have been
the first paper to suggest the idea of a "minimal acceptable return" as part
of the measurement of risk-adjusted return. Roy suggested
maximizing the ratio "(m-d)/σ", where m is
expected gross return, d is some "disaster level" (a.k.a., minimum
acceptable return) and σ is standard deviation of returns. This
ratio is just the Sharpe Ratio, only using minimum acceptable return instead
of risk-free return in the numerator! |
| Tien Foo Sing and Seow Eng Ong, "Asset
Allocation in a Downside Risk Framework," Journal of Real Estate
Portfolio Management,
July-September 2000, pp. 213-223. A good discussion of the
issues. |
| Pete Swisher and Gregory W. Kasten, "Post-Modern
Portfolio Theory," Journal of Financial Planning, September 2005,
pp. 74-85. This outstanding article describes a clear improvement
on traditional portfolio theory (a.k.a., Modern Portfolio Theory). The
principle idea is changing the statistics being optimized. In
traditional portfolio theory, the idea is to get the highest return (or
perhaps highest return above a risk-free rate) for some given amount of
volatility. This paper suggests instead trying to get the highest return
(above some Minimal Acceptable Return) for some given amount of volatility,
with the volatility calculated as the deviations below that Minimum Acceptable
Return. |
| Susan Wheelock, "Risky Business," Plan Sponsor, September 1995. An excellent, very readable description of downside risk. All of the performance measures discussed in the Performance Evaluation section are risk-adjusted measures. The Sortino Ratio and the Upside Potential Ratio use downside risk as their risk measure. |
Momentum investing refers to buying stocks that have recently done well and selling stocks that have recently done poorly. While there is some evidence that this strategy can be successful in the short term before transaction fees are considered, transaction fees tend to "eat up" most, if not all, of any potential profits. By transaction fees, you need to include brokerage commissions, bid-ask spreads, and market-impact costs. We do not recommend this as a strategy.
| Narasimhan Jegadeesh and Sheridan Titman, "Returns
to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,"
Journal of Finance, March 1993, pp. 65-91 (2.8mb). This paper
documented a short term (3 to 12 month) momentum effect for stocks. The
paper suggests that it may make sense to buy recent winning stocks and sell
recent losing stocks. Unfortunately, the paper doesn't investigate the
costs associated with implementing such a strategy. For the bad news on
momentum investing, see the Keim and Lesmond/Schill/Zhou papers below. |
| Louis K.C. Chan, Narasimhan Jegadeesh, and Josef Lakonishok, "The Profitability of Momentum Strategies," Financial Analysts
Journal, Nov/Dec 1999, pp. 80-90. This paper concludes that,
if transaction costs are ignored, momentum strategies were profitable over a 6
to 12 month horizon. But it goes on to add, "Chasing momentum can
generate high turnover, so much of the potential profit from momentum
strategies may be dissipated by transaction costs." The latter statement
was confirmed in a quantitative fashion by the Keim and Lesmond/Schill/Zhou papers below. |
| Gene Fama, Jr., "The
Big Mo,"
Financial Planning, May 2008, pp. 127-130. The pragmatic
article looks at a practical way that a mutual fund can make momentum work for
it, while avoiding the negative effects. This describes the rationale
behind DFA's momentum screens. |
| Donald B. Keim, "The Cost of Trend Chasing and the
Illusion of Momentum Profits," Wharton School working paper, July 29 2003
(1.21mb).
While some studies, such as Jegadeesh/Titman above, suggest that significant
abnormal returns can be gained by following short-term momentum strategies,
few have investigated the trading costs such strategies would require.
This paper studies the actual trading costs incurred by such trading and finds
that the costs exceed the (pre-cost) beneficial effect. In other words,
short-term momentum trading strategies may be successful before costs are
considered, but they aren't sufficiently superior to a more conventional
approach to justify their high transaction costs. |
| David A. Lesmond, Michael J. Schill, and Chunsheng
Zhou, "The
Illusory Nature of Momentum Profits," Journal of Financial Economics,
February 2004, pp. 349-380 (248kb).
Here's another copy. This paper confirms the results of the
Keim study above. It finds that the stocks which generate the largest
pre-cost momentum returns are the ones with the highest costs. "We
conclude that the magnitude of the abnormal returns associated with these
trading strategies creates an illusion of profit opportunity when, in fact,
none exists." |
| Lynn O'Shaughnessy, "The
Truth Behind Momentum Investing: The theory works, until you factor in trading
costs," Financial Advisor, March 2004, pp. 61-62. A
good layman's discussion of the above academic papers. |
Mortgage refinancing is largely an investing issue. Homeowners are always wondering whether they should refinance, whether they should take additional cash out of their homes, what term of mortgage should they get, what points should they pay, etc.
| Randall S. Billingsley and Don M. Chance, "Reevaluating
Mortgage Refinancing 'Rules of Thumb'," Journal of Financial Planning,
Spring 1986, pp. 37-45. A good discussion of the refinancing
question. |
| Rich Fortin, Stuart Michelson, Stanley D. Smith, and
William Weaver, "Mortgage
refinancing: the interaction of break even period, taxes, NPV, and IRR,"
Financial Services Journal, Volume 16 (2007), pp. 197-209.
This paper goes into great detail regards how a professional can do a
quantitative analysis in support of the refinancing question. |
| Delbert C. Goff and Don R. Cox, "15-Year
Versus 30-Year Mortgage: Which is the Better Option?," Journal of
Financial Planning, April 1998. This paper concentrates on
the 15-year or 30-year question. |
| Vance P. Lesseig and John G. Fulmer, Jr., "Including
a Decreased Loan Life in the Mortgage Decision," Journal of
Financial Planning, December 2003, pp. 66-71. This excellent
paper thoroughly discusses the tradeoffs between a 15-year and a 30-year
mortgage. It also discusses the issue of how much to pay in points. |
Fees should be one of the primary considerations when selecting a mutual fund. Much of investing requires dealing with uncertainties. Fees, however, are one of the few important factors that you have complete control over. It is almost always prudent to minimize fees, unless you have a compelling reason not to.
"Beware of small expenses; a small leak will sink a great ship." — Benjamin Franklin
| Antonio Apap and John M. Griffith, "The
Impact of Expenses on Equity Mutual Fund Performance," Journal of
Financial Planning, February 1998. "...
the results indicate that a significant inverse relationship exists between
expense ratios and both abnormal and total returns ..." |
| John C. Bogle, "What
Can Active Managers Learn from Index Funds?," Lecture delivered on
December 4 2000. |
| John M.R. Chalmers, Roger M. Edelen, and Gregory B.
Kadlec, "Fund
Returns and Trading Expenses: Evidence on the Value of Active Management,"
Working Paper, October 15 2001. "We find a strong negative
relation between fund returns and trading expenses. In fact, we cannot
reject the hypothesis that every dollar spend on trading expenses results in a
dollar reduction in fund value." "In this paper we reject the hypothesis
that active fund management enhances performance. We attribute our
strong results to our more direct measure of mutual fund trading expenses.
... we find a strong negative relation between fund returns and trading
expenses, while we find no relation between fund returns and turnover." |
| Stephen P. Ferris and Don M. Chance, "The Effect of
12b-1 Plans on Mutual Fund Expense Ratios: A Note," Journal of Finance,
September 1987, pp. 1077-1082. This paper notes that 12b-1 plan
fees definitely increase current expenses and therefore decrease current
returns. It remains to be seen if they subsequently tend to allow mutual
funds to realize economies of scale which then result in a net decrease in
fees. This paper is consistent with a strategy of avoiding funds that
have 12b-1 fees. |
|
Irving L. Gartenberg v.
Merrill Lynch Asset Management (694 F.2d 923 (2d Cir. 1982), cert denied ,
461 U.S. 906(1983). Would you like to sue your mutual fund
managers for charging you outrageous fees? This case established what
you need to do to be successful (or at least, to avoid having your case
dismissed): "To be guilty of a violation of § 36(b), therefore, the
adviser-manager must charge a fee that is so disproportionately large that it
bears no reasonable relationship to the services rendered and could not have
been the product of arm's-length bargaining." |
| Eric E. Haas, "Mutual
Fund Expense Ratios: How High is Too High?," Journal of Financial
Planning, September 2004, pp. 54-63 (135kb). This paper
quantitatively answers the question, "How high can a mutual fund's expense
ratio be before it detracts from, rather than adds to, the expected risk-adjusted
performance of a portfolio?" This question is central to building a
portfolio of mutual funds. If the expense ratio of a prospective
additional fund is too high, it will have a negative impact on your
portfolio's performance. This paper won the 2004 Journal of Financial
Planning Call for Papers Competition. |
| Eric E. Haas,
Comment to
the SEC on proposed elimination of mutual fund 12b-1 fees, May 23 2004. A
frank discussion of the principal issues surrounding the SEC's prospective elimination
of mutual fund 12b-1 fees. |
| Jason Karceski, Miles Livingston, and Edward S. O'Neal, "Portfolio
Transactions Costs at U.S. Equity Mutual Funds," Zero Alpha Group
Working Paper, November 15 2004 (68.2kb).
Here's an
article about this study. This paper
quantitatively investigates the extent of "implicit" expenses incurred by
mutual funds. These expenses, not reflected in a fund's expense ratio,
can be as high, or higher, than the "explicit" expense reflected by the
expense ratio. |
| Tom Lauricella, "This
is news? Fund fees are too high, study says," SFGate.com, August 27
2001. This article discusses a study which shows that mutual
funds charge their retail customers higher fees than they charge their
institutional customers for the same services. |
| Alan Lavine and Gail Liberman, "Fund
Managers are Good Stock Pickers but Expenses Kill Returns," Brill.com,
January 2003. |
| Miles Livingston and Edward S. O'Neal, "Mutual Fund
Brokerage Commissions," Journal of Financial Research, Summer 1996, pp.
273-292. "... investors can on average reduce exposure to high
commissions by concentrating on larger, low expense ratio mutual funds."
"... some mutual fund managers may be charging investors high management fees
even though investors finance much of the research services through soft
dollar commissions." This paper's conclusions reinforce the strategy of
buying passively managed mutual funds with low expense ratios. |
| John Markese, "How
Much Are You Really Paying For Your Mutual Funds?," AAII Journal,
February 1999. "Loads and expenses decrease your mutual fund
return dollar-for-dollar. Looking forward—the best direction in which to look
to make judgments—loads and expenses are predictable; returns are not. Loads
are sales commissions paid to sales personnel and have only a negative impact
on fund performance. Fund expenses that are significantly higher than the
average for a category are difficult for fund managers to overcome." |
| Robert W. McLeod and D.K. Malhotra, "A
Re-Examination of the Effect of 12b-1 plans on Mutual Fund Expense Ratios,"
Journal of Financial Research, Summer 1994, pp. 231-240. "Our
study confirms ... that 12b-1 charges are a deadweight cost to shareholders."
"... the introduction of 12b-1 plans has not resulted in the benefits
suggested by proponents ..." The conclusions of this paper are
consistent with a strategy of avoiding mutual funds with 12b-1 fees. |
| Ross M. Miller, "Measuring
the True Cost of Active Management by Mutual Funds," SUNY Albany,
June 2005 (92.4kb). This
interesting paper derives a method for allocating fund expenses between active
and passive management and constructs a simple formula for finding the cost of
active management. Computing this “active expense ratio” requires only a
fund’s published expense ratio, its R-squared relative to a benchmark index,
and the expense ratio for a competitive fund that tracks that index. At the
end of 2004, the mean active expense ratio for the large-cap equity mutual
funds tracked by Morningstar was 7%, over six times their published expense
ratio of 1.15%. More broadly, funds in the Morningstar universe had a
mean active expense ratio of 5.2%, while the largest funds averaged a percent
or two less. |
| Matthew R. Morey, "Should
You Carry the Load? A Comprehensive Analysis of Load and No-Load Mutual
Fund Out-of-Sample Performance," Pace University, 2001. This
paper debunks the myth that loaded mutual funds outperform no-load funds.
It concludes that, even before loads are figured in, no-load funds tend to
outperform loaded funds. |
| Spuma M. Rao, "Does
12b-1 Plan Offer Economic Value to Shareholders of Mutual Funds?,"
Journal of Financial and Strategic Decisions, Fall 1996, pp. 33-37.
This paper examined the effect of 12b-1 fees on mutual fund performance.
"Results suggest that the existence of 12b-1 plans ... did not offer economic
value to shareholders." |
| S P Umamaheswar Rao, "Economic Impact of
Distribution Fees on Mutual Funds," American Business Review, January
2001, pp. 1-5. "The main conclusion is that the 12b-1 plan did
not offer economic value to shareholders." |
| John D. Rea, Brian K. Reid, and Travis Lee, "Mutual
Fund Costs, 1980-1998," Investment Company Institute Perspective,
September 1999, pp. 1-12 (452kb). Note that the ICI's studies
tend to be flawed in that they rely on sales-weighted costs of funds in their
analyses of fund costs. Their conclusion that fund costs are decreasing
isn't valid based on that information — their conclusion should be that
consumers' sensitivity to costs is increasing, but costs are also increasing
(which the ICI studies tend not to measure). |
| Paul F. Roye, Director of US Securities and Exchange
Commission Division of Investment Management,
Memorandum on Mutual Fund Fees, June 9 2003 (1.25mb). This
memo expounds on the SEC's position on various issues related to Mutual Fund
Fees. It was generated in response to
this letter. |
| Stephen Schurr, "False
Advertising: The Truth about 12b-1 Fees," TheStreet.com, August 13
2003. A great article about 12b-1 fees. |
| Stefan Sharkansky, "Mutual
Fund Costs: Risk Without Reward," PersonalFund.com, July 2002
(189kb). "... what, if anything, can an investor do to improve
the odds of selecting a winning fund, and to reduce the odds of getting stuck
with a losing fund? The answer is surprisingly simple: invest only in
low-cost funds and avoid high-cost funds." |
| Nicolaj Siggelkow, "Expense
Shifting: An Empirical Study of Agency Costs in the Mutual Fund Industry,"
Wharton School, January 1999 (208kb). This paper exposes 12b-1 fees as a
significant detriment to mutual fund performance (i.e., the paper supports a
strategy of avoiding mutual funds that charge 12b-1 fees). |
| Nicolaj Siggelkow, "Caught
between two principals,"
Wharton School, May 2004 (137kb).
Here's the link
to the actual paper. This paper finds that mutual funds tend,
through their actions, to favor the interests of the fund company over the
interests of fund shareholders. |
| Dawn Smith, "A
Baby Step on Fund Fees," SmartMoney.com, January 10 2001.
A summary of the SEC report below. |
| Lori Walsh, "The Costs and Benefits to Fund
Shareholders of 12b-1 Plans: An Examination of Fund Flows, Expenses, and
Returns," U.S. Securities and Exchange Commission, April 26 2004
(785kb).
"The paper finds that while funds with 12b-1 plans do, in fact, grow
faster than funds without them, shareholders are not obtaining benefits in the
form of lower average expenses or lower flow volatility." "These
results highlight the significance of the conflict of interest that 12b-1
plans create. Fund advisers use shareholder money to pay for asset growth from
which the adviser is the primary beneficiary through the collection of higher
fees." |
| Neil Weinberg and Emily Lambert, "The
Great Fund Failure," Forbes.com, September 15 2003. An
outstanding discussion of issues surrounding excessive mutual fund fees. |
| Greg Wolper, "Girl
Scout Cookies, the Mutual Fund Way," Morningstar.com, January 27 2004.
A great tongue-in-cheek article about how girl scout cookie sales might work
if they were sold like mutual funds. You may have to register (for free)
to read this article. |
| "Division
of Investment Management: Report on Mutual Fund Fees and Expenses," U.S.
Securities and Exchange Commission, December 2000. A
comprehensive study of trends in mutual fund fees and expenses. |
| "Mutual
Fund Fees: Additional Disclosure Could Encourage Price Competition,"
United States General Accounting Office, June 2000 (9.3mb). This
report recommends that the SEC require mutual funds to disclose the
approximate dollar amount that each individual implicitly pays in fees on
periodic statements. |
| "Mutual
Fund Fees and Expenses", Investment Company Institute. Links
to several studies on this topic. Note that the ICI's studies tend to be
flawed in that they rely on sales-weighted costs of funds in their analyses of
fund costs. Their conclusion that fund costs are decreasing isn't valid
based on that information — their conclusion should be that consumers'
sensitivity to costs is increasing, but costs are also increasing (which the ICI studies tend not to measure). |
| "Mutual
Fund Fees and Expenses," U.S. Securities and Exchange Commission, October
19 2000. A brief tutorial on the major types of fees associated
with mutual funds. |
| "Funds
With Low Expense Ratios Outperforming Their More Expensive Peers Over Long
Term, Says S&P," Standard & Poor's, June 11 2003. An
excellent short press release which makes the case for minimizing a mutual
fund's expense ratio, all else being the same. Interestingly, you'll
note from studying the data that the difference in expense ratios has a strong
correlation with the difference in returns (implying that, for every dollar of
additional expenses paid, you lose a dollar in returns). |
Mutual Fund Persistence refers to the question of whether past performance of a mutual fund has any positive correlation with future performance. The lack of persistence in mutual funds (and pension funds, etc.) is a large part of the empirical argument for passive management.
The root of this issue is whether it is possible for ANY actively-managed mutual fund to consistently achieve superior risk-adjusted returns. This is an important question. If the answer is no, then it implies that actively managed funds should be avoided (because they tend to be more expensive). If the answer is yes, then it inspires a separate, but equally important, question of whether it is possible to identify the few funds which will consistently outperform in advance. We believe that, while it is possible for an actively managed fund to occasionally achieve superior returns through good luck, it is impossible to identify those lucky mutual fund managers in advance. The majority of well-done studies tend to support a lack of persistence for all but the worst performing equity mutual funds.
| Mark M. Carhart, "On Persistence in Mutual Fund Performance,"
Journal of Finance, March 1997, pp. 57-82 (3.1mb). Also
here. This may be the best and
most authoritative study of persistence. The study concludes that there
is virtually no persistence, except for the worst performing mutual funds
(which is explainable either by their having high fees, poor
strategies, and/or tax-loss harvesting by investors). | ||||||
| William J. Bernstein, "Sucker's
Bet: Overwhelming empirical evidence shows that attempting to select
successful active managers is virtually impossible, so why try?,"
Financial Planning, April 1 2001. | ||||||
| Stephen J. Brown and William N. Goetzmann,
"Performance Persistence," Journal of Finance, June 1995, pp. 679-698
(2.1mb).
This paper concludes that some persistence does seem to exist among mutual
funds, but it is
mostly due to poor performers (i.e., poor performance persists, but good
performance doesn't). This paper's conclusions confirm the prudence of a
passive strategy of investing in low cost index mutual funds. | ||||||
| Keith C. Brown and W. Van Harlow, "Staying
the Course: Mutual Fund Investment Style Consistency and Performance
Persistence," University of Texas Working Paper, April 2 2004 (408kb).
This paper tests and finds support for each of the following hypotheses:
| ||||||
| James L. Davis, "Mutual Fund Performance and Manager
Style," Financial Analysts Journal, January/February 2001, pp. 19-27.
"The results of this study are not good news for investors
who purchase actively managed mutual funds." | ||||||
| F. Larry Detzel and Robert A. Weigand, "Explaining Persistence in Mutual Fund Performance," Financial Services Review, 1998 Vol 7 issue 1, pp. 45-55 (990kb). This paper found that there was virtually no persistence that could not be explained by market risk, expense ratios, market |
