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"The mark of a well educated person is not necessarily in knowing all the answers, but in knowing where to find them."

           —— Douglas Everett.

Here you will find relatively brief articles and papers, each of which focuses on a fairly narrow topic.  For more broad coverage of investing issues, see our Reading Room for Books.

We've listed herein a mix of good articles from the popular press (intended for lay people) and highly technical academic papers.  Hopefully, these materials will elucidate more than they confuse.  We've included links for the vast majority of the entries.  Note that some of the papers are quite lengthy and may take a fair amount of time to download.

Unfortunately, some papers aren't freely available on the Internet at this time (to the best of our knowledge).  You may be able to find them at large public libraries.  You almost certainly will be able to locate them at most business school libraries.  For those papers which aren't freely available online, we've tried to include brief summaries.

Articles written in a fashion such that laypeople can probably understand them are colored blue — most people should be able to comprehend them.  Technical articles and papers intended for professionals/academics are colored red.

If you have questions or comments about any of the materials referenced here, contact us — we love talking about this stuff!

bulletAsset Allocation
bulletBid-Ask Spreads
bulletBonds
bulletBroker/Dealers
bulletCapital Asset Pricing Model (CAPM)
bulletCharitable Giving
bulletClosed-End Funds
bulletCollege Planning
bulletCommodity Futures
bulletCurrency Hedging
bulletData Mining
bulletDefined Benefit Pension Plans
bulletDefined Contribution Pension Plans
bulletDimensional Fund Advisors (DFA)
bulletDiversification
bullet Diversification of Concentrated Positions
bulletDividends
bulletDollar Cost Averaging
bulletEfficient Market Hypothesis
bulletEmerging Markets
bulletEndowment Fund Management
bulletEquity Premium
bulletEstate Planning
bulletExchange Traded Funds
bulletFama/French Three-Factor Model
bulletForeign Investing
bulletHedge Funds
bulletHigh-Yield Bonds (Junk Bonds)
bulletIlliquidity Premium
bulletIndex Weighting
bulletInflation-Indexed Bonds (TIPS and I-Bonds)
bulletInvestor Psychology/Behavioral Finance
bulletLife Insurance
bulletLong Term Care Insurance
bulletMarket Timing
bulletModern Portfolio Theory
bulletModern Portfolio Theory using Downside Risk
bulletMomentum Investing
bulletMortgage Refinancing
bulletMutual Fund Fees
bulletMutual Fund Persistence
bulletPassive vs. Active Management
bulletPension Fund Management
bulletPerformance Evaluation
bulletPerformance Measurement
bulletPrivate Equity
bulletPrudent Investor Rule
bulletReal Estate Investment Trusts (REITs)
bulletRebalancing
bulletRetirement Investing
bulletReversion to the Mean
bulletRisk Measures
bulletSocial Security Retirement Benefits
bulletSurvivorship Bias
bulletSynthetic/Enhanced Indexing
bulletTax Loss Harvesting
bulletTax Managed Investing
bulletVariable Annuities
bulletMiscellaneous Other

Asset Allocation

Asset allocation refers to the division of one's investment portfolio across the various asset classes.  At the highest level, this refers to a split between stocks and bonds.  Many more finely defined sub-asset allocations are also common.  Also, see Modern Portfolio Theory, Rebalancing and Tax-Managed Investing.

bulletGary P. Brinson, L. Randolph Hood, and Gilbert P. Beebower, "Determinants of Portfolio Performance," Financial Analysts Journal, July/August 1986, pp. 39-44.  This was the paper which revolutionized portfolio construction by emphasizing the importance of asset allocation.  It found that, on average, 93.6% of the total return variation of the pension funds studied over time was due solely to asset allocation.  Further, it found that active management resulted in an annual reduction of 1.1 percentage points in total returns.

bulletGary P. Brinson, Brian D. Singer, and Gilbert P. Beebower, "Determinants of Portfolio Performance II: An Update," Financial Analysts Journal, May/June 1991, pp. 40-48.  "Clearly, the contribution of active management [which was found to be somewhat negative] is not statistically different from zero."  An update of their previous work, with similar conclusions.

bulletJohn C. Bogle, "The Riddle of Performance Attribution: Who's in Charge Here — Asset Allocation or Cost?," a speech presented before the Financial Analysts Seminar Sponsored by the Association for Investment Management and Research At Northwestern University, Evanston, Illinois July 20, 1997.  Vanguard's founder concludes that, while asset allocation is very important, controlling costs is also very important.

bulletNatalie Chieffe, "Asset Allocation, Rebalancing, and Returns," Journal of Investing, Winter 1999, pp. 43-48.  "The results of this research show that market conditions tend not to provide reliable information on which to base the rebalancing decision [i.e., tactical asset allocation decisions].  Much of the advice presented to investors during periods of unusual market activity should be ignored.  It is more important to rebalance the retirement portfolio on the basis of a change in risk aversion, rather than on the conditions in the financial markets."  Basically, this paper supports the idea of strategic, not tactical, asset allocation.

bulletJohn H. Cochrane, "Portfolio Advice for a multifactor world," Economic Perspectives, XXIII (3) Third quarter 1999 (Federal Reserve Bank of Chicago), pp. 59-78 (296kb).  Pragmatic advice on asset allocation.

bulletWolfgang Drobetz and Friederike Köhler, "The Contribution of Asset Allocation Policy to Portfolio Performance,"  WWZ/Department of Finance Working Paper No 2/02 (115kb).  "... active management not only failed to add value above the policy benchmarks [but] it destroyed a significant portion of investors' value."  This paper concludes that asset allocation accounts for about 134 percent of the level of portfolio performance (implying that active management accounts for about minus 25%).

bulletEugene F. Fama and G. William Schwert, "Asset Returns and Inflation," Journal of Financial Economics, November 1978, pp. 115-146 (1.49mb).  For a smaller file version, see here (749kb).  This paper studies the relative efficacy of various asset classes as inflation hedges.  It finds that treasury bonds are a complete hedge against expected inflation.  It also finds that private residential real estate is a complete hedge against both expected and unexpected inflation.

bulletRoger C. Gibson, "A Timely Reminder: The recent market tumult offers a perfect opportunity to remember the advantages of a diversified, balanced portfolio," Financial Planning, October 2001.  An excerpt from Mr. Gibson's outstanding book, Asset Allocation: Balancing Financial Risk (McGraw-Hill, 2000).

bulletSherman Hannah and Peng Chen, "Subjective and Objective Risk Tolerance: Implications for Optimal Portfolios," Financial Counseling and Planning Journal, Vol 8 No 1 1997, pp. 17-26.  "For a typical investor under the age of 50, a retirement savings portfolio should be 100% in stocks."  This paper attempts to make suggestions primarily based on need and ability to bear risk ("objective risk"), but not very much on willingness to bear risk ("subjective risk").  In general, we do not agree with the 100% stock asset allocation recommendation except in cases where there is a very high willingness and ability to tolerate risk.

bulletSteven Horan, "After-Tax Valuation of Tax-Sheltered Assets," Financial Services Review, 11 2002, pp. 253-275.  This study builds on Reichenstein and Sibley papers below.

bulletJeffrey T. Hoernemann, Dean A. Junkans, and Carmen M. Zarate, "Strategic Asset Allocation and Other Determinants of Portfolio Returns," Journal of Wealth Management, Winter 2005, pp. 26-38.  This study reviews and revises the Brinson studies above.  This study concludes that strategic asset allocation only explains about 77.5% of the variability of portfolio returns, not 90+% as suggested by Brinson et. al.

bulletKwok Ho, Moshe Arye Milevsky, and Chris Robinson, "Asset Allocation, Life Expectancy, and Shortfall," Financial Services Review, 3(2) 1994, pp. 109-126.  Also here.  This study suggests that, in order to minimize shortfall risk, it may be appropriate for investors to maintain 100% stock allocations well into their retirements (i.e., as late as age 75 for men and 80 for women).  In general, we do not agree that most retirees should use such a high stock allocation unless they have a very high willingness and ability to tolerate risk.

bulletRoger G. Ibbotson and Paul D. Kaplan, "Does Asset Allocation Policy Explain 40, 90, or 100% of Performance?," Ibbotson Associates (97kb).  Also here.  The full article appeared in Financial Analysts Journal, January/February 2000 (244kb).  An analysis of criticisms of the two "Determinants of Portfolio Performance" papers.

bulletScott L. Lummer and Mark W. Riepe, "The Role of Asset Allocation in Portfolio Management," Ibbotson Associates (40kb).  Also here.  This paper also appeared in Global Asset Allocation: Techniques for Optimizing Portfolio Management (John Wiley & Sons, 1994).

bulletDavid Nawrocki, "The Problems with Monte Carlo Simulation," Journal of Financial Planning, November 2001, pp. 92-106.  Also here.  This excellent article puts Monte Carlo simulations into perspective.  Consumers are increasingly being led to believe that use of a Monte Carlo simulator accurately projects the probability of meeting their financial goals.  The article correctly exposes this fraud.  We believe that Monte Carlo simulators may be useful in educating clients about the nature of risk and return tradeoffs, but they certainly shouldn't be counted on to determine one's asset allocation.  The principal problem with them is that the entire analysis depends solely on the validity of the data inputs as predictors of the future.  Unfortunately, there is only one thing we know for certain about those inputs, whatever they might be: they are wrong.  We don't know how wrong they are or whether they overstate or understate the future, but we are 100% certain that they are wrong.  Good bibliography at the end and good sidebar by John Kingston.

bulletJohn Nuttall, "The Importance of Asset Allocation."  A harsh, but very valid, critique of the "Determinants of Portfolio Performance" papers.

bulletAndré F. Perold and William F. Sharpe, "Dynamic Strategies for Asset Allocation," Financial Analysts Journal, January/February 1988, pp. 16-27.  This paper studies three dynamic asset allocation strategies: Buy-and-hold, portfolio insurance (both constant proportion and options-based), and constant-mix.  The paper concludes that each might be most appropriate in certain market conditions or for certain clients.  We believe that the constant-mix strategy is most appropriate for most individual investors in that it controls the amount of risk in the portfolio.  Controlling risk not only controls expected return, but it tends to preclude investors from allowing well-documented psychological phenomena to influence them to do things which are adverse to their financial well-being.

bulletWilliam Reichenstein, "Calculating Asset Allocation," Journal of Wealth Management, Fall 2000 (54kb).  A similar article, "Rethinking the Family's Asset Allocation," appeared in Journal of Financial Planning, May 2001, pp. 102-109.  Another similar paper, "Asset Allocation and Asset Location Decisions Revisited," appeared in the Journal of Wealth Management, Summer 2001.  Yet another similar paper, "Calculating the family's asset mix," appeared in the Financial Services Review, Volume 7 Number 3 1998 (1.49mb). This paper suggests that asset allocation should be calculated on the basis of post-tax values of your portfolio.  For example, $100,000 in a Roth IRA is worth much more than $100,000 in a 401(k) due to eventual tax effects.

bulletWilliam Reichenstein, "10 Lessons You Should Learn from Recent Market History," AAII Journal, February 2003.  Here are the ten lessons referred to in the title:
bulletMixing bonds and stocks moderates portfolio risk;
bulletPortfolio risk rises disproportionately slowly as stocks are added to the portfolio;
bulletAn all-bonds portfolio is not the lowest-risk portfolio;
bulletPortfolio returns rise disproportionately quickly as stocks are added to the portfolio;
bulletAn often-overlooked risk for the long-run investor is the risk of having a too-conservative portfolio;
bulletBy rebalancing once a year, you maintain a stable risk exposure;
bulletA balanced portfolio avoids market timing;
bulletDue to rebalancing, if an asset class becomes overvalued, you will be selling it as it rises; and, if an asset class becomes undervalued, you will be buying it as it falls;
bulletRebalancing provides a discipline that helps investors overcome inertia;
bulletA fixed-weight strategy takes little time and it can save time at tax time.

bulletL. Jacobo Rodriguez, "Core Equity: An Integrated Portfolio Solution," Institute for Fiduciary Education, 2005.  This paper describes a somewhat novel approach to designing a portfolio.  Rather than developing your asset allocation and then implementing it with several highly specialized funds, you would instead build all (or most) of the allocation preferences into a single fund.  DFA has done this with their "Core Equity" funds, of which they have five.  The idea is that you'd combine one or more of those funds together, with other Core Equity funds or other funds, to get the overall portfolio factor exposure that you desire.

bulletPaul A. Samuelson, "The Long-Term Case for Equities: and how it can be oversold," Journal of Portfolio Management, Fall 1994, pp. 15-24.  This paper, written by a Nobel prize winner, warns against market timing, warns against active management, and generally supports the prudence of strategic asset allocation.

bulletPaul A. Samuelson, "Asset allocation could be dangerous to your health: Pitfalls in across-time diversification," Journal of Portfolio Management, Spring 1990, pp. 5-8.  This paper, written by a Nobel prize winner, warns against tactical asset allocation (and is consistent with the prudence of strategic asset allocation).

bulletMike Sibley, "On the Valuation of Tax-Advantaged Retirement Accounts," Financial Services Review, 11 (2002), pp. 233-251 (726kb).  An excellent discussion of how to get an after-tax valuation for a retirement account.  Due to the assumption made that the taxable equivalent investment is perfectly tax inefficient, the equations' applicability is limited only to valuing bond investments.

bulletSteve Strongin and Melanie Petsch, "Protecting A Portfolio Against Inflation Risk," Investment Policy, July/August 1997, pp. 63-82 (439kb).  An excellent discussion of how to hedge against various types of inflation risk.  It suggests that international diversification, inflation-indexed bonds, and commodities are the best hedges against inflation.

bulletRonald J. Surz, Dale Stevens, and Mark Wimer, , "The Importance of Investment Policy," Journal of Investing, Winter 1999, pp. 80-85.  "We find that, on average, policy [a.k.a., asset allocation] explains approximately 100% of investment returns. If a manager succeeds in adding value, this can drop to as low as 85% when risk is not incorporated, and even to 75% on a risk-adjusted basis. If the manager fails to add value, policy can explain as much as 135% of return unadjusted for risk, or 165% risk-adjusted; the difference between these percentages and 100% is explained by manager value reduced through market timing, selection, and/or costs.  In other words, if a manager neither adds nor reduces value, policy explains 100% of performance."

bulletRonald J. Surz, Dale Stevens, and Mark Wimer, "The Importance of Investment Policy: A Simple Answer to A Contentious Question," PPCA.  "We find that, on average, policy [a.k.a., asset allocation] explains approximately 100% of investment returns. If a manager succeeds in adding value, this can decrease to as low as 85% when risk is not incorporated, and even further to 75% on a risk-adjusted basis. On the other hand, if the manager fails to add value, policy can explain as much as 135% of return unadjusted for risk, or 165% risk-adjusted ..."

bulletRonald J. Surz, Dale Stevens, and Mark Wimer, "Investment Policy Explains All," Journal of Performance Measurement, Summer 1999, pp. 43-47 (22kb)  This paper also appeared in Journal of Investing, Winter 1999, pp. 80-86.  Another critique of the two Determinants of Portfolio Performance papers.

bulletYesim Tokat, "The Asset Allocation Debate: Provocative Questions, Enduring Realities," Investment Research and Counseling /ANALYSIS, April 2005.  A summary of the issues.  "Unless there is a strong belief in the ability to select active managers who will deliver higher risk-adjusted net returns, investors’ focus should be on the asset allocation choice and its implementation using broadly diversified, low-cost portfolios with limited market-timing."

bulletYesim Tokat, Nelson Wicas, and Francis M. Kinniry, "The Asset Allocation Debate: A Review and Reconciliation," Journal of Financial Planning, October 2006, pp. 52-63.  A summary of the issues.  "Unless there is a strong belief in the ability to select active managers who will deliver higher risk-adjusted net returns, investors’ focus should be on the asset allocation choice and its implementation using broadly diversified, low-cost portfolios with limited market-timing."

bulletR. Douglas Van Eaton and James A. Conover, “Equity Allocations and the Investment Horizon: A Total Portfolio Approach,” Financial Services Review, 11(2) Summer 2002, pp. 117-133 (1.65mb).  Also here.  This article provides support for the idea that an investor's equity exposure should be somewhat proportional to their time horizon (actually it should be somewhat proportional to the ratio of existing assets to future savings).

Bid-Ask Spreads

All securities bought or sold on exchanges have a bid-ask spread.  This is the difference between the security's selling price and its buying price.  The difference covers the costs and profits of the market maker.  Whenever you buy or sell a security on an exchange, you implicitly incur one-half of the bid-ask spread as a transaction cost.  Also, see Illiquidity Premium.

bulletKidwell, Blackwell, Peterson, and Whidbee, "Financial Institutions, Markets, and Money," John Wiley & Sons.  This slide presentation summarizes Chapter 10 of the referenced book.  The highlight as it applies to this topic:  In general, bid-ask spreads:

bulletare proportionately higher for low-priced stocks due to fixed costs of operations.
bulletare higher for trades of a few shares.
bulletare higher for a large block trade; a liquidity service is performed.
bulletare narrower with more frequent trading, where the costs of providing liquidity are less.
bulletare wider with traders with insider information, where the dealer may have to incur the cost of price discovery, or buying high, selling low!

bulletJinbaek Kim, "A Study on the Bid-Ask Spread," U.C. Berkeley Working Paper.  The appendices here are outstanding.  They summarize the important existing research on the bid-ask spread.

bulletRichard Roll, "A Simple Implicit Measure of the Bid-Ask Spread in an Efficient Market," Journal of Finance, September 1984, pp. 1127-1139(342kb).  This paper suggests a simple formula for the effective Bid-Ask spread in an efficient market.

bulletHans Stoll, "Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests," Journal of Finance, March 1989, pp. 115-134.  See here for a good discussion of this paper.  This paper finds that serial return covariances are strongly negatively correlated with the square of the bid-ask spread.  Further, the paper finds that the bid-ask spread can be broken down empirically into the following components:
 
bulletAdverse Information Costs: 43%.
bulletInventory Holding Costs: 10%.
bulletOrder Processing Costs: 47%.

bullet "Empirical Market Microstructure Research."  A good summary of the important existing research on the bid-ask spread.

Bonds

Fixed income assets (e.g., bonds) are often added to a portfolio to lessen its volatility.  Another benefit from including bonds in a (otherwise all equity) portfolio is the improved risk/return characteristics resulting from the less than perfect correlation of bonds with equities and other assets.  Also, see Inflation-Indexed Bonds and High-Yield Bonds (Junk Bonds).

bulletDavid A. Plecha, "Fixed Income," Dimensional Fund Advisors.  Details the rationale behind DFA's fixed income strategies.  An excellent, very readable article.

bulletVance Anthony, Martha Mahan Haines, and Murat Aydogyu, "Report on Transactions in Municipal Securities," United States Securities and Exchange Commission, July 1 2004 (2.3mb).  This excellent study quantifies the extent of typical bid-ask spreads for individual municipal bonds (they're big).  The bid-ask spread is effectively a transaction cost.  Effectively, any time you buy or sell a municipal bond, you pay one-half of the bid-ask spread as a transaction cost, perhaps in addition to a brokerage commission.  For a good discussion of this study, see the Zweig article below.

bulletManoj V. Athavale and Terry L. Zivney, "Now is Always the Best Time to Buy Bonds," Journal of Financial Planning, August 2005, pp. 56-61.  This outstanding paper suggests that it makes sense to buy bonds when you need them, even if that happens to be in a rising interest rate environment.  "... financial planners would better serve their clients by helping them define their investment time frame and helping them understand the role of bonds in their portfolio, and discouraging speculation on the direction and magnitude of interest rate changes."

bulletThomas J. Berger, "Global Bonds and Emerging Debt: Worth Considering or Worth Forgetting?," Institute for Fiduciary Education, October 1 1999 (140kb).  This paper points out the diversification benefits of investing a portion of your fixed income portfolio overseas.

bulletDonald G. Bennyhoff, "Municipal Bond Funds and Individual Bonds," The Vanguard Group, July 2004.  Also here.  This paper looks at the pros and cons of using muni bond funds vs. using individual bonds.

bulletChristopher R. Blake, Edwin J. Elton, Martin J. Gruber, "The Performance of Bond Mutual Funds," Journal of Business, July 1993, pp. 371-403.  This study concludes, "Overall and for subcategories of bond funds, we found that bond funds underperformed relevant indexes.  ... this underperformance was approximately equal to the average management fees ..."  "... on average, a percentage point increase in expense leads to a percentage point decrease in returns ..."  This paper strongly supports the prudence of a strategy of selecting bond funds by cost (i.e., choosing no-load funds with the lowest expense ratios).

bulletJames L. Davis, "The Information in the Term Structure: An Update," Dimensional Fund Advisors, October 2000.  Details the empirical support for DFA's "variable maturity" strategy.

bulletDale L. Domian and William Reichenstein, "Performance and Persistence in Money Market Fund Returns," Financial Services Review, 1997 Vol 6, pp. 169-183.  This paper confirms strong persistence in money market mutual funds due principally to the almost perfect negative correlation of expenses and performance.  The paper strongly supports the prudence of a strategy of selecting money market funds by cost (i.e., choosing no-load funds with the lowest expense ratios).

bulletDale L. Domian, Terry S. Maness, and William Reichenstein, "Rewards to Extending Maturity: Implications for investors," Journal of Portfolio Management, Spring 1998, pp. 77-92.  This paper confirms that short term bonds offer superior risk-adjusted returns to those offered by longer term bonds.  "The average term premium appears to rise very sharply as maturity lengthens through about one year, continues to rise through about three years, remains essentially flat from. about three through fifteen years, and falls thereafter."  "The greatest reward to risk is realized for extending maturity through the shortest end of the bond market. In fact, most of the average reward to extending maturity probably occurs by the time maturity reaches one year."

bulletDale L. Domian and William Reichenstein, "Predicting Municipal Bond Fund Returns," Journal of Investing, Fall 2002, pp. 53-65.  This paper confirms persistence in municipal bond mutual funds due principally to the almost perfect negative correlation of expenses and performance.  The paper strongly supports the prudence of a strategy of selecting municipal bond funds by cost (i.e., choosing no-load funds with the lowest expense ratios).

bulletScott J. Donaldson, "Taxable Bond Investing: Bond Funds or Individual Bonds," Vanguard Investment Counseling & Research/ANALYSIS, March 2005 (662kb).  Also here.  An excellent paper which compares and contrasts the pros and cons of buying individual bonds vs. using low-cost bond mutual funds.

bulletEdwin J. Elton, Martin J. Gruber, Deepak Agrawal, and Christopher Mann, "Explaining the Rate Spread on Corporate Bonds," Journal of Finance, February 2001, pp. 247-278 (219kb).  This paper studies the factors which influence the difference between returns on corporate bonds and government bonds.  They found that the possibility of default for corporates explains about 18% of the difference.  They also found that the tax-exempt treatment of government bonds at the state and local level explains about 36% of the difference.  Of the remaining effects, about 85% is explained by factors which are commonly used to explain common stock returns.

bulletCheol S. Eun and Bruce G. Resnick, "International Diversification of Investment Portfolios: U.S. and Japanese Perspectives," Management Science, January 1994, pp. 140-161.  "For U.S. investors, the international bond diversification with exchange risk hedging offers a superior risk-return trade-off than the international stock diversification, with or without hedging."  This paper supports the prudence of hedging the currency risk on foreign bond investments.
 
bulletEugene F. Fama, "Update of the Research Underlying Dimensional's Bond Strategies," Dimensional Fund Advisors, September 2003.  Updates the empirical support for DFA's "variable maturity" strategy.

bulletEugene F. Fama and Robert R. Bliss, "The Information in Long-Maturity Forward Rates," American Economic Review, September 1987, pp. 680-692.  This paper suggests that long forward interest rates have significant power in predicting future spot interest rates.  "The 1-year forward rate calculated from the prices of 4- and 5-year bonds explains 48 percent of the variance of the change in the 1-year interest rate 4 years ahead."  In other words, the market is fairly efficient at anticipating future interest rates.

bulletWalter 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.

bulletRoberto C. Gutierrez, Jr., "Book-to-Market, Equity, Size, and the Segmentation of the Stock and Bond Markets," Texas A&M Working Paper, April 11 2001 (85kb).  This paper suggests that book-to-market ratio and market capitalization have explanatory power for the cross section of corporate bond returns, just as they do for stocks.

bulletEric E. Haas, "Corporate Bond Fund or Individual Treasuries: Which is Better?," Altruist Financial Advisors LLC Working Paper, May 4 2005.  This paper quantitatively answers the question, "Which is better for an individual investor: A bond fund or individual bonds?"  As you might imagine, the answer ultimately is, "It depends."  But basically, this paper suggests that, over the period studied (85-02), a short-term investment grade corporate bond fund would have outperformed, on a risk-adjusted basis, a portfolio of individual treasury bonds, if the difference in its fees were less than about 0.71 percentage points.  Since such funds are generally available (e.g., the Vanguard Short-Term Investment Grade Fund (VFSTX)), it seems prudent for most individual investors to go the bond fund route.

bulletDelroy Hunter and David P. Simon, "Benefits of International Bond Diversification," Journal of Fixed Income, March 2004, pp. 57-68 (1mb).  This paper finds that, during the period 1992 to 2002, there was benefit to diversifying a bond portfolio overseas, but only if you hedged the currency risk.

bulletAntti Ilmanen, "Does Duration Extension Enhance Long-Term Returns?," Journal of Fixed Income, September 1996, pp. 23-36.  "The main conclusion is that duration extension does increase expected returns at the front end of the [yield] curve ... and for durations longer than two years, no conclusive evidence exists of rising expected returns."

bulletAntti Ilmanen, Rory Byrne, Heinz Gunasekera, and Robert Minikin, "Which Risks Have Been Best Rewarded?: Duration, equity market, and short-dated credit risk," Journal of Portfolio Management, Winter 2004, pp. 53-57.  This outstanding paper looks at what return enhancing strategies are most "worthwhile" for bond investors: extending duration, changing from bonds to stocks, and decreasing credit quality.  It finds that the highest increase in risk adjusted returns comes from extending duration from treasury money market to the 1 to 3 year range, and from increasing credit risk from zero (Treasuries) to investment-grade corporates.  This paper supports a strategy of using short-term investment grade corporate bonds as the (non-inflation indexed) bond component in your portfolio.

bulletHaim Levy and Zvi Lerman, "The Benefits of International Diversification in Bonds," Financial Analysts Journal, September/October 1988, pp. 56-64.  "There appears to be a very large potential for international diversification in stocks and bonds, even if we qualify the expectation of possible gains by recognizing the possible extra costs associated with holding foreign investments."

bulletBurton G. Malkiel, "Expectations, Bond Prices, and the Term Structure of Interest Rates," Quarterly Journal of Economics, May 1962, pp. 197-218.  This seminal paper laid out clearly some of the principal phenomena affecting bond pricing.

bulletCraig McCauley, "The Case for Global Fixed Income," Global Investor, October 1996, pp. 29-31.  "... presents a compelling case for US investors to substantially increase their exposures to international fixed income markets (on a fully hedged or unhedged basis), and to maintain a permanent exposure to this asset class."

bulletRobert C. Merton, "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, May 1974, pp. 449-470 (1.58mb).  This paper suggests that corporate bonds can be modeled as riskless bonds (i.e., Treasury bonds) plus a put (i.e., an option to sell the stock) that bondholders issue to the owners of the company’s stock.  As the company's prospects become better, the stock's price increases, which causes the value of the put to decrease (which is good for the bondholders who issue the virtual puts), which causes the value of the bond to increase, which causes the yield on the bond to decrease.  On a separate line of thought, as the company becomes riskier, the value of the put increases (which is bad for the bondholders who issue the virtual puts), which causes the value of the bond to decrease, which causes the yield on the bond to increase.  This is how high-yield bonds get to be high-yield bonds!

bulletFrederick S. Mishkin, "The Information in the Term Structure: Some Further Results," Journal of Applied Econometrics, Oct-Dec 1988, pp. 307-314.  "The term structure does help predict spot interest rate movements several months into the future."  This paper provides additional support for the prudence of DFA's "variable maturity" strategy.

bulletAlejandro Murguía and Dean T. Umemoto, "Analyzing Fixed-Income Securities and Strategies," Journal of Financial Planning, November 2005, pp. 80-90.  A good discussion of issues around investing in bonds.

bulletEugene A. Pilotte and Frederick Sterbenz, "Sharpe and Treynor Ratios on Treasury Bonds," Journal of Business, January 2006.  "Most striking is our finding that reward-to-risk ratios vary inversely with maturity and are incredibly high for short-term bills. Apparently investors would do much better engaging in highly leveraged investments in bills instead of purchasing long maturity bonds or common stocks."  This paper provides additional support for the prudence of keeping bond durations short.

bulletTom Potts and William Reichenstein, "Predictability of Fixed Income Fund Returns," Journal of Financial Planning, November 2004.  This paper finds that relative bond fund returns are somewhat predictable.  For funds with similar duration and credit worthiness, the difference in returns is likely to be similar to the difference in expense ratio.  The gross returns for Intermediate-Term bond funds were consistent (over five year periods, but less so for shorter periods) with the yield on five year treasuries at the beginning of the period.  The gross returns for Long-Term bond funds were consistent (over ten to twenty year periods, but less so for shorter periods) with the yield on twenty year treasuries at the beginning of the period.

bulletWilliam Reichenstein, "Bond Fund Returns and Expenses: A Study of Bond Market Efficiency," Journal of Investing, Winter 1999, pp. 8-16 (488kb).  This paper finds a strong persistence in bond fund performance.  It suggests this is due to the strong negative correlation between a bond fund's expenses and its performance.  In other words, this paper suggests that selecting bond funds by price (i.e., no-load funds with the lowest expense ratios) is an extremely prudent strategy.

bulletV. Vance Roley and Gordon H. Sellon, Jr., "Monetary Policy Actions and Long-Term Interest Rates," The Federal Reserve Bank of Kansas City Economic Review, Fourth Quarter 1995, pp. 73-89 (142kb).  This excellent paper describes, theoretically, how bond yields respond to changes in the Federal Funds Target rate and why.

bulletSandeep Singh and William H. Dresnack, "Market Knowledge in Managed Municipal Bond Portfolios," Financial Services Review, 6(3), pp. 185-196.  "This study provides further support in favor of indexing."  "When state income taxes are considered significant, for example, in states like New York and California, it is beneficial for the individual investor to buy into state-specific municipal bond funds."  The paper found that state-specific muni-bond funds were riskier than national funds, but they offered superior risk-adjusted after-tax returns.

bulletJason Zweig, "The dark side of the muni: Municipal bonds seem safe, but buying or selling them is fraught with peril.  Protect yourself," Money, August 20 2004.  This article discusses the high transaction costs of buying and selling municipal bonds, as well as market inefficiencies of the municipal bond market, at least from the perspective of an individual investor.  The study discusses the Anthony/Haines/Aydogyu study above.

bullet"Global Bond Observations: A Realistic View of the Excess Return of Corporates," Bridgewater Associates (572kb).  This excellent paper points out that, while it may be true that corporate bonds are expected in the long run to have higher returns than treasuries, it is due to higher riskiness.  It suggests that you'd have to wait about 26 years to have a 90 percent probability of the added riskiness paying off in higher returns.

bullet"Global Bond Observations: The Rationale for Investing in Global Bonds: A Brief Overview," Bridgewater Associates, February 2000 (114kb).  Also here.  This excellent paper suggests that hedged foreign bonds can be expected to outperform similar US bonds by about 0.5 percentage points per year with less volatility.

Broker/Dealers

Broker/Dealers are involved with selling financial products and executing brokerage transactions (as opposed to providing objective advice as a fiduciary).  Sadly, the public is ill-informed about the conflicts of interest exhibited by Broker/Dealers and subsequently tend to accept sales-pitches masquerading as objective financial advice as such objective financial advice.

bulletDaylian M. Cain, George Lowenstein, and Don A. Moore, "The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest," Journal of Legal Studies, Vol 34 (2005), p 1.    This outstanding study shows that even if Broker/Dealers plainly disclose their inherent conflict of interest, the consumer might actually be worse off than if the disclosure didn't happen.  This study confirms the prudence of requiring fiduciaries to avoid, rather than merely disclosing, conflicts of interest.  "Conflicts of interest can lead experts to give biased advice. While disclosure has been proposed as a potential solution to this, we show that disclosure can have perverse effects, and might even increase bias. Disclosure may increase bias because advisors feel morally licensed and strategically encouraged to exaggerate their advice even further from the truth. As for those receiving the advice, proper use of the disclosure depends on understanding how the conflict of interest biased the advice and how that advice impacted them. Because people lack this understanding, disclosure can fail to solve the problems created by conflicts of interest."

bulletEric E. Haas, Comment to the SEC on Broker/Dealer exemption to the Advisers Act of 1940, August 23 2004.  A frank discussion of the principal issues surrounding the SEC's proposed exemption of Broker/Dealers from the requirements of the Investment Adviser's Act of 1940.

bulletEric E. Haas, Comment to the SEC on Broker/Dealer exemption to the Advisers Act of 1940, January 25 2005.  Another brief comment on the principal issues surrounding the SEC's proposed exemption of Broker/Dealers from the requirements of the Investment Adviser's Act of 1940.

bulletDuane R. Thompson, Letter to the SEC commenting on Broker/Dealer exemption to the Advisers Act of 1940, February 7 2005.  An excellent discussion of the issues surrounding the SEC's proposed exemption of Broker/Dealers from the requirements of the Investment Adviser's Act of 1940.

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.

bulletFrank Armstrong, "Capital Asset Pricing Model," Investor Solutions, 2002.  An excellent introduction to the CAPM.

bulletEugene F. Fama and Kenneth R. French, "The Capital Asset Pricing Model: Theory and Evidence," CRSP Working Paper 550, January 2004 (105kb).  Also here.  This excellent paper discusses some of the major problems with the CAPM.  "The problems are serious enough to invalidate most applications of the CAPM"  "... despite its seductive simplicity, the CAPM's empirical problems probably invalidate its use in applications."

bulletEugene F. Fama and Kenneth R. French, "Disagreement, Tastes, and Asset Prices," CRSP Working Paper 552, February 2004 (89kb).  Also here.  This paper discusses the implications of one of the assumptions of the CAPM that there is complete agreement among investors about probability distributions of future payoffs on assets.

bulletWilliam N. Goetzmann, "An Introduction to Investment Theory," Yale School of Management.  This is from a college course.  It is an excellent introduction to the CAPM.

bulletWilliam F. Sharpe, "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk," Journal of Finance, September 1964, pp. 425-442 (1.17mb).  Also here.  This is the paper that basically defined the CAPM and won Dr. Sharpe the Nobel Prize.

Charitable Giving

Charitable Giving has several benefits.  First, of course, it is good for the soul.  But many don't realize how it can have enormously beneficial tax effects as well.  For example, if, instead of donating cash, you donate highly appreciated securities, you can avoid paying capital gains taxes on those securities (and the charity wouldn't have to pay them either).  This is in addition, of course, to the benefit of the tax-deduction you get for charitable gifts of any kind.

There are at least two means for implementing a long-term giving program: Donor-Advised Funds and Charitable Remainder Trusts.  Of the two, Donor-Advised Funds are the simplest to set up and administer.  The Vanguard Charitable Endowment Program and the Fidelity Charitable Gift Fund are generally the most preferred DAFs due to their exceptionally low fees.  Investors who want a bigger, better selection of investments to choose from might choose The American Endowment Foundation, which has a tiered fee scale.

Also, see Estate Planning.

bulletRoccy 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.

bulletElfrena Foord, "Philanthropy 101: Donor-Advised Funds," Journal of Financial Planning, November 2003, pp. 66-73.  A good article which compares Donor-Advised Funds to Private Foundations.

bulletLawrence 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.

bulletEric Lee Smith, "Donor-Advised Funds: A Well Kept Secret," The CPA Journal, September 2001, pp. 62-63.  A good discussion of Donor-Advised Funds.

bulletEric Lee Smith, "An Introduction to Donor-Advised Funds," from The ePhilanthropy Foundation's Guide to Success Online, 2001.  This interesting article (a chapter from a book) is geared towards organizations who might be considering starting a Donor-Advised Fund.
 
bullet"Gifting Assets?  Here's What's to Know," The Vanguard Group, November 16 2005.  A good discussion of the various options for gifting assets.

Closed-End Funds

Closed End Funds are mutual funds which are bought and sold on exchanges (i.e., like you buy and sell stocks).  Interestingly, the share price, determined by the market, can dramatically differ from the share price determined by the current value of the securities a closed end fund holds (i.e., its NAV).  This gives an investor the opportunity to get exposure to securities at a deep discount.  Whether or not it is prudent to do so is a different story.  Before going out and buying discounted closed-end funds, be sure to read the Pontiff and Reichert/Timmons papers below.

bulletDominic Gasbarro, Richard D. Johnson, and J. Kenton Zumwalt, "Evidence on the Mean-Reverting Tendencies of Closed-End Fund Discounts," The Financial Review, May 2003, pp. 273-291.  This paper examines the "mean-reverting" tendency of closed-end funds.  Specifically, it examines the hypothesis that funds sold at a discount to NAV tend to have their discount narrow (i.e., the fund share price tends to increase towards NAV over time).  The truth of this hypothesis is important for investors who desire to engage in closed-end fund arbitrage.

bulletBurton G. Malkiel, "The Valuation of Closed-End Investment Company Shares," Journal of Finance, June 1977, pp. 847-859.  This paper suggested that it seemed possible to get significant abnormal positive returns through investing in deeply discounted closed-end funds.  Specifically, this paper found at least two reasons to consider deeply discounted closed-end funds:
bulletThe expected returns on a deeply discounted closed-end fund are much higher than the expected returns on a similar portfolio of the underlying securities.  Even if the discount doesn't narrow, you get all of the income from the underlying securities with a fraction of the up-front investment.
bulletFund discounts seem to narrow when the market falls and increase when the market rises.  This suggests that closed end funds might make good diversifiers, all else being equal.

bulletJeffrey Pontiff, "Excess Volatility and Closed-End Funds," The American Economic Review, March 2003, pp. 155-169.  This interesting paper finds that the prices of closed end funds are about 64 percent more volatile than the assets they hold.  This is yet another reason to think twice before attempting a closed end fund arbitrage strategy.

bulletCarolyn Reichert and J. Douglas Timmons, "Closed-End Investment Companies: Historic Returns and Investment Strategies," The Financial Review, May 2003, pp. 273-291.  This interesting paper models the results of a simple investment strategy designed to take advantage of the presumed tendency of a closed-end fund (which is trading at a discount) to have its discount lessen over time.  Specifically, this paper analyzes a strategy of buying the closed-end funds with the greatest discount, holding them for one year, then replacing them with the funds which a year later are available at the greatest discount.  This paper's conclusion: "The results do not support the use of a simple mechanical strategy.  Even when marginally significant before-tax returns are available, transaction costs and taxes erode the benefits.  Excess returns are not possible for investors lacking the time or resources to actively trade in the marketplace.  Small investors following simple trading rules with a minimum of rebalancing are unlikely to earn the abnormal returns documented in earlier studies.  This should serve as a warning to investors lured by the promise of excess returns from CEIC [Closed-End Investment Company] funds selling at discounts.  It is important for small investors to be aware of the need for additional monitoring, more frequent trading, larger initial investments, or short selling if they want to use CEIC funds to outperform the market.  Investors wanting to avoid these complications should consider alternative investments."

bulletRex Thompson, "The information content of discounts and premiums on closed-end funds," Journal of Financial Economics, 6, pp. 151-186.  Thompson finds that a relatively simple trading rule (based on discounts for closed-end funds) earned statistically significant abnormal returns of about 4% per year over the period 1940-1971. In addition, the results are quite uniform throughout the period.

College Planning

There are several tax-advantaged means of saving for college.  For most people, 529 savings plans are the best choice.  If your state offers tax-deductions for contributions to your state's plan, you should consider (the direct purchased version of) that plan (i.e., don't buy it through a financial adviser).  Otherwise, you should consider one of the low cost alternatives: Colorado, Iowa, Michigan, Minnesota, Missouri, Nebraska, Nevada (Vanguard), New York, Ohio, Utah or Virginia (note that Nebraska's and New York's plans offer significantly greater investing flexibility than the others).  Utah's plan is definitely the least expensive of the bunch, followed closely by Ohio's and Virginia's.  Note that West Virginia's SMART529 Select plan, while not being among the lowest cost plans, has the best investment choices and may be the best value, especially for very young beneficiaries (for information on what makes a "good" investing choice, see here).  For information on all 529 plans, see SavingforCollege.com.  Note that, if you choose another state's plan, it may be necessary to transfer it back to your state's plan immediately before college in order to avoid taxation of withdrawals by your state.

bulletKeith R. Davenport, Douglas Fore, and Jennifer Ma, "Miracle Growth?  Everyone touts the benefits of 529 college savings plans.  But compared to the alternatives, are they really that extraordinary?," Investment Advisor, September 2001, pp. 58-66.  Here's another link.

bulletRamon P. DeGennaro, "Asset Allocation and Section 529 Plans," Federal Reserve Bank of Atlanta Working Paper 2003-1 (70kb).  Also here.  A good discussion of these issues.

bulletSusan M. Dynarski, "Who Benefits from the Education Savings Incentives?  Income, Educational Expectations, and the Value of the 529 and Coverdell," NBER Working paper W10470, May 2004.  This excellent paper finds that the advantages of the 529 and Coverdell ESA rise sharply with income.  While they still make sense for low income people, 529 and Coverdell plans are a dramatically better "deal" for high-income savers.  Also, see the discussion of this paper here.

bulletSusan M. Dynarski, "Tax Policy and Education Policy: Collision or Coordination?  A case study of 529 and Coverdell Savings Vehicles," NBER Working paper W10357, March 2004 (434kb). 

bulletJennifer Ma and Douglas Fore, "Saving for College: A Comparison of Section 529 Plans with Other Options: An Update," TIAA-CREF Institute research dialogue, January 2002, pp. 1-20.  An excellent comparison of 529 plans to other savings vehicles.

bulletJennifer Ma, "The Impact of the 2003 Tax Law on College Savings Option," TIAA-CREF Institute, July 31 2003.  This note studies the impact of the 2003 tax law on college savings.  It finds that Coverdell ESAs and 529 plans still tend to be the optimal choice for most investors.

bulletBarry Marks and William Reichenstein, "Tax Strategies for Financing Higher Education," Journal of Financial Planning, May 2000.  The authors survey the various means of saving for college education.  Note that this article preceded the vast tax law changes enacted in 2001.

bulletMark C. Neath, "Section 529 Prepaid Tuition Plans: A Low Risk Investment with Surprising Applications," Journal of Financial Planning, April 2002, pp. 92-98.  "In short, Section 529 plans promise to become an important tool for financial planners, not only for college savings, but for a wide range of asset protection, estate planning and other financial planning goals."

bulletLynn O'Shaughnessy, "Avoiding Fee Pitfalls as College Savings Climb," New York Times, July 13 2003.  Also here.  A discussion of 529 plans, emphasizing the importance of fees when choosing a plan.

bulletJohn J. Spitzer and Sandeep Singh, "The Fallacy of Cookie Cutter Asset Allocation: Some Evidence from 'New York's College Savings Program'," Financial Services Review, Volume 10(4) 2001.  This study was done before 529 plan qualified withdrawals were made tax-free, which somewhat affects the conclusions, but it is an interesting analysis nonetheless (especially since the cur