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  • This paper documents that arbitrageurs were unable to maintain similar prices of similar assets when prime brokers failed to provide leverage during the 2008 financial crisis.

    The imminent failure of large Wall Street prime brokerage firms during the 2008 financial crisis caused a sudden and dramatic decrease in the amount of financial leverage afforded hedge funds. This decrease in financing resulted from the ex post asymmetrical payoff to rehypothecation lenders – the ultimate providers of financing, through prime brokers, to hedge funds. Seemingly long-term debt capital became short-term capital creating a large mismatch in the duration of arbitrage opportunities on the left-hand side of arbitrageurs’ balance sheet and liabilities on the right-hand side. A primary consequence of this withdrawal of financing was the inability of hedge funds involved in relative-value trades to maintain prices of substantially similar assets at substantially similar prices. The magnitudes of these mispricings, and the time required to correct them, provide an indication of the role played by arbitrageurs in maintaining rational prices during normal times.

  • An explanation of major arbitrage strategies, and their potential roles in a diversified portfolio.

    Arbitrage strategies use relative value trades to generate excess returns with attractive risk profiles. Their low betas with respect to traditional asset classes make arbitrage strategies particularly effective components of a diversified portfolio. This paper offers a brief introduction to arbitrage, including descriptions of several common strategies and an overview of their historical performance.

  • This result suggests that returns to risk arbitrage are similar to those obtained from selling uncovered index put options, uncorrelated in up markets but correlated in down markets.

    This paper uses a sample of 4,750 stock swap mergers, cash mergers, and cash tender offers during 1963 - 1998 to characterize the risk and return in risk arbitrage. For out-of-sample comparison, we also examine the risk/return profile for a sample of active risk arbitrage hedge funds during 1990 - 1998. Results from both samples indicate that risk arbitrage returns are positively correlated with market returns in severely depreciating markets but uncorrelated with market returns in flat and appreciating markets. This result suggests that returns to risk arbitrage are similar to those obtained from selling uncovered index put options. Although linear asset pricing models provide reasonable estimates of the excess returns in risk arbitrage, a contingent claims analysis that incorporates the non-linearity in returns provides a more accurate description of the risk/return relationship. After controlling for both the non-linear return profile and transaction costs, we find that risk arbitrage generates excess returns of 4% per year.

  • This paper finds that EPS accretion has a positive and statistically significant effect on acquirer abnormal performance, both at announcement and for the period up to 18 months following completion of the deal.

    There is a widespread concern among practitioners and corporate managers that transactions which result in changes in future earnings-per-share ("EPS") have real effects on stock prices, irrespective of whether these changes reflect differences in future cash flows. As a result, investment decisions are often conditioned on their being accretive to EPS. This paper addresses this notion by testing whether there is any relation between EPS accretion and both announcement and long-term abnormal returns for acquiring firms in mergers and acquisitions. Using a sample of 224 transactions completed between 1975 and 1994, and a measure of EPS accretion designed to exclude the real effects of any potential synergies from the acquisition, I find that EPS accretion has a positive and statistically significant effect on acquirer abnormal performance, both at announcement and for the period up to 18 months following completion of the deal. This effect is robust across different measures of abnormal performance, and after controlling for other factors known to affect the long-term performance of acquiring firms. Also, the magnitude of the effect is higher for firms with a larger percentage of unsophisticated investors. On the other hand, the estimated effect, although reliably positive, is one order of magnitude smaller than implied by practitioners' views, suggesting that the concerns expressed by managers are largely exaggerated.

  • An analysis of the optimal trading strategy that minimizes transaction costs while efficiently exploiting trading signals. A closed-form solution that illuminates the key role of alpha decay.

    This paper derives in closed form the optimal dynamic portfolio policy when trading is costly and security returns are predictable by signals with different mean-reversion speeds. The optimal updated portfolio is a linear combination of the existing port-folio, the optimal portfolio absent trading costs, and the optimal portfolio based on future expected returns and transaction costs. Predictors with slower mean reversion (alpha decay) get more weight since they lead to a favorable positioning both now and in the future. We implement the optimal policy for commodity futures and show that the resulting portfolio has superior returns net of trading costs relative to more naive benchmarks. Finally, we derive natural equilibrium implications, including that demand shocks with faster mean reversion command a higher return premium.

  • What once appeared to be unique "alpha" becomes "beta" as strategies become better-understood. This applies directly to hedge funds.

    Alpha is shrinking, and it’s good news for investors. This idea may seem paradoxical. But alpha is really just the portion of a portfolio’s returns that cannot be explained by exposure to common risk factors (betas). With the emergence of new betas, the unexplained portion (alpha) shrinks – alpha gets reclassified as beta. The rise of a group of risk factors we call hedge fund betas makes this transformation especially relevant today. Hedge fund betas are the common risk exposures shared by hedge fund managers pursuing similar strategies. We believe these risk factors can capture not just the fundamental insights of hedge funds, but also a meaningful portion of their returns. Hedge fund betas are available for investment and can also be used to enhance portfolio construction and risk management. Ultimately, we believe the rise of hedge fund betas will lead not only to the reclassification of alpha, but also to better diversified portfolios with greater transparency, improved risk control, and – perhaps most importantly – higher net returns.

  • This paper looks into the specific situation when the market value of a company is less than its subsidiary.

    We examine 82 situations where the market value of a company is less than its subsidiary. These situations imply arbitrage opportunities, providing an ideal setting to study the risks and market frictions that prevent arbitrageurs from immediately forcing prices to fundamental values. For 30 percent of the sample, the link between the parent and its subsidiary is severed before the relative value discrepancy is corrected. Furthermore, returns to a specialized arbitrageur would be 50 percent larger if the path to convergence was smooth rather than as observed. Uncertainty about the distribution of returns and characteristics of the risks limits arbitrage.

  • In a model with heterogeneous-risk-aversion agents facing margin constraints, we show how securities’ required returns increase in both their betas and their margin requirements.

    In a model with heterogeneous-risk-aversion agents facing margin constraints, we show how securities’ required returns increase in both their betas and their margin requirements. Negative shocks to fundamentals make margin constraints bind, lowering risk-free rates and raising Sharpe ratios of risky securities, especially for high-margin securities. Such a funding-liquidity crisis gives rise to “bases,” that is, price gaps between securities with identical cash-flows but different margins. In the time series, bases depend on the shadow cost of capital, which can be captured through the interest-rate spread between collateralized and uncollateralized loans and, in the cross-section, they depend on relative margins. We test the model empirically using the credit default swap–bond bases and other deviations from the Law of One Price, and use it to evaluate central banks’ lending facilities.

  • This paper looks at over 4000 mergers from 1973-1998 and looks at if mergers create value for the stockholders of the combined firms, with the stockholders of the target accruing the majority of it.

    Empirical research on mergers and acquisitions has revealed a great deal about their trends and characteristics over the last century. For example, a profusion of event studies has demonstrated that mergers seem to create shareholder value, with most of the gains accruing to the target company. This paper will provide further evidence on these questions, updating our database of facts for the 1990s.

  • When a large trader liquidates, “predators” also sell, leading to price over-shooting and systemic risk.

    This paper studies predatory trading, trading that induces and/or exploits the need of other investors to reduce their positions. We show that if one trader needs to sell, others also sell and subsequently buy back the asset. This leads to price overshooting and a reduced liquidation value for the distressed trader. Hence, the market is illiquid when liquidity is most needed. Further, a trader profits from triggering another trader’s crisis, and the crisis can spill over across traders and across markets.

  • This paper finds considerable support for the existence of price pressure around mergers caused by uninformed shifts in excess demand, but that these effects are short-lived, consistent with the notion that short-run demand curves for stocks are not perfectly elastic.

    This paper examines the trading behavior of professional investors around 2,130 mergers announced between 1994 and 2000. We find considerable support for the existence of price pressure around mergers caused by uninformed shifts in excess demand, but that these effects are short-lived, consistent with the notion that short-run demand curves for stocks are not perfectly elastic. We estimate that nearly half of the negative announcement period stock price reaction for acquirers in stock-financed mergers reflects downward price pressure caused by merger arbitrage short selling, suggesting that previous estimates of merger wealth effects are biased downward.

  • Empirical evidence: when arbitrageurs lose capital and new capital arrives slowly, prices become depressed and later rebound.

    Unlike textbook arbitrageurs who instantaneously trade when prices deviate from fundamental values, real world arbitrageurs must overcome various frictions. For example, they often invest other people’s money, resulting in a principal/agent problem that is exacerbated in market downturns. Rather than increasing investment levels when prices dip below fundamental values, arbitrageurs may, in the face of capital constraints, sell cheap securities causing prices to decline further. As a result, mispricings can be large and can extend for long periods of time.

  • An examination of the causes for the considerable cheapening of convertible bonds throughout 2008, and the medium-term return prospects given price levels in mid-2009.

    This white paper was first published on December 31, 2008 to examine the likely causes and circumstance surrounding the convertible bond market dislocation which had culminated in the fourth quarter. The size and scope of the sell-off was extraordinary and led to significant losses for many convertible arbitrage investors before year-end. However, this paper also argued that the dislocation likely created a historic investment opportunity for long term investors who could purchase convertible bonds at the steepest discounts to fair value in our 23 years of recorded history. Indeed, many convertible bond investors realized significantly positive returns in the first half of 2009 following on the heels of the massive market dislocation of 2008.

  • Finds evidence of the disposition effect in equity returns, and its interaction with the momentum effect.

    This paper tests whether the “disposition effect,” that is the tendency of investors to ride losses and realize gains, induces “underreaction” to news, leading to return predictability. I use data on mutual fund holdings to construct a new measure of reference purchasing prices for individual stocks, and I show that post-announcement price drift is most severe whenever capital gains and the news event have the same sign. The magnitude of the drift depends on the capital gains (losses) experienced by the stock holders on the event date. An event-driven strategy based on this effect yields monthly alphas of over 200 basis points.

  • Financing concerns limit arbitrage in a liquidity crisis, but also offer extraordinary opportunistic returns to potential liquidity providers.

    Like many investment strategies, convertible bond arbitrage suffered abysmal results in late 2008, following the collapse of Lehman Brothers. Because this strategy is closer to the theoretical concept of arbitrage than many, an examination of how convertible arbitrage fared during this volatile period offers a case study of how these strategies can break down in times of crisis, and the opportunities they offer in the aftermath. This chapter is divided into three parts. Part I explains the mechanics of convertible bond arbitrage and some of the unique characteristics of the strategy. Part II reviews the performance of convertible bond arbitrage from the beginning of the credit crisis in 2007 through the middle of 2009. We use a proprietary data set to show the fluctuations in bond “cheapness” and use our experience trading convertible bonds to shed light on investor behavior during this volatile period. Part III assesses the implications for investors. Investors need to recognize the limitations of arbitrage strategies, but at the same time these strategies may offer extraordinary opportunistic returns in periods of crisis.

  • This paper proposes a simple framework to consider the impacts of ESG issues with respect to their role in investment decisions.

    It is often argued that the world is changing and that the impact of Environmental, Social and Governance (ESG) issues could pose a significant risk or potential opportunity for pension assets. While this argument may well have merit, it rarely leads to actionable steps or clarity of direction. In some sense it is a call to arms against an unknown enemy. The inherent breadth and ambiguity of issues has resulted in the integration of ESG considerations into portfolio design remaining largely a philosophical push without clarity on the direct and indirect impacts on shareholder value. This paper proposes a simple framework to consider the impacts of ESG issues with respect to their role in investment decisions. This framework allows ESG considerations to be disentangled and provides a clearer path for further investigation of the impact of good/bad ESG policies on shareholder value and how these considerations may be appropriately included in the investment decisions of both investors and fiduciaries.

  • We suggest seven sources of value-added beyond the traditional view of "alpha".

    Many institutional investors focus primarily on one source of alpha: expected returns, perhaps relative to a benchmark. There are many drawbacks to this approach, including manager search costs, limited performance persistence, and (potentially) high fees. We argue that "alpha" can be more reliably captured in virtually every other stage of the investment process. In this article, we suggest seven sources of value-added beyond the traditional view of "alpha", grouped under three themes: portfolio construction, risk management, and cost control.

  • An exploration of the role of hedge funds, their growth and returns. (Part I of II)

    One of the main financial market stories of the last three to five years has been the explosive growth of hedge funds. Depending on whom you ask, hedge funds are either the wave of the future, or they are a dangerous fad that has been grossly overcapitalized and all will end in ruin. Both sentiments contain elements of truth. The good news for hedge funds is that a portfolio structure that divides capital between traditional index funds to obtain beta (or market exposure) and hedge funds to earn alpha is very appealing. Traditional active management attempts to add alpha by adjusting index holdings in an arbitrary, confusing, and constraining manner.1 It can be viewed as a tie-in sale between an index fund and a very constrained hedge fund. Hedge funds allow for a much clearer separation of the unrelated activities of obtaining index exposure and generating alpha, thus leading to clean portfolio construction, performance attribution, and fee breakdowns. Furthermore, sources of alpha and techniques unavailable in traditional mandates are available in this format. To fulfill their promise, hedge funds need to recognize and improve on shortcomings. A companion piece to this article explores hedge fund fees in more depth, examines various dark sides to hedge fund investing, and recommends future evolutionary changes needed to help hedge funds achieve their potential (see Asness [2004]). Given my generally pro-hedge fund slant here, some fair disclosure is in order. I am a hedge fund manager.

  • How unpredictable changes in liquidity affect security returns, developing a novel liquidity-adjusted CAPM.

    This paper solves explicitly a simple equilibrium model with liquidity risk. In our liquidity adjusted capital asset pricing model, a security’s required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with the market return and liquidity. In addition, a persistent negative shock to a security’s liquidity results in low contemporaneous returns and high predicted future returns. The model provides a unified framework for understanding the various channels through which liquidity risk may affect asset prices. Our empirical results shed light on the total and relative economic significance of these channels and provide evidence of flight to liquidity.

  • Thoughts on the proper allocation to emerging market equities, evidence for active vs passive management and inflation hedging potential.

    Over the past decade, emerging market equities have become a meaningful portion of global equity markets. In 2003, emerging equities accounted for just 4% of global equity market capitalization as measured by the MSCI ACWI index. Today that figure is close to 13%. Many US institutions hold much less than 13% either due to a benchmark choice that explicitly allocates less (if anything) to emerging markets or due to an active bet relative to the benchmark. At the end of 2009, US pension plans on average allocated between 3-8% of their capital to emerging markets, while many had no exposure whatsoever. However, an increase in manager search activity suggests that pension plans are either increasing exposure to emerging markets or rotating their emerging markets managers. Research group EPFR reported that emerging equity fund inflows reached $80.3 billion in 2009 – the largest inflow in the asset class since the company began tracking this data in 1997. For investors evaluating their exposure, three meaningful topics to weigh are: I. How to approach risk budgeting and asset allocation in light of the global equity markets’ changing composition II. The pros and cons of various investment styles III. How inflation impacts emerging equities This paper provides insight into these questions. Part I addresses asset allocation and portfolio risk. Part II analyzes fundamental and quantitative emerging market active managers. This section presents evidence that there are meaningful gains to holding a diversified portfolio of both fundamental and quantitative emerging equities managers. Lastly, Part III outlines the potential benefits to holding emerging equities in periods of rising inflation.

  • Five alternatives to traditional tail-risk hedging. Unlike purchasing portfolio insurance, these strategies may enhance portfolio efficiency and long-term expected returns.

    In the wake of 2008, investors are now painfully aware of tail risk – the risk of unexpectedly large losses. Today many institutional investors are insuring against tail risk directly, often by purchasing puts or structuring collars. Unfortunately, experience and financial theory suggest that the long-term cost of such insurance strategies will be larger than the payouts. No surprise, really. The expected return for perpetual insurance buyers is negative, and conversely positive for insurance sellers (see: the entire insurance industry). Arguably, relatively risk-tolerant investors should be selling tail-risk insurance rather than buying it. Our recommendation, if reducing tail risk is deemed necessary, is to approach tail risk fundamentally, primarily by modifying the portfolio structure itself and by addressing risk management policy. This paper considers fi ve approaches, which we think are most effective when used in combination: 1. Diversify by risk, not just by assets 2. Actively manage volatility 3. Embrace uncorrelated alternatives 4. Take advantage of low-beta equities 5. Have a crisis plan before you need one We think these approaches lead to better constructed portfolios for all investors, not just those concerned with tail risk. For investors who are unable to pursue these approaches, we think the best way to reduce tail risk is to reduce total market exposure rather than to buy insurance.

  • An analysis of the optimal trading strategy that minimizes transaction costs while efficiently exploiting trading signals. A closed-form solution that illuminates the key role of alpha decay.

    This paper derives in closed form the optimal dynamic portfolio policy when trading is costly and security returns are predictable by signals with different mean-reversion speeds. The optimal updated portfolio is a linear combination of the existing port-folio, the optimal portfolio absent trading costs, and the optimal portfolio based on future expected returns and transaction costs. Predictors with slower mean reversion (alpha decay) get more weight since they lead to a favorable positioning both now and in the future. We implement the optimal policy for commodity futures and show that the resulting portfolio has superior returns net of trading costs relative to more naive benchmarks. Finally, we derive natural equilibrium implications, including that demand shocks with faster mean reversion command a higher return premium.

  • Key structural issues - including liquidity, transparancy, and fees - need to be addressed, but the diversification benefits of hedge fund strategies remain compelling.

    Following the many disappointments of 2008, investors are questioning the role of hedge funds in institutional portfolios. Investors spent the better part of the last decade buying investments that were supposed to be uncorrelated, only to see virtually every asset class fall sharply in late 2008 and hopes held out for hedge funds to come to the rescue were left waning. We think that a few key issues are responsible for investors’ disappointment in hedge funds - too little diversification, too much illiquidity - coupled with some structural issues – transparency, leverage and fees – that make it hard for investors to remain enthusiastic. Exuberance took things too far, where investors were swayed by the idea of hedge funds rather than the substance of what they deliver. The good news is that many of these problems can be addressed by the industry, and We believe the investment strategies that result should give hedge fund investors what they wanted in the first place meeting the needs of both investors who have long believed that hedge funds have a role in institutional portfolios and those who have been skeptical.

  • Case study on implementing portable alpha in a pension fund portfolio: board governance, alpha sourcing, ongoing management allocations.

    The years 2002-04 were deeply transformative for NPPERS’ investments. A 2002 asset-liability study had resulted in two dramatic changes in the investment policies and objectives of the then $5 billion fund: 1. a push towards greater asset class diversification; and 2. a mandate to significantly increase the contribution of active management (i.e., “alpha”) to overall performance. To achieve the latter, the investment team decided to implement a portable alpha program, which eventually came to represent about 20% of total plan assets (over $1 billion). This case study describes how the NPPERS portable alpha program was conceived, structured and implemented.

  • Despite correlations rising in a crisis, international diversification protects investors over the medium to long term.

    Critics of international diversification observe that it does not protect investors against short-term market crashes because markets become more correlated during downturns. Although true, this observation misses the big picture. Over longer horizons, underlying economic growth matters more than short-lived panics with respect to returns, and international diversification does an excellent job of protecting investors.

  • What once appeared to be unique "alpha" becomes "beta" as strategies become better-understood. This applies directly to hedge funds.

    Alpha is shrinking, and it’s good news for investors. This idea may seem paradoxical. But alpha is really just the portion of a portfolio’s returns that cannot be explained by exposure to common risk factors (betas). With the emergence of new betas, the unexplained portion (alpha) shrinks – alpha gets reclassified as beta. The rise of a group of risk factors we call hedge fund betas makes this transformation especially relevant today. Hedge fund betas are the common risk exposures shared by hedge fund managers pursuing similar strategies. We believe these risk factors can capture not just the fundamental insights of hedge funds, but also a meaningful portion of their returns. Hedge fund betas are available for investment and can also be used to enhance portfolio construction and risk management. Ultimately, we believe the rise of hedge fund betas will lead not only to the reclassification of alpha, but also to better diversified portfolios with greater transparency, improved risk control, and – perhaps most importantly – higher net returns.

  • Leverage aversion changes the predictions of modern portfolio theory. Specifically, lower risk assets may offer higher risk-adjusted returns, creating an opportunity for strategies such as risk parity.

    We show that leverage aversion changes the predictions of modern portfolio theory: It implies that safer assets must offer higher risk-adjusted returns than riskier assets. Consuming the high risk-adjusted returns offered by safer assets requires leverage, creating an opportunity for investors with the ability and willingness to apply leverage. A Risk Parity (RP) portfolio exploits this in a simple way, namely by equalizing the risk allocation across asset classes, thus overweighting safer assets relative to their weight in the market portfolio. Consistent with our theory of leverage aversion, we find empirically that RP has outperformed the market over the last century by a statistically and economically significant amount.

  • Risk parity strategies should be designed to adjust for changing market conditions.

    At the heart of risk parity, there is risk management. Risk parity’s core benefit – improved portfolio diversification – ultimately is a product of how well risk is assessed and managed. For investment managers, the practical considerations are important. In this article we consider two essential aspects of risk management for risk parity portfolios: maintaining balanced risk exposures through time and managing portfolios through periods of significant market stress. We conclude that risk parity portfolios require dynamic management; their holdings need to be regularly adjusted to reflect the dynamics of underlying market risk. Further, we conclude that risk parity portfolios should incorporate a planned capital preservation strategy to try to avoid significant disruptions in a crisis.

  • A review of investing principles that were ignored in the tech bubble and that may still have been forgotten in the bust.

    The Financial Analysts Journal's 60th anniversary happens to coincide with the five-year anniversary of the peak of the Great Stock Market Bubble of 1999–2000. The combination of proximity in time, with just a bit of distance, makes this year an appropriate time to consider what we may have learned from this momentous event. This article suggests lessons that, if we haven't learned them, we should have.

  • Ideas on investment policy, effective governance, and managing risks more efficiently.

    Being an institutional investor is tough, now more than ever. And while there is no "silver bullet" to solve the many challenges investors face, we want to share a few thoughts and ideas in the hope of sparking or sustaining a dialogue with investors.

  • The much-coveted 5 percent real rate of return is difficult to achieve, but for investors willing to use derivatives and leverage there is a potential way to do it.

    In recent years some investors have gingerly lowered their long-run return targets, but few institutions outwardly expect less than a 4 percent real return or 6 to 7 percent nominal return on their overall portfolios. Over the past decade and a half, such expectations have generally not been fulfilled, and most investors will likely be disappointed yet again over the coming decade. In fact, those with simple, traditional portfolios like 60-40 U.S. stocks and bonds are even more likely to be disappointed going forward.

  • We argue and show that factor diversification has been more effective than asset-class diversification in general and, in particular, during crises.

    Diversification is one of the most fundamental concepts in investment theory and practice. It is famously referred to as the only "free lunch" in investing. Implicit in this statement is the notion that one can reduce a portfolio's volatility without reducing its expected return. Yet, diversification has come under attack after the 2007-2009 financial crisis, when diversification seemed to fail as virtually all long-only assets, other than high-quality soverign debt, moved in the same direction (down). We argue that the attacks are undeserved. Instead, we believe that the problem is "user error"; most investors were never as diversified as they thought they were. There is ample room for improvement by shifting the focus from asset class diversification to factor diversification.

  • Fundamental Indexing is less of a revolution in investing and more of a repackaging of a long-established discipline of value tilting.

    There is an interesting and sometimes heated debate under way about the merits of traditional capitalization-weighted indexing versus so-called Fundamentally WeightedTM indexes. Robert Arnott, chairman of Research Affiliates, a Pasadena, California–based investment management firm, and finance professor Jeremy Siegel of the Wharton School of the University of Pennsylvania have led the charge for Fundamental Indexing. Vanguard Group founder Jack Bogle and Princeton University economics professor Burton Malkiel have been the chief defenders of traditional indexing. I write this piece as one stuck in the middle. On the one hand, Bogle and Malkiel are right: If we use a strict definition of the word “index,” the only indexes that truly make sense are cap-weighted. On the other hand, I am not a pure index fund investor. Instead, I try to outperform indexes by making active bets — and the bets I favor are in the direction of Arnott and Siegel.

  • A summary of Antti's book, Expected Returns: An Investor's Guide To Harvesting Market Rewards, and ideas about how to build a better portfolio.

    Investors tend to think of expected returns as a function of asset class risk, but this thinking may have led them to take on too much equity risk. For behavioral reasons, diversifying across investment styles, such as blending momentum and value, may offer greater returns for less risk. Limited market timing may also increase returns.

  • Reinsurance has historically delivered attractive risk premiums independent of financial markets. Broad introduction to an asset class underepresented in institutional portfolios.

    This paper discusses many characteristics of reinsurance with the goal of demystifying the asset class to the institutional investor community. In Part 1 we discuss the history and evolution of insurance and reinsurance and describe the participants in these markets. Following that we examine various types of reinsurance risks and give examples of particular contracts, together with the terms and jargon needed to understand the marketplace. Next we make the strategic case for reinsurance as a diversifying asset class. This takes two forms, for in addition to being uncorrelated to traditional stock, bond or commodity strategies, reinsurance risks exhibit internal, pairwise independence that is not evident within any capital market asset class. In the end this yields portfolio diversification benefits unlike any traditional asset class. We illustrate this with an example comparing a single stock to a single reinsurance risk and then evolve it to a portfolio of stocks compared to a portfolio of reinsurance contracts. Historical data on reinsurance contracts is limited, but nevertheless in Part 2 we examine historical risk premiums for different territory and peril classes of risk. We also review the performance of two different hypothetically-constructed reinsurance portfolios, with a particular emphasis on their comparisons to more traditional assets. In Part 2 we also highlight the performance and correlation characteristics of reinsurance in the fi nancial meltdown of 2008 as well as the 2001/2002 tech bubble collapse. We conclude with a discussion of reinsurance risk allocations in more traditional portfolios. Lastly, in Part 3 we review ways in which institutions can gain access to reinsurance risks and discuss their associated liquidity characteristics. We also discuss best practices in managing portfolios of such risks, including sourcing, pricing, underwriting, portfolio risk management, and optimal portfolio construction.

  • This paper provides an introduction to a risk parity strategy, which is an asset allocation strategy that seeks to diversify portfolios by risk, rather than by capital. This paper describes a Simple Risk Parity Strategy and illustrates its consistent outperformance over a traditional portfolio over nearly 40 years of historical data.

    The outperformance of Risk Parity strategies during the recent credit crisis has confirmed the benefits of a truly diversified portfolio. Traditional diversification focuses on dollar allocation; but because equities have disproportionate risk, a traditional portfolio’s overall risk is often dominated by its equity portion. Risk Parity diversification focuses on risk allocation. We find that by making significant investments in non-equity asset classes, investors can achieve true diversification – and expect more consistent performance across the spectrum of potential economic environments. First, the paper highlights the concentration risk embedded in traditional portfolios, and explains the intuition behind Risk Parity. Next, we describe a Simple Risk Parity Strategy and demonstrate its consistent outperformance over nearly 40 years of historical data. Finally, we delve into the more advanced portfolio construction and risk management techniques used to implement actual Risk Parity portfolios.

  • How institutional investors can use derivatives and leverage to increase returns, improve diversification and reduce risk.

    We are about to defend, and in some cases praise, the use of leverage and derivatives in managing a pension plan. Although that may seem like a fool’s errand given the devastating financial crisis we have just lived through, we do realize that we are not in the Kansas of 2006 anymore. In fact, let’s paraphrase some inspiring comments that have become commonplace in recent times: • Derivatives are financial weapons of mass destruction. • There has been no valuable financial innovation for decades. • Short-selling is un-American. • Excessive leverage caused all our problems. There is, of course, some truth behind these quotes. But there is also much more exaggeration and overreaction behind them. Leverage and derivatives are financial tools that have many legitimate and helpful applications. Like any tool, they can be used for good or for bad. A few years ago, as would be likely before any crisis, many of us were undervigilant to their dangers. Today, as should be expected after a crisis, the conventional wisdom is overvigilant, stifling many of their benefits.

  • An investor willing to bear the risk of 100% equities can do even better with a diversified portfolio.

    A diversified portfolio historically delivers more return, while not increasing risk (measuring risk along several dimensions). This is shown most clearly when an investor is willing to lever, although even without leverage, 100% equities would rarely be optimal. Furthermore, regardless of which portfolio is ultimately chosen, this article argues that choosing how much risk to bear, and constructing a set of portfolios with the most expected return for a given amount of risk, are separate tasks. Choosing a portfolio of 100% equities based on their historical realized return misses this separation.

  • How unpredictable changes in liquidity affect security returns, developing a novel liquidity-adjusted CAPM.

    This paper solves explicitly a simple equilibrium model with liquidity risk. In our liquidity adjusted capital asset pricing model, a security’s required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with the market return and liquidity. In addition, a persistent negative shock to a security’s liquidity results in low contemporaneous returns and high predicted future returns. The model provides a unified framework for understanding the various channels through which liquidity risk may affect asset prices. Our empirical results shed light on the total and relative economic significance of these channels and provide evidence of flight to liquidity.

  • Traditional approaches to international investing can lead to taking unintended risks. This paper examines these risks and outlines best practices in international equity investing.

    The diversification benefit of investing internationally has led to a significant shift in assets from domestic to global portfolios over time. However, investing internationally involves taking on risks that are not present when investing domestically. The academic literature has extensively analyzed the relative importance of stock-specific risk, sector risk, and country risk for global stocks. Specifically, it is well documented that country risk is an important driver of individual stock returns, especially in emerging markets. In contrast, the literature has devoted less attention to the impact of country membership on actively managed stock portfolios. For instance, it is an open question whether ignoring country membership can yield negative side effects in portfolio construction. We address this question by showing that failing to explicitly control for country membership can lead to significant misallocation of risk. In particular, country bets can dominate a portfolio that aims to represent skill in selecting individual stocks. Worse, the country bets can be completely unrelated to the underlying investment signals and can thereby potentially reduce risk-adjusted returns.

  • A model of leverage and margin constraints helps explain why low-beta assets offer higher risk-adjusted returns than high-beta assets.

    We present a model with leverage and margin constraints that vary across investors and time. We find evidence consistent with each of the model’s five central predictions: (1) Since constrained investors bid up high-beta assets, high beta is associated with low alpha, as we find empirically for U.S. equities, 20 international equity markets, Treasury bonds, corporate bonds, and futures; (2) A betting-against-beta (BAB) factor, which is long leveraged low-beta assets and short high-beta assets, produces significant positive risk-adjusted returns; (3) When funding constraints tighten, the return of the BAB factor is low; (4) Increased funding liquidity risk compresses betas toward one; (5) More constrained investors hold riskier assets.

  • An investigation of the stories that encourage the purchase or retention of stocks or mutual funds.

    A bull market, and the incentives of those who make their living from bull markets, can create its own form of logic. This book explores some of the stories that encourage the purchase or retention of stocks or mutual funds and the logic behind these stories. Some of these stories are honest attempts to explain new phenomenon, and may or may not prove true going forward. Some seem to be unintended falsehoods that come from an incomplete or lazy application of economic reasoning. Finally, some seem less well intended. The stories, and the logical analyses behind them, generally originate with Wall Street (both sell side and buy side), sometimes riding the coattails of academia, and are often readily absorbed by investors engaged in wishful thinking. Such wishful thinking has led to a stock market, and the growth/tech sector of the market in particular, that is priced so expensively that even very long-term investors will probably end up disappointed, perhaps greatly so.

  • In this study, we seek to improve the understanding of what makes a stock a "Buffett stock," the drivers of Berkshire's performance, and how a diversified Buffett-styled portfolio would have performed over the past 30 years.

    Berkshire Hathaway has a higher Sharpe ratio than any stock or mutual fund with a history of more than 30 years and Berkshire has a significant alpha to traditional risk factors. However, we find that the alpha become statistically insignificant when controlling for exposures to Betting-Against-Beta and quality factors. We estimate that Berkshire’s average leverage is about 1.6-to-1 and that it relies on unusually low-cost and stable sources of financing. Berkshire’s returns can thus largely be explained by the use of leverage combined with a focus on cheap, safe, quality stocks. We find that Berkshire’s portfolio of publicly-traded stocks outperform private companies, suggesting that Buffett’s returns are more due to stock selection than to a direct effect on management.

  • Thoughts on the proper allocation to emerging market equities, evidence for active vs passive management and inflation hedging potential.

    Over the past decade, emerging market equities have become a meaningful portion of global equity markets. In 2003, emerging equities accounted for just 4% of global equity market capitalization as measured by the MSCI ACWI index. Today that figure is close to 13%. Many US institutions hold much less than 13% either due to a benchmark choice that explicitly allocates less (if anything) to emerging markets or due to an active bet relative to the benchmark. At the end of 2009, US pension plans on average allocated between 3-8% of their capital to emerging markets, while many had no exposure whatsoever. However, an increase in manager search activity suggests that pension plans are either increasing exposure to emerging markets or rotating their emerging markets managers. Research group EPFR reported that emerging equity fund inflows reached $80.3 billion in 2009 – the largest inflow in the asset class since the company began tracking this data in 1997. For investors evaluating their exposure, three meaningful topics to weigh are: I. How to approach risk budgeting and asset allocation in light of the global equity markets’ changing composition II. The pros and cons of various investment styles III. How inflation impacts emerging equities This paper provides insight into these questions. Part I addresses asset allocation and portfolio risk. Part II analyzes fundamental and quantitative emerging market active managers. This section presents evidence that there are meaningful gains to holding a diversified portfolio of both fundamental and quantitative emerging equities managers. Lastly, Part III outlines the potential benefits to holding emerging equities in periods of rising inflation.

  • This paper contradicts the view held by many that a low dividend payout ratio is a sign that future earnings growth will be above historical averages.

    Many market observers point to the very high fraction of earnings retained (or low dividend payout ratio) among companies today as a sign that future earnings growth will be well above historical norms. This view is sometimes interpreted as an extension of the work of Miller and Modigliani. They proved that, given certain assumptions about market efficiency, dividend policy should not matter to the value of a firm. Extending this concept intertemporally, and to the market as a whole, as many do, whenever market-wide dividend payout ratios are low, higher reinvestment of earnings should lead to faster future aggregate growth. However, in the real world, many complications exist that could confound the expected inverse relationship between current payouts and future earnings growth. For instance, dividends might signals managers' private information about future earnings prospects, with low payout ratios indicating fear that the current earnings may not be sustainable. Alternatively, earnings might be retained for the purpose of "empire-building," which itself can negatively impact future earnings growth. We test whether dividend policy, as we observe in the payout ratio of the market portfolio, forecasts future aggregate earnings growth. This is, in a sense, one test of whether dividend policy "matters." The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low. This relationship is not subsumed by other factors such as simple mean reversion in earnings. Our evidence contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is fully consistent with anecdotal tales about managers signaling their earnings expectations through dividends, or engaging in inefficient empire building, at times; either of these phenomena will conform with a positive link between payout ratios and subsequent earnings growth. Our findings offer a challenge to optimistic market observers who see recent low dividend payouts as a sign of high future earnings growth to come. These observers may prove to be correct, but history provides scant support for their thesis. This challenge is potentially all the more serious, as recent stock prices, relative to earnings, dividends and book values, rely heavily upon this expectation of superior future real earnings growth.

  • This paper explorers the link between future stock returns and key financial ratios, both analytically and empirically. More specifically, the paper analyzes how shocks to operating/financing measures, like net income margin, asset turnover efficiency and financial leverage through Du Pont decomposition, would affect stocks returns and volatility.

    This paper investigates the dynamic relation between stock returns and key financial ratios, both analytically and empirically. Ratio analysis has been a traditional topic in financial statement analysis literature for academia and practitioners. Within these lines of research, there are many papers or publications that try to link stock returns or accounting earnings with underlying financial ratios, which is a fundamental objective of financial statement analysis. But there have been relatively few papers to propose an explicit analytical link between the stock returns and financial ratios. This paper tries to analytically establish a dynamic relation between unexpected stock returns and key financial ratios – asset turnover and financial leverage – then uses a methodology, which is called variance decomposition, proposed by Campbell (1991) to empirically implement the proposed model.

  • Tax implications for value, growth and momentum investors.

    We examine the tax efficiency and after-tax performance of long only equity styles. On an after-tax basis, value and momentum portfolios outperform, and growth underperforms, the market. We find that momentum, despite its higher turnover, is often more tax efficient than value, because it generates substantial short-term losses and lower dividend income. Tax optimization improves the returns to all equity styles, with the biggest improvements accruing to value and momentum styles. However, only momentum allows significant tax minimization without incurring significant style drift. This is because managing gain and loss realization incurs less tracking error than avoiding dividend income and momentum's tax exposure is primarily capital gains, while value and growth's tax exposures are more sensitive to dividends. The effect of taxes across equity styles are magnified within a broader asset allocation framework and in down markets.

  • Despite correlations rising in a crisis, international diversification protects investors over the medium to long term.

    Critics of international diversification observe that it does not protect investors against short-term market crashes because markets become more correlated during downturns. Although true, this observation misses the big picture. Over longer horizons, underlying economic growth matters more than short-lived panics with respect to returns, and international diversification does an excellent job of protecting investors.

  • This paper looks into the relationship between the number of Dow Jones news articles and market activity such as returns and volatility.

    We study the relation between the number of news announcements reported daily by Dow Jones & Company and aggregate measures of securities market activity including trading volume and market returns. We find that the number of Dow-Jones announcements and market activity are directly related and that the results are robust to the addition of factors previously found to influence financial markets such as day-of-the-week dummy variables, news importance as proxied by large New York Times headlines and major macroeconomic announcements, and noninformation sources of market activity as measured by dividend capture and triple witching trading. However, the observed relation between news and market activity is not particularly strong and the patterns in news announcements do not explain the day-of-the-week seasonalities in market activity. Our analysis of the Dow Jones database confirms the difficulty of linking volume and volatility to observed measures of information.

  • Momentum appears to deliver positive returns across country equity markets, except for in Japan. However, by analyzing momentum and value as a system, this paper finds that momentum works well in Japan, and may add value to equity strategies.

    Momentum strategies deliver positive profits in a variety of market and asset classes with one glaring exception - Japan. The failure of momentum in Japan has led some to call into question momentum’s viability, suggesting that perhaps momentum’s success elsewhere may be the result of data mining. We reject that interpretation. We argue that because value and momentum strategies are strongly negatively correlated, they need to be studied as a system. We show that the results in Japan are perfectly consistent with value and momentum working everywhere at similar levels and are entirely within the range of statistical noise. Viewed as a system, we show momentum strategies are actually a success in Japan. In sum, we find the Japanese momentum results supportive, not contrary, to the idea that momentum is a strong ex ante efficacious strategy around the world. Put differently, the Japanese momentum results are the exception that proves the rule.

  • This paper looks at over 4000 mergers from 1973-1998 and looks at if mergers create value for the stockholders of the combined firms, with the stockholders of the target accruing the majority of it.

    Empirical research on mergers and acquisitions has revealed a great deal about their trends and characteristics over the last century. For example, a profusion of event studies has demonstrated that mergers seem to create shareholder value, with most of the gains accruing to the target company. This paper will provide further evidence on these questions, updating our database of facts for the 1990s.

  • Tools that work for security selection (book-to-market ratio, market equity and one year momentum) also work for country selection.

    Book-to-market ratio (BE/ME), market equity (ME), and one- year past return (momentum) (MOM) help explain the cross- section of expected individual stock returns within the U.S. and within other countries. Examining equity markets as a whole, in contrast to individual stocks, we uncover strong parallels between the explanatory power of these variables for individual stocks and for countries. First, country versions of BE/ME, ME, and MOM help explain the cross-section of expected country returns. Second, the January seasonal in ME's explanatory power for stocks also appears for countries. Third, portfolios formed by sorting stocks and countries on these variables produce similar patterns in profitability before and after the portfolio formation date.

  • An examination of how political risk influences returns in emerging vs. developed markets.

    Political risk represents a more important determinant of stock returns in emerging than in developed markets. Using analyst estimates of political risk, we show that average returns in emerging markets experiencing decreased political risk exceed those of emerging markets experiencing increased political risk by approximately 11 percent a quarter. In contrast, the difference is only 2.5 percent a quarter for developed markets. Furthermore, the difference between the impact of political risk in emerging and developed markets is statistically significant. We also document a global convergence in political risk. During the past 10 years, political risk has decreased in emerging markets and increased in developed markets. If this trend continues, the differential impact of political risk on returns in emerging and developed markets may narrow.

  • This paper looks at within-industry variables and across-industry variables to better predict firms' stock returns.

    Better proxies for the information about future returns contained in firm characteristics such as size, book-to-market equity, cash flow-to-price, percent change in employees, and various past return measures are obtained by breaking these explanatory variables into two industry-related components. The components represent (1) the difference between firms' own characteristics and the average characteristics of their industries (within-industry variables), and (2) the average characteristics of firms' industries (across-industry variables). Each variable is reliably priced within-industry and measuring the variables within-industry produces more precise estimates than measuring the variables in their more common form. Contrary to Moskowitz and Grinblatt [1999], we find that within-industry momentum (i.e., the firm's past return less the industry average return) has predictive power for the firm's stock return beyond that captured by across-industry momentum. We also document a significant short-term (one-month) industry momentum effect which remains strongly significant when we restrict the sample to only the most liquid firms.

  • A discussion of the challenges in predicting equity market returns and Cliff's 10-year forecast.

    In 2001, and again in 2011, I participated in a forum about the equity risk premium. Presented here are some informal thoughts about the equity premium that I composed after the second forum. These thoughts are an eclectic collection inspired by, but not limited to, what we discussed together.

  • A review of investing principles that were ignored in the tech bubble and that may still have been forgotten in the bust.

    The Financial Analysts Journal's 60th anniversary happens to coincide with the five-year anniversary of the peak of the Great Stock Market Bubble of 1999–2000. The combination of proximity in time, with just a bit of distance, makes this year an appropriate time to consider what we may have learned from this momentous event. This article suggests lessons that, if we haven't learned them, we should have.

  • Short sellers search for stock owners and pay a lending fee. The lending fee increases the stock's price.

    We present a model of asset valuation in which short-selling requires searching for security lenders and bargaining over the lending fee. If lendable securities are difficult to locate, then the price of the security is initially elevated, and expected to decline. This price decline is to be anticipated, for example, after an initial public offering, and is increasing in the degree of heterogeneity of beliefs about the future value of the security. The prospect of lending fees may push the initial price of a security above even the most optimistic buyer’s valuation of the security’s future dividends. A higher price can thus be obtained with some shorting than if shorting is disallowed.

  • There are legitimate arguments and difficult issues related to how to expense stock options. Still, stock options should be expensed.

    The debate about whether stock options should be expensed at the time they are issued is really no debate at all. Although legitimate issues exist about how to carry out this endeavor (what model to use, what time period to expense them over, how and when to tax them), there is simply no strong argument against expensing ? and very powerful arguments in its favor. This article reviews many of the arguments against expensing and the slam-dunk case for it. A great many attacks on expensing have been undertaken, but they systematically fall short of the mark, with some of them intellectually dishonest to a degree not normally observed in dialogue among serious people.

  • This paper argues that the difference between stock yields and bond yields is affected by the long-run difference in volatility between stocks and bonds.

    From the 19th century through the mid-20th century, the dividend yield (dividends/price) and earnings yield (earnings/price) on stocks generally exceeded the yield on long-term U.S. government bonds, usually by a substantial margin. Since the mid-20th century, however, the situation has radically changed. In addressing this situation, I argue that the difference between stock yields and bond yields is driven by the long-run difference in volatility between stocks and bonds. This model fits 1871–1998 data extremely well. Moreover, it explains the currently low stock market dividend and earnings yields. Many authors have found that although both stock yields forecast stock returns, they generally have more forecasting power for long horizons. I found, using data up to May 1998, that the portion of dividend and earnings yields explained by the model presented here has predictive power only over the long term whereas the portion not explained by the model has power largely over the short term.

  • This article explores the use value spread and earnings growth spread to forecast the returns to value vs growth.

    A large body of both academic and industry research supports the efficacy of value strategies for choosing individual stocks. Yet value strategies are far from riskless; they can produce long periods of poor performance. In an effort to improve upon value strategies, researchers have tried to forecast these returns, with mixed results. We propose a different approach considering two simple and intuitive variables: 1) the spread in valuation multiples between a value portfolio and a growth portfolio (the value spread); and 2) the spread in expected earnings growth between a growth portfolio and a value portfolio (the earnings growth spread).

  • Unlike optimistic new-paradigm advocates, we find low payout ratios historically precede low earnings growth.

    We investigate whether dividend policy, as observed in the payout ratio of the U.S. equity market portfolio, forecasts future aggregate earnings growth. The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low. This relationship is not subsumed by other factors, such as simple mean reversion in earnings. Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is consistent with anecdotal tales about managers signaling their earnings expectations through dividends or engaging, at times, in inefficient empire building. Our findings offer a challenge to market observers who see the low dividend payouts of recent times as a sign of strong future earnings to come.

  • This paper presents an overview of AQR’s tax-aware research with particular application for Australian taxed investors investing in global equity portfolios though the framework has broader application.

    This paper presents an overview of AQR’s tax-aware research which has resulted in an enhancement to the efficiency of AQR’s existing long-only global equity strategy. In the interest of brevity, this paper does not attempt to describe AQR’s complete investment process, rather it overviews a marginal input which may improve the return profile for Australian-taxed investors. The maximization of pre-tax returns over an investment cycle is and will remain the primary objective of AQR’s active global equity strategy. Potential implementation costs, such as brokerage, trading impact and taxation implications are considered within the broader process to ensure such factors do not inadvertently undermine the forecast return profile of the active investment strategy. Taxawareness will neither change AQR’s views on the return prospects of securities within the strategy’s investment universe, nor will it alter the risk profile of the strategy. All statements made in this paper should be read with this context in mind.

  • A new methodology for calculating the Book-to-Price ratio produces value portfolios with better returns than standard Fama-French HML portfolio.

    This paper challenges the standard method for measuring “value” used in academic work on factor pricing and behavioral finance. The standard method calculates book-to-price (B/P) at portfolio formation using lagged book data, aligns price data using the same lag (ignoring recent price movements), and holds these values constant until the next rebalance. We propose two simple alternatives that use more timely price data while retaining the necessary lag for measuring book. We construct portfolios based on the different measures for a US sample (1950-2011) and an International sample (1983-2011). We show that B/P ratios based on more timely prices better forecast true (unobservable) B/P ratios at fiscal year end. Value portfolios based on the most timely measures earn statistically significant alphas ranging between 305 and 378 basis point per year against a 5-factor model itself containing the standard measure of value, as well as market, size, momentum and a short term reversal factor.

  • This paper looks at the earnings announcement premiums and shows that stocks with the largest predicted volume increases in previous announcement months tend to have higher subsequent premia.

    On average, stock prices rise around scheduled earnings announcement dates. We show that this earnings announcement premium is large, robust, and strongly related to the fact that volume surges around announcement dates. Stocks with high past announcement period volume earn the highest announcement premium, suggesting some common underlying cause for both volume and the premium. We show that high premium stocks experience the highest levels of imputed small investor buying, suggesting that the premium is driven by buying by small investors when the announcement catches their attention.

  • An investigation into value and momentum, specifically whether the strategies are independent or related.

    Researchers have demonstrated convincingly that both "value" and "momentum" strategies have power to predict the cross-section of stock returns. This paper examines whether these strategies are independent or related. Measures of momentum and value are negatively correlated across stocks, yet each is univariately positively related to the cross-section of average stock returns. We examine whether the marginal power of value or momentum differs depending upon the level of the other variable. Value strategies work in general, but are strongest among low momentum (loser) stocks and weakest among high momentum (winner) stocks. The momentum strategy works in general, but is particularly strong among low value (expensive) stocks. We uncover these results despite finding comparable spreads in our value measures among stocks with different levels of momentum, and comparable spread in our momentum measure among stocks with different levels of value. Any explanation for why value and momentum work must also explain the interaction we document.

  • The role of shorting, firm size, and time on the profitability of size, value, and momentum strategies.

    We examine the role of shorting, firm size, and time on the profitability of size, value, and momentum strategies. We find that long positions comprise the bulk of the returns to size, slightly more than half of value, and half of momentum. Shorting becomes less important for momentum and more important for value as firm size decreases. The value premium decreases with firm size and is negligible among the largest stocks. Momentum profits, contrary to claims in the literature, are unaffected by firm size. These effects are robust over 83 years of U.S. equity data and over 30 years of data in four international equity markets and five asset classes. Variation over time and across markets of these effects is consistent with random chance.

  • Fundamental Indexing is less of a revolution in investing and more of a repackaging of a long-established discipline of value tilting.

    There is an interesting and sometimes heated debate under way about the merits of traditional capitalization-weighted indexing versus so-called Fundamentally WeightedTM indexes. Robert Arnott, chairman of Research Affiliates, a Pasadena, California–based investment management firm, and finance professor Jeremy Siegel of the Wharton School of the University of Pennsylvania have led the charge for Fundamental Indexing. Vanguard Group founder Jack Bogle and Princeton University economics professor Burton Malkiel have been the chief defenders of traditional indexing. I write this piece as one stuck in the middle. On the one hand, Bogle and Malkiel are right: If we use a strict definition of the word “index,” the only indexes that truly make sense are cap-weighted. On the other hand, I am not a pure index fund investor. Instead, I try to outperform indexes by making active bets — and the bets I favor are in the direction of Arnott and Siegel.

  • Antti Ilmanen estimates the equity risk premium over the coming decade, summarizing ongoing debates over the "building blocks" to his forecast.

    What is considered to be the best source of information about the future equity risk premium has shifted from historical average returns to forward-looking valuation indicators. Thus, the dividend discount model provides a useful framework for decomposing and debating the values of key components of future premiums. From this analysis, the ERP may stay unchanged from the current 3 percent.

  • The rationale, economic intuition, and evidence for a defensive approach to equity investing, and potential roles for portfolios.

    The outperformance of simulated defensive equity portfolios during the global credit crisis and during the recent turmoil in European financial markets has highlighted the potential benefit of avoiding concentrating risks in securities with the highest sensitivity to market fluctuations.1 By over-weighting safer securities and under-weighting risky ones, defensive equity strives to reduce sensitivity to market movements – seeking long-term benchmark-like returns with lower volatility. This paper analyzes the intuition behind defensive equity. We review the empirical evidence, analyze construction and performance of defensive equity portfolios, and discuss the possible explanations for its outperformance. Finally, we discuss the role defensive equities can play in investors’ overall portfolios.

  • Value and Momentum effects appear across global markets in equities, commodities, and bonds. We find that value (momentum) in one asset class is positively correlated with value (momentum) in other asset classes, and value and momentum are negatively correlated within and across asset classes.

    Value and momentum ubiquitously generate abnormal returns for individual stocks within several countries, across country equity indices, government bonds, currencies, and commodities. We study jointly the global returns to value and momentum and explore their common factor structure. We find that value (momentum) in one asset class is positively correlated with value (momentum) in other asset classes, and value and momentum are negatively correlated within and across asset classes. Liquidity risk is positively related to value and negatively to momentum, and its importance increases over time, particularly following the liquidity crisis of 1998. These patterns emerge from the power of examining value and momentum everywhere simultaneously and are not easily detectable when examining each asset class in isolation.

  • An investor willing to bear the risk of 100% equities can do even better with a diversified portfolio.

    A diversified portfolio historically delivers more return, while not increasing risk (measuring risk along several dimensions). This is shown most clearly when an investor is willing to lever, although even without leverage, 100% equities would rarely be optimal. Furthermore, regardless of which portfolio is ultimately chosen, this article argues that choosing how much risk to bear, and constructing a set of portfolios with the most expected return for a given amount of risk, are separate tasks. Choosing a portfolio of 100% equities based on their historical realized return misses this separation.

  • We seek to establish whether the strong performance of trend-following is a statistical fluke of the last few decades or a more robust phenomenon that exists over a wide range of economic conditions.

    We study the performance of trend-following investing across global markets since 1903, extending the existing evidence by more than 80 years. We fi nd that trend-following has delivered strong positive returns and realized a low correlation to traditional asset classes each decade for more than a century. We analyze trend-following returns through various economic environments and highlight the diversifi cation benefi ts the strategy has historically provided in equity bear markets. \Finally, we evaluate the recent environment for the strategy in the context of these long-term results.

  • An exploration of the role of hedge funds, their growth and returns. (Part I of II)

    One of the main financial market stories of the last three to five years has been the explosive growth of hedge funds. Depending on whom you ask, hedge funds are either the wave of the future, or they are a dangerous fad that has been grossly overcapitalized and all will end in ruin. Both sentiments contain elements of truth. The good news for hedge funds is that a portfolio structure that divides capital between traditional index funds to obtain beta (or market exposure) and hedge funds to earn alpha is very appealing. Traditional active management attempts to add alpha by adjusting index holdings in an arbitrary, confusing, and constraining manner.1 It can be viewed as a tie-in sale between an index fund and a very constrained hedge fund. Hedge funds allow for a much clearer separation of the unrelated activities of obtaining index exposure and generating alpha, thus leading to clean portfolio construction, performance attribution, and fee breakdowns. Furthermore, sources of alpha and techniques unavailable in traditional mandates are available in this format. To fulfill their promise, hedge funds need to recognize and improve on shortcomings. A companion piece to this article explores hedge fund fees in more depth, examines various dark sides to hedge fund investing, and recommends future evolutionary changes needed to help hedge funds achieve their potential (see Asness [2004]). Given my generally pro-hedge fund slant here, some fair disclosure is in order. I am a hedge fund manager.

  • Harvard Business School case study: the AQR DELTA strategy, how it captures classic hedge fund strategy returns, and how it compares to the hedge fund industry.

    In the summer of 2008, AQR Capital Management was considering the launch of a new hedge fund strategy. The proposed DELTA portfolio would offer investors exposure to a basket of nine major hedge fund strategies. The DELTA strategy would be innovative in two ways. First, in terms of its structure, AQR would implement these underlying strategies using a well-defined investment process, with the goal being to deliver exposure to a well-diversified portfolio of hedge fund strategies. Second, in terms of its fees, the new DELTA strategy would charge investors relatively lower fees: 1 percent management fees plus 10 percent of performance over a cash hurdle (or, alternatively, a management fee of 2 percent only). This fee shedule was low relative to the industry, where 2 percent management fees plus 20 percent of performance, often with no hurdle, was standard.

  • Harvard Business School case study: AQR's DELTA strategy, its performance and tactical tilts.

    In the summer of 2008, AQR Capital Management was considering the launch of a new hedge fund strategy. The proposed DELTA portfolio would offer investors exposure to a basket of nine major hedge fund strategies. The DELTA strategy would be innovative in two ways. First, in terms of its structure, AQR would implement these underlying strategies using a well-defined investment process, with the goal being to deliver exposure to a well-diversified portfolio of hedge fund strategies. Second, in terms of its fees, the new DELTA strategy would charge investors relatively lower fees: 1 percent management fees plus 10 percent of performance over a cash hurdle (or, alternatively, a management fee of 2 percent only). This fee shedule was low relative to the industry, where 2 percent management fees plus 20 percent of performance, often with no hurdle, was standard.

  • This paper documents that arbitrageurs were unable to maintain similar prices of similar assets when prime brokers failed to provide leverage during the 2008 financial crisis.

    The imminent failure of large Wall Street prime brokerage firms during the 2008 financial crisis caused a sudden and dramatic decrease in the amount of financial leverage afforded hedge funds. This decrease in financing resulted from the ex post asymmetrical payoff to rehypothecation lenders – the ultimate providers of financing, through prime brokers, to hedge funds. Seemingly long-term debt capital became short-term capital creating a large mismatch in the duration of arbitrage opportunities on the left-hand side of arbitrageurs’ balance sheet and liabilities on the right-hand side. A primary consequence of this withdrawal of financing was the inability of hedge funds involved in relative-value trades to maintain prices of substantially similar assets at substantially similar prices. The magnitudes of these mispricings, and the time required to correct them, provide an indication of the role played by arbitrageurs in maintaining rational prices during normal times.

  • An explanation of major arbitrage strategies, and their potential roles in a diversified portfolio.

    Arbitrage strategies use relative value trades to generate excess returns with attractive risk profiles. Their low betas with respect to traditional asset classes make arbitrage strategies particularly effective components of a diversified portfolio. This paper offers a brief introduction to arbitrage, including descriptions of several common strategies and an overview of their historical performance.

  • A model of leverage and margin constraints helps explain why low-beta assets offer higher risk-adjusted returns than high-beta assets.

    We present a model with leverage and margin constraints that vary across investors and time. We find evidence consistent with each of the model’s five central predictions: (1) Since constrained investors bid up high-beta assets, high beta is associated with low alpha, as we find empirically for U.S. equities, 20 international equity markets, Treasury bonds, corporate bonds, and futures; (2) A betting-against-beta (BAB) factor, which is long leveraged low-beta assets and short high-beta assets, produces significant positive risk-adjusted returns; (3) When funding constraints tighten, the return of the BAB factor is low; (4) Increased funding liquidity risk compresses betas toward one; (5) More constrained investors hold riskier assets.

  • Characteristics investors should look for when selecting liquid alternative strategies and how to build a broadly diversified alternatives portfolio.

    Once available only to institutional investors, alternative strategies are becoming widely accessible in a mutual fund format. Financial advisors are increasingly recommending alternatives as a way to deliver better portfolios to their clients. However, the rules for investing in alternatives are less well-known than for their traditional counterparts. What are the criteria for choosing an alternative investment? How many should be included in a portfolio? How do you allocate strategically, and when do you change that allocation? And what are the practical challenges for implementation? This paper presents AQR’s thinking on these parameters. We end with the case for multi-strategy alternative funds, which we believe should be at the core of an alternatives allocation.

  • How the carry trade is subject to crash risk during funding liquidity crisis. Results help resolve the “forward premium puzzle”.

    This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between high-interest-rate and low-interest-rate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which risk appetite and funding liquidity decrease. Funding liquidity measures predict exchange rate movements, and controlling for liquidity helps explain the uncovered interest-rate puzzle. Carry-trade losses reduce future crash risk, but increase the price of crash risk. We also document excess co-movement among currencies with similar interest rate. Our findings are consistent with a model in which carry traders are subject to funding liquidity constraints.

  • Five alternatives to traditional tail-risk hedging. Unlike purchasing portfolio insurance, these strategies may enhance portfolio efficiency and long-term expected returns.

    In the wake of 2008, investors are now painfully aware of tail risk – the risk of unexpectedly large losses. Today many institutional investors are insuring against tail risk directly, often by purchasing puts or structuring collars. Unfortunately, experience and financial theory suggest that the long-term cost of such insurance strategies will be larger than the payouts. No surprise, really. The expected return for perpetual insurance buyers is negative, and conversely positive for insurance sellers (see: the entire insurance industry). Arguably, relatively risk-tolerant investors should be selling tail-risk insurance rather than buying it. Our recommendation, if reducing tail risk is deemed necessary, is to approach tail risk fundamentally, primarily by modifying the portfolio structure itself and by addressing risk management policy. This paper considers fi ve approaches, which we think are most effective when used in combination: 1. Diversify by risk, not just by assets 2. Actively manage volatility 3. Embrace uncorrelated alternatives 4. Take advantage of low-beta equities 5. Have a crisis plan before you need one We think these approaches lead to better constructed portfolios for all investors, not just those concerned with tail risk. For investors who are unable to pursue these approaches, we think the best way to reduce tail risk is to reduce total market exposure rather than to buy insurance.

  • How end user demand affects option pricing when dealers cannot perfectly hedge. New theory and unique data.

    We model demand-pressure effects on option prices. The model shows that demand pressure in one option contract increases its price by an amount proportional to the variance of the unhedgeable part of the option. Similarly, the demand pressure increases the price of any other option by an amount proportional to the covariance of the unhedgeable parts of the two options. Empirically, we identify aggregate positions of dealers and end-users using a unique dataset, and show that demand-pressure effects make a contribution to wellknown option-pricing puzzles. Indeed, time-series tests show that demand helps explain the overall expensiveness and skew patterns of index options, and cross-sectional tests show that demand impacts the expensiveness of single-stock options as well.

  • Many hedge funds contain substantially more market risk than you might think.

    In addition to attractive returns, many hedge funds claim to provide significant diversification for traditional portfolios. This paper empirically examines the return and diversification benefits of hedge fund investing using the CSFB/Tremont hedge fund indices from 1994-2000. We, like many others, find that simple regressions of monthly hedge fund excess returns on monthly S&P 500 excess returns seem to support the claims. The regressions show only modest market exposure and positive added value. However, this type of analysis can produce misleading results. Many hedge funds hold, to various degrees and combinations, illiquid exchange-traded securities or difficult-to-price over-the-counter securities. For the purposes of monthly reporting, hedge funds often price these securities using either last available traded prices or estimates of current market prices. These practices can lead to reported monthly hedge fund returns that are not perfectly synchronous with monthly S&P 500 returns due to the presence of either stale or "managed" prices. Non-synchronous return data can lead to understated estimates of actual market exposure. We employ standard techniques that account for this problem and find that hedge funds in the aggregate contain significantly more market exposure than simple estimates indicate. Furthermore, after accounting for this increased market exposure, we find that taken as a whole the broad universe of hedge funds does not add value over this period. With the stock market still near all-time high valuations, investors who view their hedge funds as protection from a market correction should consider this a potentially serious issue.

  • An analysis of the optimal trading strategy that minimizes transaction costs while efficiently exploiting trading signals. A closed-form solution that illuminates the key role of alpha decay.

    This paper derives in closed form the optimal dynamic portfolio policy when trading is costly and security returns are predictable by signals with different mean-reversion speeds. The optimal updated portfolio is a linear combination of the existing port-folio, the optimal portfolio absent trading costs, and the optimal portfolio based on future expected returns and transaction costs. Predictors with slower mean reversion (alpha decay) get more weight since they lead to a favorable positioning both now and in the future. We implement the optimal policy for commodity futures and show that the resulting portfolio has superior returns net of trading costs relative to more naive benchmarks. Finally, we derive natural equilibrium implications, including that demand shocks with faster mean reversion command a higher return premium.

  • Key structural issues - including liquidity, transparancy, and fees - need to be addressed, but the diversification benefits of hedge fund strategies remain compelling.

    Following the many disappointments of 2008, investors are questioning the role of hedge funds in institutional portfolios. Investors spent the better part of the last decade buying investments that were supposed to be uncorrelated, only to see virtually every asset class fall sharply in late 2008 and hopes held out for hedge funds to come to the rescue were left waning. We think that a few key issues are responsible for investors’ disappointment in hedge funds - too little diversification, too much illiquidity - coupled with some structural issues – transparency, leverage and fees – that make it hard for investors to remain enthusiastic. Exuberance took things too far, where investors were swayed by the idea of hedge funds rather than the substance of what they deliver. The good news is that many of these problems can be addressed by the industry, and We believe the investment strategies that result should give hedge fund investors what they wanted in the first place meeting the needs of both investors who have long believed that hedge funds have a role in institutional portfolios and those who have been skeptical.

  • Tax implications for value, growth and momentum investors.

    We examine the tax efficiency and after-tax performance of long only equity styles. On an after-tax basis, value and momentum portfolios outperform, and growth underperforms, the market. We find that momentum, despite its higher turnover, is often more tax efficient than value, because it generates substantial short-term losses and lower dividend income. Tax optimization improves the returns to all equity styles, with the biggest improvements accruing to value and momentum styles. However, only momentum allows significant tax minimization without incurring significant style drift. This is because managing gain and loss realization incurs less tracking error than avoiding dividend income and momentum's tax exposure is primarily capital gains, while value and growth's tax exposures are more sensitive to dividends. The effect of taxes across equity styles are magnified within a broader asset allocation framework and in down markets.

  • Four investment strategies – Value, Momentum, Carry and Defensive – have delivered positive long-term returns with low correlation across a multitude of asset classes, markets, and time periods. We discuss the intuition and evidence for “style investing,” and describe a strategy to capture these premia through liquid securities.

    Investors are bombarded by a variety of investment strategies and alternatives from an evergrowing and increasingly complex financial industry, each claiming to improve returns and reduce risk. Amid the clamor, academic and practitioner research has sifted through the vast landscape and found four intuitive investment strategies that, when applied effectively, have delivered positive long-term returns with low correlation across a multitude of asset classes, markets, and time periods using very liquid securities. These four investment “styles” are Value, Momentum, Carry, and Defensive, which form the core foundation in explaining the cross-section of returns of most asset classes. In this paper, we will describe “style investing,” discuss the intuition and evidence for the four pervasive styles, and detail how to implement a strategy that can access these premia to improve the risk and return characteristics of traditional portfolios. Despite a wealth of academic evidence on style premia, an accessible investment vehicle that delivers a very broad yet consistent set of style returns (at reasonable terms) has not existed. We seek to change that by offering a new fund that provides investors with an intuitive, transparent, and costeffective approach to gain exposure to these pervasive investment styles.

  • What once appeared to be unique "alpha" becomes "beta" as strategies become better-understood. This applies directly to hedge funds.

    Alpha is shrinking, and it’s good news for investors. This idea may seem paradoxical. But alpha is really just the portion of a portfolio’s returns that cannot be explained by exposure to common risk factors (betas). With the emergence of new betas, the unexplained portion (alpha) shrinks – alpha gets reclassified as beta. The rise of a group of risk factors we call hedge fund betas makes this transformation especially relevant today. Hedge fund betas are the common risk exposures shared by hedge fund managers pursuing similar strategies. We believe these risk factors can capture not just the fundamental insights of hedge funds, but also a meaningful portion of their returns. Hedge fund betas are available for investment and can also be used to enhance portfolio construction and risk management. Ultimately, we believe the rise of hedge fund betas will lead not only to the reclassification of alpha, but also to better diversified portfolios with greater transparency, improved risk control, and – perhaps most importantly – higher net returns.

  • This paper looks into the specific situation when the market value of a company is less than its subsidiary.

    We examine 82 situations where the market value of a company is less than its subsidiary. These situations imply arbitrage opportunities, providing an ideal setting to study the risks and market frictions that prevent arbitrageurs from immediately forcing prices to fundamental values. For 30 percent of the sample, the link between the parent and its subsidiary is severed before the relative value discrepancy is corrected. Furthermore, returns to a specialized arbitrageur would be 50 percent larger if the path to convergence was smooth rather than as observed. Uncertainty about the distribution of returns and characteristics of the risks limits arbitrage.

  • This paper looks at over 4000 mergers from 1973-1998 and looks at if mergers create value for the stockholders of the combined firms, with the stockholders of the target accruing the majority of it.

    Empirical research on mergers and acquisitions has revealed a great deal about their trends and characteristics over the last century. For example, a profusion of event studies has demonstrated that mergers seem to create shareholder value, with most of the gains accruing to the target company. This paper will provide further evidence on these questions, updating our database of facts for the 1990s.

  • When a large trader liquidates, “predators” also sell, leading to price over-shooting and systemic risk.

    This paper studies predatory trading, trading that induces and/or exploits the need of other investors to reduce their positions. We show that if one trader needs to sell, others also sell and subsequently buy back the asset. This leads to price overshooting and a reduced liquidation value for the distressed trader. Hence, the market is illiquid when liquidity is most needed. Further, a trader profits from triggering another trader’s crisis, and the crisis can spill over across traders and across markets.

  • This paper finds considerable support for the existence of price pressure around mergers caused by uninformed shifts in excess demand, but that these effects are short-lived, consistent with the notion that short-run demand curves for stocks are not perfectly elastic.

    This paper examines the trading behavior of professional investors around 2,130 mergers announced between 1994 and 2000. We find considerable support for the existence of price pressure around mergers caused by uninformed shifts in excess demand, but that these effects are short-lived, consistent with the notion that short-run demand curves for stocks are not perfectly elastic. We estimate that nearly half of the negative announcement period stock price reaction for acquirers in stock-financed mergers reflects downward price pressure caused by merger arbitrage short selling, suggesting that previous estimates of merger wealth effects are biased downward.

  • Ideas on investment policy, effective governance, and managing risks more efficiently.

    Being an institutional investor is tough, now more than ever. And while there is no "silver bullet" to solve the many challenges investors face, we want to share a few thoughts and ideas in the hope of sparking or sustaining a dialogue with investors.

  • Finds evidence of the disposition effect in equity returns, and its interaction with the momentum effect.

    This paper tests whether the “disposition effect,” that is the tendency of investors to ride losses and realize gains, induces “underreaction” to news, leading to return predictability. I use data on mutual fund holdings to construct a new measure of reference purchasing prices for individual stocks, and I show that post-announcement price drift is most severe whenever capital gains and the news event have the same sign. The magnitude of the drift depends on the capital gains (losses) experienced by the stock holders on the event date. An event-driven strategy based on this effect yields monthly alphas of over 200 basis points.

  • This paper looks at the earnings announcement premiums and shows that stocks with the largest predicted volume increases in previous announcement months tend to have higher subsequent premia.

    On average, stock prices rise around scheduled earnings announcement dates. We show that this earnings announcement premium is large, robust, and strongly related to the fact that volume surges around announcement dates. Stocks with high past announcement period volume earn the highest announcement premium, suggesting some common underlying cause for both volume and the premium. We show that high premium stocks experience the highest levels of imputed small investor buying, suggesting that the premium is driven by buying by small investors when the announcement catches their attention.

  • An investigation into value and momentum, specifically whether the strategies are independent or related.

    Researchers have demonstrated convincingly that both "value" and "momentum" strategies have power to predict the cross-section of stock returns. This paper examines whether these strategies are independent or related. Measures of momentum and value are negatively correlated across stocks, yet each is univariately positively related to the cross-section of average stock returns. We examine whether the marginal power of value or momentum differs depending upon the level of the other variable. Value strategies work in general, but are strongest among low momentum (loser) stocks and weakest among high momentum (winner) stocks. The momentum strategy works in general, but is particularly strong among low value (expensive) stocks. We uncover these results despite finding comparable spreads in our value measures among stocks with different levels of momentum, and comparable spread in our momentum measure among stocks with different levels of value. Any explanation for why value and momentum work must also explain the interaction we document.

  • Financing concerns limit arbitrage in a liquidity crisis, but also offer extraordinary opportunistic returns to potential liquidity providers.

    Like many investment strategies, convertible bond arbitrage suffered abysmal results in late 2008, following the collapse of Lehman Brothers. Because this strategy is closer to the theoretical concept of arbitrage than many, an examination of how convertible arbitrage fared during this volatile period offers a case study of how these strategies can break down in times of crisis, and the opportunities they offer in the aftermath. This chapter is divided into three parts. Part I explains the mechanics of convertible bond arbitrage and some of the unique characteristics of the strategy. Part II reviews the performance of convertible bond arbitrage from the beginning of the credit crisis in 2007 through the middle of 2009. We use a proprietary data set to show the fluctuations in bond “cheapness” and use our experience trading convertible bonds to shed light on investor behavior during this volatile period. Part III assesses the implications for investors. Investors need to recognize the limitations of arbitrage strategies, but at the same time these strategies may offer extraordinary opportunistic returns in periods of crisis.

  • The role of shorting, firm size, and time on the profitability of size, value, and momentum strategies.

    We examine the role of shorting, firm size, and time on the profitability of size, value, and momentum strategies. We find that long positions comprise the bulk of the returns to size, slightly more than half of value, and half of momentum. Shorting becomes less important for momentum and more important for value as firm size decreases. The value premium decreases with firm size and is negligible among the largest stocks. Momentum profits, contrary to claims in the literature, are unaffected by firm size. These effects are robust over 83 years of U.S. equity data and over 30 years of data in four international equity markets and five asset classes. Variation over time and across markets of these effects is consistent with random chance.

  • Value and Momentum effects appear across global markets in equities, commodities, and bonds. We find that value (momentum) in one asset class is positively correlated with value (momentum) in other asset classes, and value and momentum are negatively correlated within and across asset classes.

    Value and momentum ubiquitously generate abnormal returns for individual stocks within several countries, across country equity indices, government bonds, currencies, and commodities. We study jointly the global returns to value and momentum and explore their common factor structure. We find that value (momentum) in one asset class is positively correlated with value (momentum) in other asset classes, and value and momentum are negatively correlated within and across asset classes. Liquidity risk is positively related to value and negatively to momentum, and its importance increases over time, particularly following the liquidity crisis of 1998. These patterns emerge from the power of examining value and momentum everywhere simultaneously and are not easily detectable when examining each asset class in isolation.

  • A review of quantitative investing, performance of quantitative strategies, and outlook.

    For more than a year now, investors have been questioning the efficacy of quantitative investing. Much of their questioning has to do with performance. Many quant strategies have simply failed to deliver on their investment promise over the past few years. The problem, the reasoning goes, is that everybody knows about these strategies, so there are no returns left. It was this very argument that the editors of Institutional Investor recently posed to us, as they asked whether quantitative equity investing has a future.

  • How institutional investors can use derivatives and leverage to increase returns, improve diversification and reduce risk.

    We are about to defend, and in some cases praise, the use of leverage and derivatives in managing a pension plan. Although that may seem like a fool’s errand given the devastating financial crisis we have just lived through, we do realize that we are not in the Kansas of 2006 anymore. In fact, let’s paraphrase some inspiring comments that have become commonplace in recent times: • Derivatives are financial weapons of mass destruction. • There has been no valuable financial innovation for decades. • Short-selling is un-American. • Excessive leverage caused all our problems. There is, of course, some truth behind these quotes. But there is also much more exaggeration and overreaction behind them. Leverage and derivatives are financial tools that have many legitimate and helpful applications. Like any tool, they can be used for good or for bad. A few years ago, as would be likely before any crisis, many of us were undervigilant to their dangers. Today, as should be expected after a crisis, the conventional wisdom is overvigilant, stifling many of their benefits.

  • Investors can make potentially signifi cant improvements in their commodity portfolios by incorporating risk balancing, risk control, and tactical tilts

    Institutional investment in commodities has been rising steadily for the past decade, in large part due to their portfolio diversifi cation properties. The majority of assets invested in commodities are based on first-generation passive indices, the S&P GSCI and the Dow Jones-UBS Commodity Index, which suffer from two problems: over-concentration in volatile sectors such as energies, and a lack of risk management in adverse markets. Rather than relying on these passive indices, investors can potentially build a better commodities portfolio – one that is risk-balanced across sectors and targets a steady level of volatility through time. Investors may also benefi t from employing tactical allocations based on commodity fundamentals, macroeconomic data, and price trends.

  • This market update from the spring of 2011 reviews the choices the European Central Bank must make between maintaining low inflation (which it has traditionally aimed to do) and the effects this would have on economies of peripheral european countries and the banking sector which both were vulnerable.

    Inflation concerns are taking center stage in Europe. • Global inflation risk has been on the rise due to increasing commodity prices and expansionary monetary policy in many of the world’s largest economies. • Since inception, the European Central Bank (ECB) has successfully continued the low inflation policy established by the German Bundesbank. • However, the current state of Europe’s various economies and financial institutions poses a unique challenge to the ECB in its quest to combat Eurozone inflationary pressures. • Given current Eurozone inflation uncertainty, we urge investors to examine their asset allocations in light of changing inflation risks and to consider the potential effects on their overall portfolios. This note elaborates on the challenges facing the ECB and discusses some implications for institutional investors.

  • We outline some of the main issues surrounding the inflation debate, and seek to clarify some of the major misconceptions about inflation and inflation-linked assets.

    While there’s no shortage of topics to analyze as a result of the 2008-2009 global recession, the unprecedented monetary stimulus has justifiably focused investor attention on potential inflation. As an institutional asset manager with strategies incorporating inflation-linked assets, we are frequently asked how best to hedge against inflation. There is undoubtedly a case to be made for higher future inflation; there are also strong arguments for more moderate levels. Our aim in Part I of this series is not to predict, but rather to outline what we believe are the key issues surrounding the inflation debate, and to clarify some misconceptions about inflation and inflation-linked assets. We also offer some analysis which investors may find helpful in deciding how to position a portfolio for various inflationary environments. In a follow-up paper to this series, Part II will discuss the potential rewards and risks of holding various assets in a portfolio during distinct inflation and economic environments.

  • Empirical evidence for inflation-hedging potential of various traditional and real assets, encompassing both rising inflation regimes and inflation surprises.

    Traditional institutional portfolios with risk characteristics similar to a 60/40 stocks/bonds allocation are not well-positioned for unexpected infl ation. Our conclusion is based on the following findings: • Stocks are not effective inflation hedges, particularly in the short- and medium-term • Traditional institutional allocations resemble a “bet” on moderate inflation However, while predicting future inflation is challenging, a risk-based approach to strategic asset allocation may generate more balanced performance across both inflationary and deflationary periods. We also find that: • Tactical hedging against inflation or deflation can be accomplished more effectively with strategies that have a high beta to unexpected changes in inflation • Waiting for a period of high inflation (or inflation uncertainty) to occur may be too late to efficiently hedge against its negative effects Our analysis examines periods of increasing and decreasing inflation but focuses on unexpected changes which lead to revaluations of asset prices. One of the main drawbacks of traditional inflation analyses is the limited number of observations, as well as the absence of data for some assets such as TIPS in stagflation. A benefit of our focus on unexpected inflation is the ability to observe multiple data points of asset performance in both inflationary and deflationary periods (160 inflation surprise periods vs. only 22 inflation regime periods).

  • Implications of QE2 for inflation, TIPS, and institutional investor portfolios.

    An update on the topic of inflation is warranted given the Fed’s announcement of QE2 and the recent auction of 5 year TIPS conducted on October 25th, 2010 that resulted in the fi rst ever negative yield issuance (-0.55%). In this short update to our recent series on inflation , we will address the current outlook for inflation, outline the issues which resulted in the first ever negative yield TIPS issuance, and discuss what the future impact of government actions may be. We conclude with comments on the implication of these events for institutional investors.

  • We seek to establish whether the strong performance of trend-following is a statistical fluke of the last few decades or a more robust phenomenon that exists over a wide range of economic conditions.

    We study the performance of trend-following investing across global markets since 1903, extending the existing evidence by more than 80 years. We fi nd that trend-following has delivered strong positive returns and realized a low correlation to traditional asset classes each decade for more than a century. We analyze trend-following returns through various economic environments and highlight the diversifi cation benefi ts the strategy has historically provided in equity bear markets. \Finally, we evaluate the recent environment for the strategy in the context of these long-term results.

  • Five alternatives to traditional tail-risk hedging. Unlike purchasing portfolio insurance, these strategies may enhance portfolio efficiency and long-term expected returns.

    In the wake of 2008, investors are now painfully aware of tail risk – the risk of unexpectedly large losses. Today many institutional investors are insuring against tail risk directly, often by purchasing puts or structuring collars. Unfortunately, experience and financial theory suggest that the long-term cost of such insurance strategies will be larger than the payouts. No surprise, really. The expected return for perpetual insurance buyers is negative, and conversely positive for insurance sellers (see: the entire insurance industry). Arguably, relatively risk-tolerant investors should be selling tail-risk insurance rather than buying it. Our recommendation, if reducing tail risk is deemed necessary, is to approach tail risk fundamentally, primarily by modifying the portfolio structure itself and by addressing risk management policy. This paper considers fi ve approaches, which we think are most effective when used in combination: 1. Diversify by risk, not just by assets 2. Actively manage volatility 3. Embrace uncorrelated alternatives 4. Take advantage of low-beta equities 5. Have a crisis plan before you need one We think these approaches lead to better constructed portfolios for all investors, not just those concerned with tail risk. For investors who are unable to pursue these approaches, we think the best way to reduce tail risk is to reduce total market exposure rather than to buy insurance.

  • An analysis of the optimal trading strategy that minimizes transaction costs while efficiently exploiting trading signals. A closed-form solution that illuminates the key role of alpha decay.

    This paper derives in closed form the optimal dynamic portfolio policy when trading is costly and security returns are predictable by signals with different mean-reversion speeds. The optimal updated portfolio is a linear combination of the existing port-folio, the optimal portfolio absent trading costs, and the optimal portfolio based on future expected returns and transaction costs. Predictors with slower mean reversion (alpha decay) get more weight since they lead to a favorable positioning both now and in the future. We implement the optimal policy for commodity futures and show that the resulting portfolio has superior returns net of trading costs relative to more naive benchmarks. Finally, we derive natural equilibrium implications, including that demand shocks with faster mean reversion command a higher return premium.

  • This paper documents significant “time series momentum” in equity indices, currencies, commodities and bond futures. We find persistence in returns for 1 to 12 months that partially reverses over longer horizons, consistent with sentiment theories of initial under-reaction and delayed over-reaction.

    We document significant "time series momentum" in equity index, currency, commodity, and bond futures for each of the 58 liquid instruments we consider. We find persistence in returns for 1 to 12 months that partially reverses over longer horizons, consistent with sentiment theories of initial under-reaction and delayed over-reaction. A diversified portfolio of time series momentum strategies across all asset classes delivers substantial abnormal returns with little exposure to standard asset pricing factors, and performs best during extreme markets. We show that the returns to time series momentum are closely linked to the trading activities of speculators and hedgers, where speculators appear to profit from it at the expense of hedgers.

  • This paper provides an introduction to managed futures, an alternative investment strategy that has historically achieved strong performance in both up and down markets and exhibited low correlation to traditional investments. The paper discusses the economic intuition behind the strategy and illustrates how it performs across various market environments.

    “Managed futures” is an alternative investment that has historically achieved strong performance in both up and down markets, exhibiting low correlation to traditional investments. It was one of the few investing styles that performed well in 2008 as most traditional and alternative investments suffered. As a consequence, this little understood strategy has attracted much attention. This paper attempts to de-mystify managed futures. We review the economic intuition, describe how to construct a simple version of this strategy, illustrate how this simple version performs in various market environments, and show how managed futures can be used to enhance the risk-return profiles of traditional portfolios.

  • An analysis of the optimal trading strategy that minimizes transaction costs while efficiently exploiting trading signals. A closed-form solution that illuminates the key role of alpha decay.

    This paper derives in closed form the optimal dynamic portfolio policy when trading is costly and security returns are predictable by signals with different mean-reversion speeds. The optimal updated portfolio is a linear combination of the existing port-folio, the optimal portfolio absent trading costs, and the optimal portfolio based on future expected returns and transaction costs. Predictors with slower mean reversion (alpha decay) get more weight since they lead to a favorable positioning both now and in the future. We implement the optimal policy for commodity futures and show that the resulting portfolio has superior returns net of trading costs relative to more naive benchmarks. Finally, we derive natural equilibrium implications, including that demand shocks with faster mean reversion command a higher return premium.

  • Summary of major risk-based and non-risk-based (behavioral) explanations for price momentum.

    Momentum is a well established empirical fact whose premium is evident in over 83 years of U.S. data, in 20 years of out of sample evidence from its original discovery, in 40 other countries, and in more than a dozen other asset classes. Its presence and robustness are remarkably stable and, along with the size and value premia, these investment styles have become the preeminent empirical regularities studied by academics and practitioners. And, like size and value, there is much debate and little consensus regarding the explanation driving this premium, though there are some compelling theories. In this short note, we summarize briefly the risk-based and non-risk based explanations for momentum. While the jury is still out on which of these explanations better fit the data, we emphasize that similar uncertainty regarding the explanation behind the size and value premium also exists. Much like momentum, stories for the size and value premium range from risk-based to behavioral and there is a healthy debate over which of these theories is most consistent with the facts. These debates are likely to continue for the foreseeable future, but as we discuss below there are many viable candidate theories for their existence—and the truth behind the source of these premia probably contains elements from several explanations.

  • Tax implications for value, growth and momentum investors.

    We examine the tax efficiency and after-tax performance of long only equity styles. On an after-tax basis, value and momentum portfolios outperform, and growth underperforms, the market. We find that momentum, despite its higher turnover, is often more tax efficient than value, because it generates substantial short-term losses and lower dividend income. Tax optimization improves the returns to all equity styles, with the biggest improvements accruing to value and momentum styles. However, only momentum allows significant tax minimization without incurring significant style drift. This is because managing gain and loss realization incurs less tracking error than avoiding dividend income and momentum's tax exposure is primarily capital gains, while value and growth's tax exposures are more sensitive to dividends. The effect of taxes across equity styles are magnified within a broader asset allocation framework and in down markets.

  • Momentum appears to deliver positive returns across country equity markets, except for in Japan. However, by analyzing momentum and value as a system, this paper finds that momentum works well in Japan, and may add value to equity strategies.

    Momentum strategies deliver positive profits in a variety of market and asset classes with one glaring exception - Japan. The failure of momentum in Japan has led some to call into question momentum’s viability, suggesting that perhaps momentum’s success elsewhere may be the result of data mining. We reject that interpretation. We argue that because value and momentum strategies are strongly negatively correlated, they need to be studied as a system. We show that the results in Japan are perfectly consistent with value and momentum working everywhere at similar levels and are entirely within the range of statistical noise. Viewed as a system, we show momentum strategies are actually a success in Japan. In sum, we find the Japanese momentum results supportive, not contrary, to the idea that momentum is a strong ex ante efficacious strategy around the world. Put differently, the Japanese momentum results are the exception that proves the rule.

  • Reviews momentum as an investment style and its potential role in a portfolio.

    Though known to financial academics for many years, momentum is for most investors the "undiscovered style,” a valuable tool in building diversified portfolios with above average returns.

  • An investigation into value and momentum, specifically whether the strategies are independent or related.

    Researchers have demonstrated convincingly that both "value" and "momentum" strategies have power to predict the cross-section of stock returns. This paper examines whether these strategies are independent or related. Measures of momentum and value are negatively correlated across stocks, yet each is univariately positively related to the cross-section of average stock returns. We examine whether the marginal power of value or momentum differs depending upon the level of the other variable. Value strategies work in general, but are strongest among low momentum (loser) stocks and weakest among high momentum (winner) stocks. The momentum strategy works in general, but is particularly strong among low value (expensive) stocks. We uncover these results despite finding comparable spreads in our value measures among stocks with different levels of momentum, and comparable spread in our momentum measure among stocks with different levels of value. Any explanation for why value and momentum work must also explain the interaction we document.

  • The role of shorting, firm size, and time on the profitability of size, value, and momentum strategies.

    We examine the role of shorting, firm size, and time on the profitability of size, value, and momentum strategies. We find that long positions comprise the bulk of the returns to size, slightly more than half of value, and half of momentum. Shorting becomes less important for momentum and more important for value as firm size decreases. The value premium decreases with firm size and is negligible among the largest stocks. Momentum profits, contrary to claims in the literature, are unaffected by firm size. These effects are robust over 83 years of U.S. equity data and over 30 years of data in four international equity markets and five asset classes. Variation over time and across markets of these effects is consistent with random chance.

  • This paper documents significant “time series momentum” in equity indices, currencies, commodities and bond futures. We find persistence in returns for 1 to 12 months that partially reverses over longer horizons, consistent with sentiment theories of initial under-reaction and delayed over-reaction.

    We document significant "time series momentum" in equity index, currency, commodity, and bond futures for each of the 58 liquid instruments we consider. We find persistence in returns for 1 to 12 months that partially reverses over longer horizons, consistent with sentiment theories of initial under-reaction and delayed over-reaction. A diversified portfolio of time series momentum strategies across all asset classes delivers substantial abnormal returns with little exposure to standard asset pricing factors, and performs best during extreme markets. We show that the returns to time series momentum are closely linked to the trading activities of speculators and hedgers, where speculators appear to profit from it at the expense of hedgers.

  • This paper provides an introduction to managed futures, an alternative investment strategy that has historically achieved strong performance in both up and down markets and exhibited low correlation to traditional investments. The paper discusses the economic intuition behind the strategy and illustrates how it performs across various market environments.

    “Managed futures” is an alternative investment that has historically achieved strong performance in both up and down markets, exhibiting low correlation to traditional investments. It was one of the few investing styles that performed well in 2008 as most traditional and alternative investments suffered. As a consequence, this little understood strategy has attracted much attention. This paper attempts to de-mystify managed futures. We review the economic intuition, describe how to construct a simple version of this strategy, illustrate how this simple version performs in various market environments, and show how managed futures can be used to enhance the risk-return profiles of traditional portfolios.

  • Value and Momentum effects appear across global markets in equities, commodities, and bonds. We find that value (momentum) in one asset class is positively correlated with value (momentum) in other asset classes, and value and momentum are negatively correlated within and across asset classes.

    Value and momentum ubiquitously generate abnormal returns for individual stocks within several countries, across country equity indices, government bonds, currencies, and commodities. We study jointly the global returns to value and momentum and explore their common factor structure. We find that value (momentum) in one asset class is positively correlated with value (momentum) in other asset classes, and value and momentum are negatively correlated within and across asset classes. Liquidity risk is positively related to value and negatively to momentum, and its importance increases over time, particularly following the liquidity crisis of 1998. These patterns emerge from the power of examining value and momentum everywhere simultaneously and are not easily detectable when examining each asset class in isolation.

  • Reinsurance has historically delivered attractive risk premiums independent of financial markets. Broad introduction to an asset class underepresented in institutional portfolios.

    This paper discusses many characteristics of reinsurance with the goal of demystifying the asset class to the institutional investor community. In Part 1 we discuss the history and evolution of insurance and reinsurance and describe the participants in these markets. Following that we examine various types of reinsurance risks and give examples of particular contracts, together with the terms and jargon needed to understand the marketplace. Next we make the strategic case for reinsurance as a diversifying asset class. This takes two forms, for in addition to being uncorrelated to traditional stock, bond or commodity strategies, reinsurance risks exhibit internal, pairwise independence that is not evident within any capital market asset class. In the end this yields portfolio diversification benefits unlike any traditional asset class. We illustrate this with an example comparing a single stock to a single reinsurance risk and then evolve it to a portfolio of stocks compared to a portfolio of reinsurance contracts. Historical data on reinsurance contracts is limited, but nevertheless in Part 2 we examine historical risk premiums for different territory and peril classes of risk. We also review the performance of two different hypothetically-constructed reinsurance portfolios, with a particular emphasis on their comparisons to more traditional assets. In Part 2 we also highlight the performance and correlation characteristics of reinsurance in the fi nancial meltdown of 2008 as well as the 2001/2002 tech bubble collapse. We conclude with a discussion of reinsurance risk allocations in more traditional portfolios. Lastly, in Part 3 we review ways in which institutions can gain access to reinsurance risks and discuss their associated liquidity characteristics. We also discuss best practices in managing portfolios of such risks, including sourcing, pricing, underwriting, portfolio risk management, and optimal portfolio construction.

  • An overview of retrocession, a tool reinsurance companies can use to increase or decrease risk exposures.

    Reinsurance allows insurance companies to lay off excess or unwanted risks. Retrocession (“retro”) does this for reinsurance companies, protecting a reinsurer’s balance sheet against an unusual or unprecedented loss scenario.

  • Traditional approaches to international investing can lead to taking unintended risks. This paper examines these risks and outlines best practices in international equity investing.

    The diversification benefit of investing internationally has led to a significant shift in assets from domestic to global portfolios over time. However, investing internationally involves taking on risks that are not present when investing domestically. The academic literature has extensively analyzed the relative importance of stock-specific risk, sector risk, and country risk for global stocks. Specifically, it is well documented that country risk is an important driver of individual stock returns, especially in emerging markets. In contrast, the literature has devoted less attention to the impact of country membership on actively managed stock portfolios. For instance, it is an open question whether ignoring country membership can yield negative side effects in portfolio construction. We address this question by showing that failing to explicitly control for country membership can lead to significant misallocation of risk. In particular, country bets can dominate a portfolio that aims to represent skill in selecting individual stocks. Worse, the country bets can be completely unrelated to the underlying investment signals and can thereby potentially reduce risk-adjusted returns.

  • Five alternatives to traditional tail-risk hedging. Unlike purchasing portfolio insurance, these strategies may enhance portfolio efficiency and long-term expected returns.

    In the wake of 2008, investors are now painfully aware of tail risk – the risk of unexpectedly large losses. Today many institutional investors are insuring against tail risk directly, often by purchasing puts or structuring collars. Unfortunately, experience and financial theory suggest that the long-term cost of such insurance strategies will be larger than the payouts. No surprise, really. The expected return for perpetual insurance buyers is negative, and conversely positive for insurance sellers (see: the entire insurance industry). Arguably, relatively risk-tolerant investors should be selling tail-risk insurance rather than buying it. Our recommendation, if reducing tail risk is deemed necessary, is to approach tail risk fundamentally, primarily by modifying the portfolio structure itself and by addressing risk management policy. This paper considers fi ve approaches, which we think are most effective when used in combination: 1. Diversify by risk, not just by assets 2. Actively manage volatility 3. Embrace uncorrelated alternatives 4. Take advantage of low-beta equities 5. Have a crisis plan before you need one We think these approaches lead to better constructed portfolios for all investors, not just those concerned with tail risk. For investors who are unable to pursue these approaches, we think the best way to reduce tail risk is to reduce total market exposure rather than to buy insurance.

  • Selling insurance and selling lottery tickets have delivered positive long-run rewards in a wide range of investment contexts. Conversely, buying financial catastrophe insurance and holding speculative lottery-like investments have delivered poor long-run rewards. Thus, bearing small risks is often well rewarded, bearing large risks not.

    Selling financial investments with insurance or lottery characteristics should earn positive long-run premiums if investors like positive skewness enough to overpay for these characteristics. The empirical evidence is unambiguous: Selling insurance and selling lottery tickets have delivered positive long-run rewards in a wide range of investment contexts. Conversely, buying financial catastrophe insurance and holding speculative lottery-like investments have delivered poor long-run rewards. Thus, bearing small risks is often well rewarded, bearing large risks not.

  • Tighter risk management can lead to illiquidity and lower prices. A multiplier effects arises with liquidity-adjusted risk management.

    This paper provides a model of the interaction between risk-management practices and market liquidity. Our main finding is that a feedback effect can arise. Tighter risk management leads to market illiquidity, and this illiquidity further tightens risk management.

  • An economic model of how to measure and manage systemic risk, with empirical support from the recent crisis.

    We present a simple model of systemic risk and we show that each financial institution's contribution to systemic risk can be measured as its systemic expected shortfall (SES), i.e., its propensity to be undercapitalized when the system as a whole is undercapitalized. SES increases with the institution's leverage and with its expected loss in the tail of the system's loss distribution. Institutions internalize their externality if they are "taxed" based on their SES. We demonstrate empirically the ability of SES to predict emerging risks during the nancial crisis of 2007-2009, in particular, (i) the outcome of stress tests performed by regulators; (ii) the decline in equity valuations of large nancial rms in the crisis; and, (iii) the widening of their credit default swap spreads.

  • Model-free methods for monitoring economy-wide leverage, with implications for monitoring systemic risk and managing liquidity crises.

  • Risk parity strategies should be designed to adjust for changing market conditions.

    At the heart of risk parity, there is risk management. Risk parity’s core benefit – improved portfolio diversification – ultimately is a product of how well risk is assessed and managed. For investment managers, the practical considerations are important. In this article we consider two essential aspects of risk management for risk parity portfolios: maintaining balanced risk exposures through time and managing portfolios through periods of significant market stress. We conclude that risk parity portfolios require dynamic management; their holdings need to be regularly adjusted to reflect the dynamics of underlying market risk. Further, we conclude that risk parity portfolios should incorporate a planned capital preservation strategy to try to avoid significant disruptions in a crisis.

  • A review of investing principles that were ignored in the tech bubble and that may still have been forgotten in the bust.

    The Financial Analysts Journal's 60th anniversary happens to coincide with the five-year anniversary of the peak of the Great Stock Market Bubble of 1999–2000. The combination of proximity in time, with just a bit of distance, makes this year an appropriate time to consider what we may have learned from this momentous event. This article suggests lessons that, if we haven't learned them, we should have.

  • Ideas on investment policy, effective governance, and managing risks more efficiently.

    Being an institutional investor is tough, now more than ever. And while there is no "silver bullet" to solve the many challenges investors face, we want to share a few thoughts and ideas in the hope of sparking or sustaining a dialogue with investors.

  • The rationale, economic intuition, and evidence for a defensive approach to equity investing, and potential roles for portfolios.

    The outperformance of simulated defensive equity portfolios during the global credit crisis and during the recent turmoil in European financial markets has highlighted the potential benefit of avoiding concentrating risks in securities with the highest sensitivity to market fluctuations.1 By over-weighting safer securities and under-weighting risky ones, defensive equity strives to reduce sensitivity to market movements – seeking long-term benchmark-like returns with lower volatility. This paper analyzes the intuition behind defensive equity. We review the empirical evidence, analyze construction and performance of defensive equity portfolios, and discuss the possible explanations for its outperformance. Finally, we discuss the role defensive equities can play in investors’ overall portfolios.

  • This paper provides an introduction to managed futures, an alternative investment strategy that has historically achieved strong performance in both up and down markets and exhibited low correlation to traditional investments. The paper discusses the economic intuition behind the strategy and illustrates how it performs across various market environments.

    “Managed futures” is an alternative investment that has historically achieved strong performance in both up and down markets, exhibiting low correlation to traditional investments. It was one of the few investing styles that performed well in 2008 as most traditional and alternative investments suffered. As a consequence, this little understood strategy has attracted much attention. This paper attempts to de-mystify managed futures. We review the economic intuition, describe how to construct a simple version of this strategy, illustrate how this simple version performs in various market environments, and show how managed futures can be used to enhance the risk-return profiles of traditional portfolios.

  • Five alternatives to traditional tail-risk hedging. Unlike purchasing portfolio insurance, these strategies may enhance portfolio efficiency and long-term expected returns.

    In the wake of 2008, investors are now painfully aware of tail risk – the risk of unexpectedly large losses. Today many institutional investors are insuring against tail risk directly, often by purchasing puts or structuring collars. Unfortunately, experience and financial theory suggest that the long-term cost of such insurance strategies will be larger than the payouts. No surprise, really. The expected return for perpetual insurance buyers is negative, and conversely positive for insurance sellers (see: the entire insurance industry). Arguably, relatively risk-tolerant investors should be selling tail-risk insurance rather than buying it. Our recommendation, if reducing tail risk is deemed necessary, is to approach tail risk fundamentally, primarily by modifying the portfolio structure itself and by addressing risk management policy. This paper considers fi ve approaches, which we think are most effective when used in combination: 1. Diversify by risk, not just by assets 2. Actively manage volatility 3. Embrace uncorrelated alternatives 4. Take advantage of low-beta equities 5. Have a crisis plan before you need one We think these approaches lead to better constructed portfolios for all investors, not just those concerned with tail risk. For investors who are unable to pursue these approaches, we think the best way to reduce tail risk is to reduce total market exposure rather than to buy insurance.

  • Leverage aversion changes the predictions of modern portfolio theory. Specifically, lower risk assets may offer higher risk-adjusted returns, creating an opportunity for strategies such as risk parity.

    We show that leverage aversion changes the predictions of modern portfolio theory: It implies that safer assets must offer higher risk-adjusted returns than riskier assets. Consuming the high risk-adjusted returns offered by safer assets requires leverage, creating an opportunity for investors with the ability and willingness to apply leverage. A Risk Parity (RP) portfolio exploits this in a simple way, namely by equalizing the risk allocation across asset classes, thus overweighting safer assets relative to their weight in the market portfolio. Consistent with our theory of leverage aversion, we find empirically that RP has outperformed the market over the last century by a statistically and economically significant amount.

  • Risk parity strategies should be designed to adjust for changing market conditions.

    At the heart of risk parity, there is risk management. Risk parity’s core benefit – improved portfolio diversification – ultimately is a product of how well risk is assessed and managed. For investment managers, the practical considerations are important. In this article we consider two essential aspects of risk management for risk parity portfolios: maintaining balanced risk exposures through time and managing portfolios through periods of significant market stress. We conclude that risk parity portfolios require dynamic management; their holdings need to be regularly adjusted to reflect the dynamics of underlying market risk. Further, we conclude that risk parity portfolios should incorporate a planned capital preservation strategy to try to avoid significant disruptions in a crisis.

  • This paper provides an introduction to a risk parity strategy, which is an asset allocation strategy that seeks to diversify portfolios by risk, rather than by capital. This paper describes a Simple Risk Parity Strategy and illustrates its consistent outperformance over a traditional portfolio over nearly 40 years of historical data.

    The outperformance of Risk Parity strategies during the recent credit crisis has confirmed the benefits of a truly diversified portfolio. Traditional diversification focuses on dollar allocation; but because equities have disproportionate risk, a traditional portfolio’s overall risk is often dominated by its equity portion. Risk Parity diversification focuses on risk allocation. We find that by making significant investments in non-equity asset classes, investors can achieve true diversification – and expect more consistent performance across the spectrum of potential economic environments. First, the paper highlights the concentration risk embedded in traditional portfolios, and explains the intuition behind Risk Parity. Next, we describe a Simple Risk Parity Strategy and demonstrate its consistent outperformance over nearly 40 years of historical data. Finally, we delve into the more advanced portfolio construction and risk management techniques used to implement actual Risk Parity portfolios.

  • An investor willing to bear the risk of 100% equities can do even better with a diversified portfolio.

    A diversified portfolio historically delivers more return, while not increasing risk (measuring risk along several dimensions). This is shown most clearly when an investor is willing to lever, although even without leverage, 100% equities would rarely be optimal. Furthermore, regardless of which portfolio is ultimately chosen, this article argues that choosing how much risk to bear, and constructing a set of portfolios with the most expected return for a given amount of risk, are separate tasks. Choosing a portfolio of 100% equities based on their historical realized return misses this separation.

  • This paper presents clinically-based studies of two acquisitions that received very different stock market reactions at announcement - one positive and one negative.

    This paper presents clinically-based studies of two acquisitions that received very different stock market reactions at announcement - one positive and one negative. Despite the differing market reactions, we find that ultimately neither acquisition created value overall. In exploring the reasons for the acquisition outcomes, we rely primarily on interviews with managers and on internally generated performance data. We compare the results of these analyses to those from analyses of post-acquisition operating and stock price performance traditionally applied to large samples. We draw two primary conclusions. (1) Our findings highlight the difficulty of implementing a successful acquisition strategy and of running an effective internal capital market. Post-acquisition difficulties resulted because: (a) managers of the acquiring company did not deeply understand the target company at the time of the acquisition; (b) the acquirer imposed an inappropriate organizational design on the target as part of the post-acquisition integration process; and (c) inappropriate management incentives existed at both the top management and division levels. (2) Measures of operating performance used in large sample studies are weakly correlated with actual post-acquisition operating performance.

  • Bid-ask spreads due to asymmetric information affect required returns differently than exogenous trading costs - paper shows explicitly how.

    An important feature of financial markets is that securities are traded repeatedly by asymmetrically informed investors. We study how current and future adverse selection affect the required return. We find that the bid-ask spread generated by adverse selection is not a cost, on average, for agents who trade, and hence the bid-ask spread does not directly influence the required return. Adverse selection contributes to trading-decision distortions, however, implying allocation costs, which affect the required return. We explicitly derive the effect of adverse selection on required return, and show how our result differs from models that consider the bid-ask spread to be an exogenous cost.

  • How unpredictable changes in liquidity affect security returns, developing a novel liquidity-adjusted CAPM.

    This paper solves explicitly a simple equilibrium model with liquidity risk. In our liquidity adjusted capital asset pricing model, a security’s required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with the market return and liquidity. In addition, a persistent negative shock to a security’s liquidity results in low contemporaneous returns and high predicted future returns. The model provides a unified framework for understanding the various channels through which liquidity risk may affect asset prices. Our empirical results shed light on the total and relative economic significance of these channels and provide evidence of flight to liquidity.

  • The effect of market structure on volume, prices, and welfare with applications to real-world auctions

    The seminal paper by Milgrom and Weber (1982) ranks the expected revenues of several auction mechanisms, taking the decision to sell as exogenous. We endogenize the sale decision. The owner decides whether or not to sell, trading off the conditional expected revenue against his own use value, and buyers take into account the information contained in the owner’s sale decision. We show that revenue ranking implies volume and welfare ranking under certain general conditions. We use this to show that, with affiliated signals, English auctions have larger expected price, volume, and welfare than second-price auctions, which in turn have larger expected price, volume, and welfare than first-price auctions.

  • In this study, we seek to improve the understanding of what makes a stock a "Buffett stock," the drivers of Berkshire's performance, and how a diversified Buffett-styled portfolio would have performed over the past 30 years.

    Berkshire Hathaway has a higher Sharpe ratio than any stock or mutual fund with a history of more than 30 years and Berkshire has a significant alpha to traditional risk factors. However, we find that the alpha become statistically insignificant when controlling for exposures to Betting-Against-Beta and quality factors. We estimate that Berkshire’s average leverage is about 1.6-to-1 and that it relies on unusually low-cost and stable sources of financing. Berkshire’s returns can thus largely be explained by the use of leverage combined with a focus on cheap, safe, quality stocks. We find that Berkshire’s portfolio of publicly-traded stocks outperform private companies, suggesting that Buffett’s returns are more due to stock selection than to a direct effect on management.

  • Shorting costs are high for corporate bonds that are of worse credit, more expensive relative to the CDS, have equity on special, smaller issues, and more illiquid.

    Using data on all corporate bond loans by one of the world's largest custodian banks, we study the main determinants of shorting costs as measured by rebate rate specialness. We find that 3.0% of corporate bonds are on loan, and 11% of loaned bonds have substantial shorting costs above 50 basis points. In the cross section, specialness is higher for bonds that are of worse credit rating, higher yield spread, smaller issues, less time to maturity, more illiquid, and bonds that appear expensive relative to the corresponding credit default swap. Bonds that are downgraded to speculative grade are more likely to be on special for several weeks before and after the downgrade, and have large shorting activity. Finally, equity specialness is positively related to the firm's bond specialness and the bond-CDS basis.

  • How end user demand affects option pricing when dealers cannot perfectly hedge. New theory and unique data.

    We model demand-pressure effects on option prices. The model shows that demand pressure in one option contract increases its price by an amount proportional to the variance of the unhedgeable part of the option. Similarly, the demand pressure increases the price of any other option by an amount proportional to the covariance of the unhedgeable parts of the two options. Empirically, we identify aggregate positions of dealers and end-users using a unique dataset, and show that demand-pressure effects make a contribution to wellknown option-pricing puzzles. Indeed, time-series tests show that demand helps explain the overall expensiveness and skew patterns of index options, and cross-sectional tests show that demand impacts the expensiveness of single-stock options as well.

  • This paper uses commercial aircraft transactions to show that financially constrained airlines receive lower prices than their unconstrained rivals when selling used narrow-body aircraft.

    This paper uses commercial aircraft transactions to determine whether capital constraints cause firms to liquidate assets at discounts to fundamental values. Results indicate that financially constrained airlines receive lower prices than their unconstrained rivals when selling used narrow-body aircraft. Capital constrained airlines are also more likely to sell used aircraft to industry outsiders, especially during market downturns. Further evidence that capital constraints affect liquidation prices is provided by airlines’ asset acquisition activity. Unconstrained airlines significantly increase buying activity when aircraft prices are depressed; this pattern is not observed for financially constrained airlines.

  • This paper empirically examines one motive for takeovers: to change control of firms that make acquisitions that diminsh the value of their equity

    This paper empirically examines one motive for takeovers: to change control of firms that make acquisitions that diminsh the value of their equity. Firms that subsequently become takeover targets make acquisitions that significantly reduce their equity value, and firms that do not become takeover targets make acquisitions that raise their equity value. Within the sample of acquisition by targets the acquisitions that reduce equity value the most are those that are later divested either in bust-up takeovers or restructuring programs to thwart the takeover. This evidence is consistent with theories advanced by Marris, Manne, and Jensen concerning the disciplinary role played by takeovers.

  • Retail investor flows into mutual funds provide a contrarian signal for the underlying stocks, related to the value effect.

    We use mutual fund flows as a measure of individual investor sentiment for different stocks, and find that high sentiment predicts low future returns. Fund flows are dumb money–by reallocating across different mutual funds, retail investors reduce their wealth in the long run. This dumb money effect is related to the value effect: high sentiment stocks tend to be growth stocks. High sentiment also is associated with high corporate issuance, interpretable as companies increasing the supply of shares in response to investor demand.

  • An analysis of the optimal trading strategy that minimizes transaction costs while efficiently exploiting trading signals. A closed-form solution that illuminates the key role of alpha decay.

    This paper derives in closed form the optimal dynamic portfolio policy when trading is costly and security returns are predictable by signals with different mean-reversion speeds. The optimal updated portfolio is a linear combination of the existing port-folio, the optimal portfolio absent trading costs, and the optimal portfolio based on future expected returns and transaction costs. Predictors with slower mean reversion (alpha decay) get more weight since they lead to a favorable positioning both now and in the future. We implement the optimal policy for commodity futures and show that the resulting portfolio has superior returns net of trading costs relative to more naive benchmarks. Finally, we derive natural equilibrium implications, including that demand shocks with faster mean reversion command a higher return premium.

  • News from companies with close economic ties (customers and suppliers) is not efficiently priced into stocks.

    This paper finds evidence of return predictability across economically linked firms. We test the hypothesis that in the presence of investors subject to attention constraints, stock prices do not promptly incorporate news about economically related firms, generating return predictability across assets. Using a data set of firms’ principal customers to identify a set of economically related firms, we show that stock prices do not incorporate news involving related firms, generating predictable subsequent price moves. A long–short equity strategy based on this effect yields monthly alphas of over 150 basis points.

  • This paper uses commercial aircraft transactions to assess the degree to which bankruptcy court protection alleviates costs of financial distress associated with asset sales.

    This paper uses commercial aircraft transactions to assess the degree to which bankruptcy court protection alleviates costs of financial distress associated with asset sales. Results indicate that bankruptcy court protection does little to mitigate price discounts associated with distressed asset sales. If anything, the discount is larger for bankrupt firms than for distressed but non-bankrupt rivals. However, bankruptcy protection does appear to limit piecemeal liquidation of distressed airlines. The rate of asset sales is relatively high in the year preceding bankruptcy, but, for airlines that eventually emerge from bankruptcy, the rate of asset sales is reduced after Chapter 11 filing.

  • Consistent with investor leverage aversion, asset classes with higher embedded leverage (ETFs, Options, etc) show lower risk-adjusted returns.

    Many financial instruments are designed with embedded leverage such as options and leveraged exchange traded funds (ETFs). Embedded leverage alleviates investors’ leverage constraints and, therefore, we hypothesize that embedded leverage lowers required returns. Consistent with this hypothesis, we find that asset classes with embedded leverage offer low risk-adjusted returns and, in the cross-section, higher embedded leverage is associated with lower returns. A portfolio which is long low-embedded-leverage securities and short high-embedded-leverage securities earns large abnormal returns, with t-statistics of 8.2 for equity options, 6.3 for index options, and 2.1 for ETFs. We provide extensive robustness tests and discuss the broader implications of embedded leverage for financial economics.

  • Examining the relationship between future returns and stock and bond market yields.

    The “Fed model” is a popular yardstick for judging whether the stock market is fairly valued. It compares the stock market's earnings yield to the long-term government bond yield, while more traditional methods evaluate stock market valuation without regard to the level of interest rates. The Fed model is theoretically flawed, as it compares a real number to a nominal number, ignoring the fact that over the long term nominal earnings generally move in tandem with inflation. The crucible for testing a valuation indicator is how well it forecasts long-term returns, and the Fed model fails this test; traditional methods ace it. Lack of predictive ability aside, investors have indeed historically required a higher stock market P/E when nominal interest rates have been lower. This does not imply that the Fed model is valid, rather only that investors have historically followed it, perhaps in error. The relationship of stock and bond market yields is more complicated than conceived by the Fed model, varying systematically with perceptions of long-term stock and bond market risk. Addition of risk to the Fed model solves the puzzle of why stocks outperformed bonds for the first half of the 20th century, but have underperformed bonds since.

  • Sell-side analysts hired as independent directors are more optimistic than average. Post-appointment data suggests firms deliberately seek management-friendly board members.

    We provide evidence that firms appoint independent directors who are overly sympathetic to management, while still technically independent according to regulatory definitions. We explore a subset of independent directors for whom we have detailed, micro-level data on their views regarding the firm prior to being appointed to the board: sell-side analysts who are subsequently appointed to the boards of companies they previously covered. We find that boards appoint overly optimistic analysts who are also poor relative performers. The magnitude of the optimistic bias is large: 82.0% of appointed recommendations are strong-buy/buy recommendations, compared to 56.9% for all other analyst recommendations. We also show that appointed analysts’ optimism is stronger at precisely those times when firms’ benefits are larger. Lastly, we find that appointing firms are more likely to have management on the board nominating committee, appear to be poorly governed, and increase earnings management and CEO compensation following these boardappointments.

  • This paper studies thirty-one highly leveraged transactions (HLTs) of the 1980s that subsequently became financially distressed. The net effect of the HLT and financial distress is a slight increase in value, overall the HLTs of the late 1980s succeeded in creating value.

    This paper studies thirty-one highly leveraged transactions (HLTs) of the 1980s that subsequently became financially distressed. At the time of distress, all sample firms have operating margins that are positive and in the majority of cases greater than the median for the industry. Therefore, we consider these firms financially distressed, not economically distressed. The net effect of the HLT and financial distress is a slight increase in value — from pre-transaction to distress resolution, the sample firms experience a marginally positive change in (market- or industry adjusted) value. This finding strongly suggests that, overall, the HLTs of the late 1980s succeeded in creating value. We also present quantitative and qualitative estimates of the (direct and indirect) costs of financial distress and their determinants. Our preferred estimates of the costs of financial distress are 10% of firm value. Our most conservative estimates do not exceed 23% of firm value. Operating margins of the distressed firms increase immediately after the HLT, decline when the firms become distressed and while they are distressed, but then rebound after the distress is resolved. Consistent with some costs of financial distress, we find evidence of unexpected cuts in capital expenditures, undesired asset sales, and costly managerial delay in restructuring. To the extent they occur, the costs of financial distress that we identify are heavily concentrated in the period after the firms become distressed, but before they enter Chapter 11.

  • An analysis of sovereign credit risk and CDS spreads, documenting that sovereign credit risk is closely related to US equity and credit markets even relative to local economic conditions.

    The sovereign debt market has grown over the past few years, providing an important source of diversification for global portfolios and affecting investment flows and funding costs. The authors examine the drivers of sovereign credit spreads and conclude that global financial factors, rather than country-specific factors, are largely responsible for changes in spreads.

  • We investigate the economic role of mergers by performing a comparative study of mergers and internal corporate investment at the industry and firm levels.

    We investigate the economic role of mergers by performing a comparative study of mergers and internal corporate investment at the industry and firm levels. We find strong evidence that merger activity clusters through time by industry, whereas internal investment does not. Mergers play both an ‘‘expansionary’’ and ‘‘contractionary’’ role in industry restructuring. During the 1970s and 1980s, excess capacity drove industry consolidation through mergers, while peak capacity utilization triggered industry expansion through non-merger investments. In the 1990s, this phenomenon is reversed, as industries with strong growth prospects, high profitability, and near capacity experience the most intense merger activity.

  • Tighter risk management can lead to illiquidity and lower prices. A multiplier effects arises with liquidity-adjusted risk management.

    This paper provides a model of the interaction between risk-management practices and market liquidity. Our main finding is that a feedback effect can arise. Tighter risk management leads to market illiquidity, and this illiquidity further tightens risk management.

  • The analysis shows (a) cross-sectional dependence of abnormal returns leads to inflated test statistics and (b) estimates of abnormal performance are small, and largely limited to small stocks, after accounting for the known mispricings of the model used to generate the results.

    A rapidly growing literature claims to reject the semi-strong form of the efficient market hypothesis by producing large estimates of long-term abnormal stock price performance subsequent to major corporate events. We re-examine three large samples of major managerial decisions, namely acquisitions, equity issues, and equity repurchases, and find little evidence of reliable long-term abnormal stock price performance for the three samples. The analysis shows (a) cross-sectional dependence of abnormal returns leads to inflated test statistics and (b) estimates of abnormal performance are small, and largely limited to small stocks, after accounting for the known mis-pricings of the model used to generate the results.

  • Market liquidity and the funding conditions are mutually reinforcing, giving rise to liquidity spirals, fragility, flight to quality, and systemic risk.

    We provide a model that links an asset’s market liquidity (i.e., the ease with which it is traded) and traders’ funding liquidity (i.e., the ease with which they can obtain funding). Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders’ funding, i.e., their capital and margin requirements, depends on the assets’ market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to “flight to quality,” and (v) co-moves with the market. The model provides new testable predictions, including that speculators’ capital is a driver of market liquidity and risk premiums.

  • This paper derives two extensions of the Campbell (1991) return decomposition and decompose contemporaneous returns into revisions in expectations, or news, about future dividends, liquidity, and net discount rates.

    Liquidity costs are not incurred once, but many times over the lifetime of an asset. Changes in forecasts of future liquidity levels impact contemporaneous prices. I derive two extensions of the Campbell (1991) return decomposition and decompose contemporaneous returns into revisions in expectations, or news, about future dividends, liquidity, and net discount rates. The two decompositions consider, respectively, news about future proportional costs and news about future fixed costs. Using the decompositions, I find that (i) both fixed cost and proportional cost news are substantially more volatile than contemporaneous proportional costs, (ii) fixed cost news is an economically important contributor to portfolio volatility and proportional cost news is not, (iii) small and illiquid stocks have more volatile proportional and fixed cost news and low turnover stocks have more volatile proportional cost news risk and less volatile fixed cost news, and (iv) the market price of risk for both fixed and proportional cost news, estimated within the Liquidity-Adjusted CAPM framework of Acharya and Pedersen (2005), is not statistically different than the price of non-liquidity risk.

  • An economic model of how to measure and manage systemic risk, with empirical support from the recent crisis.

    We present a simple model of systemic risk and we show that each financial institution's contribution to systemic risk can be measured as its systemic expected shortfall (SES), i.e., its propensity to be undercapitalized when the system as a whole is undercapitalized. SES increases with the institution's leverage and with its expected loss in the tail of the system's loss distribution. Institutions internalize their externality if they are "taxed" based on their SES. We demonstrate empirically the ability of SES to predict emerging risks during the nancial crisis of 2007-2009, in particular, (i) the outcome of stress tests performed by regulators; (ii) the decline in equity valuations of large nancial rms in the crisis; and, (iii) the widening of their credit default swap spreads.

  • A model of credit risk accounting for both default and restructuring. The study of Russian debt develops a new estimation method.

    We construct a model for pricing sovereign debt that accounts for the risks of both default and restructuring, and allows for compensation for illiquidity. Using a newand relatively efficient method, we estimate the model using Russian dollar-denominated bonds.We consider the determinants of the Russian yield spread, the yield differential across different Russian bonds, and the implications for market integration, relative liquidity, relative expected recovery rates, and implied expectations of different default scenarios.

  • Marketmakers' bid-ask spread is narrower for sophisticated investors with better search options.

    We study how intermediation and asset prices in over-the-counter markets are affected by illiquidity associated with search and bargaining. We compute explicitly the prices at which investors trade with each other, as well as marketmakers’ bid and ask prices, in a dynamic model with strategic agents. Bid–ask spreads are lower if investors can more easily find other investors or have easier access to multiple marketmakers. With a monopolistic marketmaker, bid–ask spreads are higher if investors have easier access to the marketmaker. We characterize endogenous search and welfare, and discuss empirical implications.

  • When a large trader liquidates, “predators” also sell, leading to price over-shooting and systemic risk.

    This paper studies predatory trading, trading that induces and/or exploits the need of other investors to reduce their positions. We show that if one trader needs to sell, others also sell and subsequently buy back the asset. This leads to price overshooting and a reduced liquidation value for the distressed trader. Hence, the market is illiquid when liquidity is most needed. Further, a trader profits from triggering another trader’s crisis, and the crisis can spill over across traders and across markets.

  • This paper looks at within-industry variables and across-industry variables to better predict firms' stock returns.

    Better proxies for the information about future returns contained in firm characteristics such as size, book-to-market equity, cash flow-to-price, percent change in employees, and various past return measures are obtained by breaking these explanatory variables into two industry-related components. The components represent (1) the difference between firms' own characteristics and the average characteristics of their industries (within-industry variables), and (2) the average characteristics of firms' industries (across-industry variables). Each variable is reliably priced within-industry and measuring the variables within-industry produces more precise estimates than measuring the variables in their more common form. Contrary to Moskowitz and Grinblatt [1999], we find that within-industry momentum (i.e., the firm's past return less the industry average return) has predictive power for the firm's stock return beyond that captured by across-industry momentum. We also document a significant short-term (one-month) industry momentum effect which remains strongly significant when we restrict the sample to only the most liquid firms.

  • We develop a model of incomplete-information games, and their equilibria, in which players use robust optimization to deal with payoff uncertainty.

    We present a distribution-free model of incomplete-information games, both with and without private information, in which the players use a robust optimization approach to contend with payoff uncertainty. Our “robust game” model relaxes the assumptions of Harsanyi’s Bayesian game model, and provides an alternative distribution-free equilibrium concept, which we call “robust-optimization equilibrium,” to that of the ex post equilibrium. We prove that the robust-optimization equilibria of an incomplete-information game subsume the ex post equilibria of the game and are, unlike the latter, guaranteed to exist when the game is finite and has bounded payoff uncertainty set. For arbitrary robust finite games with bounded polyhedral payoff uncertainty sets, we show that we can compute a robust-optimization equilibrium by methods analogous to those for identifying a Nash equilibrium of a finite game with complete information. In addition, we present computational results.

  • Short sellers search for stock owners and pay a lending fee. The lending fee increases the stock's price.

    We present a model of asset valuation in which short-selling requires searching for security lenders and bargaining over the lending fee. If lendable securities are difficult to locate, then the price of the security is initially elevated, and expected to decline. This price decline is to be anticipated, for example, after an initial public offering, and is increasing in the degree of heterogeneity of beliefs about the future value of the security. The prospect of lending fees may push the initial price of a security above even the most optimistic buyer’s valuation of the security’s future dividends. A higher price can thus be obtained with some shorting than if shorting is disallowed.

  • Sell-side equity analyst recommendations perform better on companies whose executive officers attended the same school, though Reg FD reduced outperformance in U.S.

    We study the impact of social networks on agents’ ability to gather superior information about firms. Exploiting novel data on the educational background of sell-side analysts and senior corporate officers, we find that analysts outperform by up to 6.60% per year on their stock recommendations when they have an educational link to the company. Pre-Reg FD, this school-tie return premium is 9.36% per year, while post- Reg FD it is nearly zero. In contrast, in an environment that did not change selective disclosure regulation (the U.K.), the school-tie premium is large and significant over the entire sample period.

  • There are legitimate arguments and difficult issues related to how to expense stock options. Still, stock options should be expensed.

    The debate about whether stock options should be expensed at the time they are issued is really no debate at all. Although legitimate issues exist about how to carry out this endeavor (what model to use, what time period to expense them over, how and when to tax them), there is simply no strong argument against expensing ? and very powerful arguments in its favor. This article reviews many of the arguments against expensing and the slam-dunk case for it. A great many attacks on expensing have been undertaken, but they systematically fall short of the mark, with some of them intellectually dishonest to a degree not normally observed in dialogue among serious people.

  • This paper examines the effects of the 2006 stock exchange shutdown on prices of securities and the relative impact on more or less liquid securities.

    On January 18, 2006, the Tokyo Stock Exchange (TSE) unexpectedly closed twenty minutes early. Forty minutes earlier, investors were informed that the number of transactions on that day had reached the daily capacity of the exchange’s computer systems. Further, the exchange disclosed that upgrading its technology would take six to twelve months, that the exchange would shut down automatically on any day in which the daily capacity had been reached, and that the exchange would close half an hour early each day in the near future to reduce the risk of an unanticipated shutdown. I estimate that over the six month period following the January 18 event, the expected number of additional market closures is 1.5 and the probability of at least one additional shutdown is 70 percent. I investigate the impact of the systematic liquidity event on relative valuations over the cross-section of stocks listed on the TSE. Stocks that only trade on the TSE lost a statistically significant 2 percent of their value relative to those that trade on the TSE and at least one additional Japanese exchange. Also, liquid stocks lost value relative to illiquid stocks. For instance, high turnover stocks lost approximately 6 percent of their value relative to low turnover stocks and liquid stocks, as measured by the Amihud (2002) illiquidity measure, lost approximately 4 percent of their value relative to illiquid stocks. The results provide further evidence that investors place an economically significant value on liquidity.

  • This paper, which studies industry-level patterns in takeover and restructuring activity during the 1982-1989 period, finds significant difference in the rate and time-series clustering of these activities.

    We study industry-level patterns in takeover and restructuring activity during the 1982-1989 period. Across 51 industries, we find significant differences in both the rate and time-series clustering of these activities. The interindustry patterns in the rate of takeovers and restructurings are directly related to the economic shocks borne by the sample industries. These results support the argument that much of the takeover activity during the 1980s was driven by broad fundamental factors and have general implications for the stock price spillover effects of takeover announcements, corporate performance following takeovers, and the timing of takeover waves.

  • Mutual fund portfolio managers take larger positions and earn higher returns in the shares of companies whose executive officers attended the same school.

    This paper uses social networks to identify information transfer in security markets. We focus on connections between mutual fund managers and corporate board members via shared education networks. We find that portfolio managers place larger bets on connected firms and perform significantly better on these holdings relative to their nonconnected holdings. A replicating portfolio of connected stocks outperforms nonconnected stocks by up to 7.8 percent per year. Returns are concentrated around corporate news announcements, consistent with portfolio managers gaining an informational advantage through the education networks. Our results suggest that social networks may be important mechanisms for information flow into asset prices.

  • This article summarises the findings of three studies that explore the value of corporate takeovers.

  • Fundamental Indexing is less of a revolution in investing and more of a repackaging of a long-established discipline of value tilting.

    There is an interesting and sometimes heated debate under way about the merits of traditional capitalization-weighted indexing versus so-called Fundamentally WeightedTM indexes. Robert Arnott, chairman of Research Affiliates, a Pasadena, California–based investment management firm, and finance professor Jeremy Siegel of the Wharton School of the University of Pennsylvania have led the charge for Fundamental Indexing. Vanguard Group founder Jack Bogle and Princeton University economics professor Burton Malkiel have been the chief defenders of traditional indexing. I write this piece as one stuck in the middle. On the one hand, Bogle and Malkiel are right: If we use a strict definition of the word “index,” the only indexes that truly make sense are cap-weighted. On the other hand, I am not a pure index fund investor. Instead, I try to outperform indexes by making active bets — and the bets I favor are in the direction of Arnott and Siegel.

  • Investors can use short-term information to help time the trades of their long-term investments.

    When long-term investors trade slowly changing portfolios, they are not particularly sensitive to when they should place or modify their bets. Short-term information can be used to guide investors on how to time their trades. Strategic trade modification provides exposure to short-term signals without imposing additional transaction costs or capacity limits. Long-term investors should not ignore short-term information simply because it is too expensive to trade on.

  • The effect of search and bargaining on asset prices and the dynamics of aggregate liquidity shocks.

    We provide the impact on asset prices of search-and-bargaining frictions in over-the-counter markets. Under certain conditions, illiquidity discounts are higher when counterparties are harder to find, when sellers have less bargaining power, when the fraction of qualified owners is smaller, or when risk aversion, volatility, or hedging demand is larger. Supply shocks cause prices to jump, and then ‘‘recover’’ over time, with a time signature that is exaggerated by search frictions: The price jump is larger and the recovery is slower in less liquid markets. We discuss a variety of empirical implications.

  • A review of quantitative investing, performance of quantitative strategies, and outlook.

    For more than a year now, investors have been questioning the efficacy of quantitative investing. Much of their questioning has to do with performance. Many quant strategies have simply failed to deliver on their investment promise over the past few years. The problem, the reasoning goes, is that everybody knows about these strategies, so there are no returns left. It was this very argument that the editors of Institutional Investor recently posed to us, as they asked whether quantitative equity investing has a future.

  • A solicited commentary on the global liquidity crisis and the "quant crisis" of August 2007. Evidence on the driving mechanisms.

    The dangers of shouting “fire” in a crowded theater are well understood, but the dangers of rushing to the exit in the financial markets are more complex. Yet, the two events share several features, and I analyze why people crowd into theaters and trades, why they run, what determines the risk, whether to return to the theater or trade when the dust settles, and how much to pay for assets (or tickets) in light of this risk. These theoretical considerations shed light on the recent global liquidity crisis and, in particular, the quant event of 2007.
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