Strategic Allocation

In his 2011 book The Power of Passive Investing: More Wealth with Less Work, author Richard Ferri presents “the detailed studies and undeniable evidence favoring a passive investing approach. …This information clearly shows that trying to beat the market has never been a reliable investment strategy in the past, and there’s no reason to believe it will beat a passive approach in the future. …Attempting to earn above market returns by picking actively managed mutual funds is an inefficient use of time and money. Knowing this fact, and acknowledging it allows you the freedom to go in a different direction–to change religion in a sense. …This book makes the case for passive investing. You’ll have to read other books for details on asset allocation recommendations and fund selection methods.” The book includes 140 citations of formal studies and expert commentaries. Some notable points from the book are: Keep Reading

Are Real Estate Investment Trusts (REIT) as an asset class a good diversifier for the stock market? To check, we focus on monthly correlation of returns as a measure of diversification capacity for Vanguard REIT Index Fund Investor Shares (VGSIX), a mutual fund with a reasonably long track record “designed to track the performance of the MSCI US REIT Index.” We use S&P 500 Depository Receipts (SPY) as a proxy for the broad U.S. stock market. For comparison, we also consider returns for three REIT Exchange-Traded Funds (ETF): iShares Dow Jones US Real Estate (IYR), SPDR Dow Jones REIT (RWR), and Vanguard REIT Index ETF (VNQ). Using monthly dividend-adjusted returns for VGSIX and SPY for the period July 1996 through December 2010 (174 monthly returns), we find that: Keep Reading

Many asset class allocation, asset valuation/selection and asset return anomaly studies ignore or treat lightly the implications of liquidity constraints. What are those implications and how serious are they? In his December 2010 paper entitled “Comatose Markets: What If Liquidity is Not the Norm?”, Aswath Damodaran examines how introducing illiquidity into decision processes affects investors with different time horizons and investment strategies. He focuses on trading friction (brokerage fees, bid-ask spread and price impact) as an illiquidity measurement. Using results from prior research and recent data on liquidity variations within and across asset classes, he finds that: Keep Reading

How effectively and consistently do equities, bonds, oil, gold and the dollar serve as hedges and safe havens for each other? In their September 2010 paper entitled “Hedges and Safe Havens – An Examination of Stocks, Bonds, Oil, Gold and the Dollar”, Cetin Ciner, Constantin Gurdgiev and Brian Lucey investigate pairwise hedging and safe haven relationships among these five major assets/asset classes. The define an asset as a hedge (safe haven) for another if respective returns are uncorrelated or negatively correlated on average over the long term (during relatively short intervals of stress). They define the long term (relatively short intervals) as their entire sample period (rolling four-month subperiods). They define intervals of stress as returns in the lowest fourth of observations. Using daily levels of the S&P 500 Index, an index of 10-year Treasuries, nearest-month gold and oil futures and the Federal Reserve Nominal Trade Weighted Effective Index for the dollar from January 1985 through October 2009 (nearly 25 years), they find that: Keep Reading

Market capitalization is the most frequently used metric for weighting the individual stock components of market indexes. Other approaches range from equal weighting to weighting on firm fundamentals to weighting generated by return-risk optimization. How do such alternative metrics work empirically? In the October 2010 draft of their paper entitled “A Survey of Alternative Equity Index Strategies”, Tzee-man Chow, Jason Hsu, Vitali Kalesnik and Bryce Little examine several popular passive index weighting alternatives to market capitalization. They impose common assumptions to backtest these alternatives on U.S. and global equity data over long periods with either annual or quarterly rebalancing. They also apply the Fama-French three-factor model to investigate sources of outperformance relative to capitalization-weighted benchmarks. Using stock/firm data for the 1,000 largest global firms spanning 1987-2009 and for the largest 1,000 U.S. firms spanning 1964-2009, they find that: Keep Reading

How stable are risk premiums? How should investors respond to instabilities? In his August 2010 paper entitled “A New ‘Risky’ World Order: Unstable Risk Premiums: Implications for Practice”, Aswath Damodaran presents approaches for estimating equity, bond and real asset risk premiums that are imprecise, unstable and linked across markets. He also explores the implications of dynamic, linked premiums for asset allocation, market timing and asset valuation. Using long-run data for all three asset classes, he concludes that: Keep Reading

How do stock index volatility and variance futures contracts compare with stock index put options as hedges against market crashes? In their August 2010 paper entitled “Using Volatility Instruments as Extreme Downside Hedges”, Bernard Lee and Yueh-Neng Lin investigate the effectiveness of stock index volatility and variance futures contracts as extreme downside hedges and compare this effectiveness to that of out-of-the-money index put options. Specifically, they compare the outcomes of hedging a long Standard & Poor’s Depository Receipts (SPY) position via 1-month and 3-month rolling positions in S&P 500 Volatility Index (VIX) futures contracts, S&P 500 3-month Variance Futures (VT) contracts and 10% out-of-the-money (OTM) S&P 500 Index put options with reasonable hedge trading frictions. Using price data for SPY, VIX and VT futures contracts and index put options spanning 6/10/04-10/14/09 for 1-month rolling hedges and 7/19/04-9/9/09 for 3-month rolling hedges, they find that: Keep Reading

Is diversification across equity anomalies beneficial? In his December 2009 preliminary paper entitled “Diversification Across Characteristics”, Erik Hjalmarsson combines long-short portfolios formed on seven stock anomalies:

1. Short-term (one-month) reversal (ST-R)
2. Medium-term (11 months plus skip-month) momentum (Mom)
3. Long-term (four years plus skip-year) reversal (LT-R)
4. Book-to-market value (B/M)
5. Cash flow-to-price ratio (C/P)
6. Earnings-to-price ratio (E/P)
7. Market capitalization (Size)

The portfolio for each anomaly is long (short) on an equally weighted basis the tenth of stocks expected to generate the most positive (negative) returns, reformed each month. Using monthly firm characteristics and return data for all NYSE, AMEX and NASDAQ stocks over the period July 1951 through December 2008, he finds that: Keep Reading

Is there a way to optimize dynamically the degree of leverage for an investment? In his November 2009 paper entitled “On the Performance of Leveraged and Optimally Leveraged Investment Funds”, Guido Giese derives a general model for leveraged multi-asset investment strategies with daily re-balancing applicable to leveraged long and short Exchange-Traded Funds (ETF) and leveraged carry trades. Using daily data for the Dow Jones EURO STOXX 50 Index, the Dow Jones EURO STOXX 50 Volatility Index (VSTOXX) and the Euro OverNight Index Average (EONIA) rate from end of 1991 through May 2009, he concludes that: Keep Reading

Are there alternatives to traditional beta and capitalization weighting strategies for asset allocation that improve investing outcomes? In the October 2009 version of their paper entitled “Beyond Cap-Weight: The Empirical Evidence for a Diversified Beta”, Rob Arnott, Vitali Kalesnik, Paul Moghtader and Craig Scholl explore diversification of beta risk by comparing the merits of four basic major strategies for portfolio weighting from a global perspective: Cap Weight; Equal Weight; Minimum Variance weighting; and, Economic Scale weighting. They also examine two combination strategies: Efficient Beta, an equal weighting of Cap Weight, Economic Scale and Minimum Variance; and, an equal weighting of all four basic strategies. Using dollarized returns and other data necessary for construction of indexes comprised of the 1,000 largest (by market capitalization) companies across 23 developed countries over the period January 1993 through June 2009, they conclude that: Keep Reading