Indexes
Frederick E. Dopfel. The author first recalls the important difference between active and passive management, i.e., that if an active fund outperforms, there is necessarily another fund that underperforms, while investors in passive cap-weighted indices accept average investment returns, rather than take the risk of earning inferior returns. The recently introduced fundamental indices look more like active strategies than passive indices, since they seek to outperform cap-weighted indices. In this article, the author proposes to identify the specific conditions in which one would do well to invest in fundamental indices. More...
14/08/08
Indexes
David Blitz, Laurent Swinkels. Fundamental indices are indices whose constituents are weighted by fundamental indicators. The possible superiority of these indices to cap-weighted indices has sparked animated debate. In this article, the authors compare the construction and performance of fundamental indices and cap-weighted indices.
Their first observation is that fundamental indices are simply an alternative form of value indices, as a fundamental index, compared to a cap-weighted index, will overweight value stocks and underweight growth stocks. According to Blitz and Swinkels, fundamental indexation is merely a new and more sophisticated way of deriving value indices. More...
13/08/08
Indexes
Dr. Thomas Neukirch. In this article, Neukirch looks into two alternative methods to cap-weighting for index construction. He suggests constructing two equivalents to the MSCI World Developed Markets Index, an index made up of about 1,950 constituents. Equal weighting and equal risk weighting are used to weight the constituents. Monthly data from February 2001 to January 2008 are used to complete the study.
Equal risk weighting involves weighting all constituents in such a way that each contributes the same amount of risk to the resulting portfolio. The risk measure used is volatility. In addition, the author also considers modifications of these weightings with respect to countries and sectors. More...
13/08/08
Performance
Chris Adcock. This article considers two measures of portfolio risk: the beta from the CAPM and the measure of portfolio risk introduced by Rubinstein (1976). The appropriate measure of portfolio risk is important, as it will determine the value of alpha in portfolio performance measurement. The traditional CAPM assumes that asset or portfolio returns are distributed according to an elliptical symmetry. But this is not so for all assets or portfolios. In particular, assets tend to exhibit skewness. To deal with the problems associated with estimates of alpha using CAPM beta, Leland (1999) proposes a measure of risk referring to Rubinstein’s (1976) asset pricing model, which takes into account the possible existence of asset return skewness, making it potentially attractive for portfolios including options. More...
07/07/08
Indexes
Sanjay Arya, Paul Kaplan. Arya and Kaplan note that capitalisation weighting, which appears to be a good weighting system from a theoretical point of view, is not without drawbacks. One of the drawbacks of cap weighting indices is that they often end up exposed to the more overpriced assets, which can possibly reverse and cause losses. As an alternative, some have turned to fundamental indexation, in which assets are weighted by measures of size such as revenue, book value, and dividends. Fundamental weighting may remedy some of the drawbacks of cap weighting, but it can also lead to value and small-cap biases, higher turnover, higher costs, problems of scalability, and macro inconsistency. More...
30/06/08
Investment Management
F. J. Fabozzi, S. M. Focardi, and C. Jonas. In April, Fabozzi, Focardi, and Jonas published the results of a survey of trends in quantitative equity management. The survey participants are 31 asset managers. 15 are US-based, and 16 are located in Europe. They manage $2.194 trillion in equities. Two types of investment processes are distinguished. First, the fundamental, or judgmental, investment process, which is based on human decisions. Second, the quantitative, or automated, investment process, in which decisions are computer-driven. More...
23/06/08
Indexes
Martijn Cremers, Antti Petajisto, Eric Zitzewitz. Cremers, Petajisto, and Zitzewitz note that passive indices, such as the S&P 500 or the Russell 2000, widely used as benchmarks in portfolio management, exhibit abnormal statistically significant returns – whether positive or negative – relative to the Carhart four-factor model. In their view, these abnormal returns suggest that this model does not correctly take into account all the factors that explain asset returns. As a result, the alpha from this model will not correctly evaluate managers’ portfolio performance: they will be credited for performance stemming from their exposure to passive indices or they will be penalised for it. More...
18/06/08
Indexes
Paul D. Kaplan. In this article, Kaplan makes his contribution to the debate between the supporters of fundamental-weighted indices and those of capitalisation-weighted indices. For Kaplan, fundamental indexers have based their theories on questionable assumptions. In this article, he examines the underlying theory of fundamental indexation from the point of view of fair value multiples, unobservable numbers that make it possible to equate the fair value of a stock, also unobserved, to some observed measure of the stock’s fundamental value. Like Hsu (2006), he assumes that a stock’s market value differs from its fair value by an independent multiplicative error term. More...
05/05/08
Performance
Yin-Ching Jan, Su-Ling Chiu. Persistence in mutual fund performance is of great interest to investors; indeed, it can determine their choice of investment. Numerous studies have used different methods of performance measurement to investigate the possible existence of persistence in fund performance. In the present article, Jan and Chiu examine whether the results depend on the measure used.
They use a data sample including 228 equity funds from the Taiwan Economic Journal Mutual Fund Database. The data cover a period beginning in January 1993 and ending in December 2004. The database includes defunct funds. Jan and Chiu evaluate fund annual performance using several methods. More...
08/04/08
Indexes
André F. Perold. Some authors have used the noisy market hypothesis to assert that weighting indices by market capitalisation has resulted in performance worse than that of strategies using other weighting schemes. For these authors, market-cap weighting over-weights overvalued stocks and under-weights undervalued stocks. The value of overvalued stocks will tend to decrease until it reaches its true value, a phenomenon that will lead to poor performance for the cap-weighted index. As an alternative, they have developed what are called fundamental indices, in which stocks are weighted by the value of their fundamental characteristics rather than by their market capitalisation. More...
08/04/08
Style analysis
Arik Ben Dor, Vernon Budinger, Lev Dynkin, Kenneth Leech. In this article, the authors stress the importance of being able to accurately evaluate the performance of mutual funds. The performance of funds is generally evaluated relative to a benchmark. Most of the time, however, the methodology used to derive the benchmark does not make it possible to have a suitable representation of the fund to be evaluated. The authors mention the use of a single index as a representative benchmark, which does not allow representation of all the asset classes a fund may be invested in. Another more sophisticated approach involves building a benchmark based on mutual fund holdings. In this case, the problem will be collecting the data, as it is difficult to obtain accurate information on fund holdings on a regular basis.
More...
18/03/08
130/30 Strategy
S. Ericson, G. Johnson, and V. Srimurthy. Ericson, Johnson, and Srimurthy, three portfolio managers, publish one of the first empirical comparisons of the performance of 130/30 funds and that of long-only strategies. These comparisons, complicated by recent launches and short track records, have hitherto been made from a largely theoretical perspective. To get around these complications, the authors opt for back tests in which the performance of 130/30 funds is simulated by applying quantitative trading rules. More...
19/12/07
Hedge Fund Performance
A. Grecu, B. G. Malkiel, and A. Saha. Why do hedge funds stop reporting performance? According to Grecu, Malkiel, and Saha, there are two possible explanations. First, funds stop reporting when they underperform their peers. Second, they stop when they do not need to attract additional capital. Through performance comparisons, hazard rate computations, and the identification of factors increasing the risk of reporting failure, the authors attempt to determine the more likely of the two possible explanations. More...
06/12/07
Indexes
Javier Estrada. The author points out that, most of the time, whether they serve for passive or active management, benchmarks are capitalisation-weighted, on the assumption that the market portfolio is mean-variance efficient. Meanwhile, academics and practitioners tend to seek strategies to outperform the market over the long term. Among them is fundamental indexation, which weights assets by fundamental measures of value, such as dividends. In this article, author Estrada investigates which capitalisation or fundamental measure, among capitalisation or fundamental measures, is the best one to weight country index funds and ETFs when building global portfolios. More...
25/10/07
Indices
Steven Schoenfeld, Robert Ginis. In this article the authors describe the various alternatives to cap-weighting systems recently developed for index construction, underlining that they in fact consist of active management strategies and do not lead to indices that may serve as benchmarks or represent an asset class.
The reason that index providers are developing alternative-weighted indices is to achieve higher returns in investment management. Different approaches are used to construct these indices. Some specifically try to isolate one or more factors that have been shown historically to outperform the market, while others attempt to redefine what size means to the market. Some even specifically target alpha-producing patterns and integrate them into their index methodology. More...
10/10/07
Alternative Investments
Daniel P.J. Capocci. The aim of this analysis of hedge fund strategies is to understand how managers make or destroy value. Capocci has developed a multi-factor performance and persistence analysis model and used it over several time periods. He also analysed the neutrality of hedge funds against equity markets in order to validate hedge fund managers’ claims that they are market neutral. Finally, he developed new efficient frontier measures, which not only include returns and volatility, but also skewness and kurtosis in order to determine whether hedge funds are really beneficial to investors. More...
13/09/07
Indexes
S. Gowri Shankar. Gowri Shankar notes that not all index funds can be considered passively managed funds since stock indices themselves are constructed and maintained in different ways. According to Sharpe’s (1991) definition of a passive index, the Russell indices, which are constructed solely on the basis of their market capitalisation, are passively constructed, while the S&P indices are actively constructed by an index committee at Standard & Poor’s that chooses firms using discretionary criteria. Nevertheless, these indices are typically considered substitutes, despite the differences in their construction. More...
27/08/07
Indexes
Olfa Hamza, Mohamed Kortas, Jean-François L’Her, Mathieu Roberge. In this article, the authors take note of the criticism of the cap-weighting systems used by international equity indices and seek the best weighting system for these indices. To that end, they construct hypothetical indices of the MSCI EAFE countries (over the period from 1970 to 2000) to examine the relative performance of the weighting schemes of the MSCI EAFE index. The authors examine the effectiveness of GDP-weighting and equal-weighting as solutions to the over-concentration inherent to cap-weighting. They note that no specific model in portfolio theory supports GDP-weighting. More...
27/08/07
Performance
Ronald Best, Charles W. Hodges, James A. Yoder. Sharpe ratios based on realised returns provide a ranking of the past performance of portfolios, but many investors use these ratios when making investment choices. This use assumes that the portfolio return distribution is stable over time—that is, that the historical returns can predict future performance. In addition, Sharpe ratios are usually estimated using short-term intervals, e.g., the previous 36 monthly returns for Morningstar. The assumption is that investors also have a corresponding investment horizon and use the same return frequency.
More...
27/08/07
Hedge Fund Performance
A. Bandopadhyaya and J.L. Grant. In their “Survey of Demographics and Performance in the Hedge Fund Industry,” authors Bandopadhyaya and Grant scrutinise hedge fund domiciles, hedge fund manager locations, and the risk-adjusted performance of these funds. Performance was calculated over the twelve years from 1994 to 2005. This period is of particular interest, as it is composed of a bullish (for the stock market) sub-period from 1994 to 1999, and a bearish sub-period from 1999 to 2005. It is thus possible to see how hedge funds fare in different market environments. More...
09/08/07
Performance
Roman Kräussl, Ralph Sandelowsky. In this article, Kräussl and Sandelowsky take into account successive improvements in Morningstar’s fund ratings—originally established in 1985—in order to investigate the predictive performance ability of these ratings. Initially, funds were rated within broad asset classes. In July 2002, Morningstar changed the risk-adjusted return measure used to evaluate fund performance. Since then, they have also been rating funds within 64 narrower fund categories. It appears that many investors base their choice of funds on the fund’s previous rating.
More...
18/06/07
Performance
Craig L. Israelsen, Gary F. Cogswell. Israelsen and Cogswell argue that the use of tracking error as an indicator of fund performance is not suitable for active managers. They note that the concerns of fund managers over tracking error are related to the fact that their performance results are always compared with benchmark indexes, making them afraid to drift from their benchmark. More...
19/04/07
Style Indexes
Vesa Puttonen, Tatu Seppä. Style investment is now an essential concept that plays a major role in investment analysis and performance evaluation. Concerns over style have led to the construction of more sophisticated benchmarks that are suited to style investors, although this has only occurred quite recently in Europe. While the first style indices, including the FTSE and MSCI style indices launched in 1997, were based on price-to-book as the only style variable, the latest developed indices use several variables in defining growth and value. More...
12/04/07
Hedge Fund Performance
T. Schneeweis, H. Kazemi, and V. Karavas. While the replication of hedge fund performance is a subject that is in vogue in the alternative industry, academic papers began to deal with this issue several years ago. In this paper, Karavas, Kazemi and Schneeweis explore the factor approach. They examine the replication of equally-weighted portfolios of European-based hedge funds for 5 strategies, namely Funds-of-Funds, Convertible Arbitrage, Fixed Income Arbitrage, Event Driven and Long/Short Equity. More...
22/01/07
Indexation
Jared Kizer. In “Index Fundamentalism Revisited”, Reinker and Tower (2004) find that a synthetic portfolio of Vanguard’s actively managed U.S. equity funds outperformed a synthetic portfolio of its U.S. equity index funds from 1977 through 2003 by about 0.8 percentage points per year. The synthetic portfolio of active funds was also less volatile than the synthetic portfolio of index funds. The present article is an extension to the Reinker-Tower study that explains these U.S. results and discusses the relevance of the findings for the future performance of active funds versus passive funds. More...
13/12/06
Indexation
Carol Alexander, Anca Dimitriu. Traditionally, benchmark replication is performed by minimizing the variance of the portfolio tracking error. Alexander and Dimitriu underline the drawbacks of this methodology. The first one is that minimizing tracking error with respect to an index may result in a very sample-specific portfolio, unstable under volatile market circumstances. In addition, correlation measure is only convenient for stationary variables. Finally, depending on the model used to estimate it, correlation can be very sensitive to the presence of outliers, non stationarity, or volatility clustering, which limit the use of long data history and can lead to erroneous conclusions about the nature of long term dependencies. The alternative proposed is to use co-integration. More...
13/12/06
Style Analysis
J. Rekenthaler, M. Gambera and J. Charlson. Style analysis is the key point in comparing a fund against a peer group of funds, and finally in evaluating the performance of a given manager. Style analysis has been developed through two leading approaches, namely the Portfolio Based Style Analysis (henceforth PFSA) and the Return Based Style Analysis (RBSA). PFSA is a holdings-based analysis. More...
12/12/06
Indexes
Robert Fernholz, Robert Garvy and John Hannon. The authors begin by identifying the desirable properties of an index to be used as a reference in an equity indexing strategy. The first such property is that it should be broadly based and hold a representative selection of a given class of equities. The second is that the selection and weighting of the securities in the portfolio are objectively established and are not dependent on individual managers. The third is minimal portfolio turnover. In addition, for asset allocation purposes, it is important that the index represents a recognisable sector of the whole equity market. It appears that most institutional index funds follow capitalisation-weighted indexes. More...
14/11/06
Indexes
Alejandro Murguia, Dean T. Umemoto. Index funds represent a significant part of mutual fund assets, and indexing is also widely used by institutional investors. This type of investment is favourably considered by individual and institutional investors for the following reasons: it provides diversification; it has lower costs; it targets the desired market; it provides a benchmark to measure performance; it is less risky; and it provides superior returns, although this last attribute is subject to debate. However, indexing has some significant flaws that advisers should seriously consider before using them in a client’s portfolio. More...
09/11/06
Hedge Fund Performance
J. Hasanhodzic and A.W. Lo. Due to the very frequent criticism aimed at hedge funds, such as their lack of transparency, lack of liquidity or excessive fees, the replication of hedge fund returns is receiving increasing interest from academics. Kat and Palaro, for example, have introduced a copula-based approach. However, Hasanhodzic and Lo choose a more traditional approach based on a linear regression model. They argue that the copula-based approach fails as it is “more complex than the hedge fund strategies they intend to replicate.” More...
02/11/06
Indices
Frank K. Reilly, David Wright. In this article, the authors investigate the various small cap indexes available and compare their respective characteristics. The indexes considered are the Dow Jones Small Cap, the Ibbotson Small Cap, the Russell 2000, the S&P Small Cap 600, the Wilshire Small Cap 1750 and the Wilshire Micro. These six indexes include fairly large samples (600 to 2,400 stocks). They are all market value-weighted and have similar distributions of stocks to the major stock exchanges. However, these indexes differ in terms of median firm size and especially maximum firm size, which varies from about $250 million to over $4 billion. The period investigated is from 1984 to 2000. More...
31/10/06
Mutual Fund Performance
H. Qi and M. Alikakos. Qi and Alikakos propose a comparison of the risk-adjusted performance generated by closed-end and open-end mutual funds. Closed-end funds sell a predetermined number of shares at a given time and generally do not buy their shares back, while open-end funds continuously sell their shares and consequently have to keep large amounts in cash or in money market vehicles. Given these characteristics, closed-end funds should intuitively outperform open-end funds. However, this requires confirmation by empirical results. More...
05/09/06
Mutual Fund Performance
S. Lee and S. Stevenson. Real estate funds are mutual funds that invest in equity securities of companies engaged in the real estate industry. In this study, Lee and Stevenson assess the selection and timing ability of 19 UK real estate funds, from the 1st quarter of 1991 to the 3rd quarter of 2001. The point that is of particular interest is the comparison between the results obtained through traditional models and through meta-analysis. The traditional models used are the Treynor and Mazuy (1966) quadratic model and two specifications of the dual-beta model of Henriksson and Merton. The Treynor and Mazuy quadratic model improves the CAPM, by adding the measure of market timing ability to the measure of selection ability. More...
24/08/06
Currency Strategy Performance
M. Huttman and L. Harris. Huttman and Harris, two London-based specialists of currency programs, highlight that the impact of currency risk in equity and bond portfolios is non-negligible. For example, focusing on equity portfolios in EUR, USD, JPY, GBP, and CHF, they show that currency risk represents about a fifth of the total risk. Then, they distinguish two ways in which to manage the currency risk. The first way consists in neutralizing the currency risk. The second consists of active currency management. According to the authors, this type of strategy is of particular interest, because “the opportunity to generate positive returns exists in all market environments.” More...
18/08/06
Indexes
Paul Demskie, Francis Gupta. It is common practice for investors to split their domestic equity allocation between equity size (large/mid/small) and styles (growth/value). Whether they use passive or active management, they select an index or a benchmark to guide their style allocation. Most of them are then convinced that their portfolio is exposed to the style they seek. In this article the authors warn investors to be cautious in their index or benchmark choice, because this choice will determine their style exposure.
They observe that different style benchmarks, which are supposed to describe one style, exhibit very different month-to-month performances. More...
08/08/06
Mutual Fund Performance
Steven Kaplan, Berk Sensoy. Kaplan and Sensoy study the benchmark-timing ability of mutual funds. Timing tests are conducted in two ways. First, benchmark-timing ability is tested by considering changes in the portfolio weight on cash. Second, benchmark-timing ability is tested by scrutinizing changes in the benchmark beta of the equity portion of the portfolio. The authors stress that it is the benchmark-timing ability, not the market-timing ability, that is examined. They focus on benchmarks that are self-designated by mutual funds in their prospectus, to respect the SEC requirement introduced in 1998. More...
28/07/06
Indexes
John Southard, Bruce Bond. Southard and Bond explain that indices were created to measure price movements in the markets and were not intended to become investment supports. As a result, most market indices do not appear to be suitable to serve as benchmarks. First, the market-cap or float-weighted construction of most indices creates a stock-specific risk problem, due to lack of diversification. The second limitation of conventional indices is that the stocks selected to enter indices are not evaluated in terms of their performance. Stocks are placed in the index regardless of their investment value, creating embedded valuation risk when used as investable portfolios. More...
30/06/06
Indexation
Françoise Charpin, Dominique Lacaze. The authors note that for the purposes of both active and passive management, it may be useful to hold only a limited number of the benchmark assets. This may avoid holding very small and illiquid positions in portfolios, and limits administration and transaction costs. This subject has already been considered by Jansen and van Dijk, who proposed to use a diversity measure to deal with constraints on the number of stocks in a portfolio. According to Jansen and van Dijk, finding the exact solution to the optimization problem, including constraints on the number of stocks, would not be possible in most cases. In the present article, Charpin and Lacaze propose modelling which allows them to introduce such a constraint and to provide an exact solution to the problem. More...
16/06/06
Indexes
Craig L. Israelsen. Since a large number of equity style indices exist, it is tempting to compare their performance. In a previous study, Tweddell (2003), looking at the performance differences among various small-cap indices, underlined that the choice of the index used as benchmark makes a considerable difference in judging fund performance. As a result, it may be possible for a mutual fund company to do what Israelsen calls “benchmark shopping”, which consists of choosing to compare its funds to the index with the worst performance, among a set of indices, in order to make its own funds look better. More...
13/06/06
Indexes
Moshe Milevsky, Andrew Aziz, Al Gross, Jane Thomson, David Wheeler. Considering the case of social responsibility investment, where some companies are discarded from a portfolio because of their lack of social responsibility, the authors propose an optimization method to find the optimal portfolio weights for the remaining assets in order for the portfolio performance to be as close as possible to that of the portfolio that does not eliminate assets. To illustrate their procedure, they consider the Canadian S&P/TSX 60 index and apply a screening process to the index based on Corporate Social Responsibility (CSR) criteria. More...
09/05/06
Indexes
Harry M. Kat. Indexation appears to be a very popular investment strategy, concerning 20 to 40% of institutionally managed assets. The idea behind indexation is that markets are efficient and that the best way to perform well is to passively hold a diversified index. However, Kat notes that indexation is not necessary an optimal investment if one considers that stock market indices are created to reflect stock market movements and not to be good investments. Stocks are not selected based on their expected future performance or risk-return profile but simply on market capitalization. As a result, the composition of indices tends to be quite unstable, and the stock weights change continuously. More...
09/05/06
Indexes
Jack Treynor. In this article, Treynor again considers the problem of designing a good index for indexation. He defines what he calls market-valuation-indifferent (MVI) indexing as being indexing in which the index is built on any weights that avoid the problem of market capitalization. It appears that stock markets price stocks imperfectly, but on average overpriced stocks counterbalance underpriced stocks, resulting in a symmetrical distribution of error. If market value is used for index construction, more weight is given to the stocks with positive price errors, while stocks with negative price errors receive less weight. More...
14/04/06
Indexes
Hamish Seegopaul, Francis Gupta, John Prestbo. The authors note that the choice of benchmark plays a considerable role in portfolio performance. Benchmarks serve to identify portfolio alpha and for that purpose they are expected to be efficient. Moreover, benchmarks are expected to be representative, measurable and replicable. Finally, benchmarks should be information-free, resulting in zero average alpha for a large population of managers over a long period. This paper investigates domestic large-cap equity benchmarks, which are identified as being of major interest for plan sponsors. More...
10/04/06
Indexes
Robert D. Arnott, Jason Hsu, Philip Moore. The authors note that most investment management relating to indexes uses capitalization-weighted indexes, even though many academic papers have rejected the hypothesis that cap-weighted indexes are mean-variance efficient and suggested the existence of more efficient indexes. In this article, Arnott, Hsu and Moore propose to use fundamental metrics to weight indexes and demonstrate that these indexes are more efficient than cap-weighted-indexes. The authors note that cap-weighted indexes have some good characteristics, which should be preserved in any other weighting system. First, capitalization-weighting is equivalent to a passive strategy and consequently requires no rebalancing. Transactions will be limited to constituent replacement. More...
05/04/06
SRI Performance
Michael Schröder. SRI investment, while still small in absolute terms, is a growing part of investment in many countries. Numerous studies have investigated the performance of SRI investment funds compared to conventional funds without finding a significance difference between the two, even though one would expect lower returns from SRI funds due to the reduction in the investment universe from the screening process. In this article Schröder analyses the effect of SRI screening on portfolio performance. Unlike previous studies, he chooses to consider SRI indexes rather than SRI funds, to avoid dealing with transaction costs, market timing and fund management skill effects in measuring performance. More...
30/03/06
Indexes
Jason C. Hsu. Hsu begins by recalling why it is interesting to choose cap-weighting to construct portfolios. First, cap-weighting is equivalent to a passive strategy and thus requires no active management, resulting in no active management fee. Second, cap-weighted portfolios are automatically rebalanced as security prices fluctuate. Therefore, rebalancing costs are restricted to portfolio constituent replacement. Third, as there is a high correlation between market capitalization and liquidity, cap-weighting, which assigns the largest weights to the biggest companies, ensures that the portfolio is mostly invested in highly liquid stocks. More...
14/03/06
SRI Performance
Rob Bauer, Jeroen Derwall, Rogér Otten. The number of socially responsible mutual funds available is growing rapidly. It has been argued that this type of investment should tend to have lower returns than conventional investment because of restrictions in asset selection and the additional costs for asset screening. However, previous studies have not concluded that there is a significant difference in performance between ethical and conventional funds. More...
09/03/06
Indexes
Chih-Wei Huang. As indexation is growing, investors are becoming more and more concerned with the way indexes are built, including their weighting methodologies. Various weighting systems have been experimented with in the past. The first index, the Dow Jones Industrials Index, was price-weighted. Later, market-capitalisation weighted indexes were considered the best way to obtain accurate market representation with limited turnover. However, this did not solve one of the most important points to focus on when deriving an index, according to Huang, which is liquidity. More...
27/02/06
SRI Performance
Rob Bauer, Kees Koedijk, Rogér Otten. The social awareness of investors has led to an increase in the development of ethically managed mutual funds and caused academics and practitioners to investigate the consequences in terms of investment performance of this specific choice. Most of the studies conducted on the subject have concerned either US or UK funds, and have only been based most of the time on the consideration of simple indicators like the Sharpe and Treynor ratios and Jensen’s alpha. In most cases, the conclusion was that there were no statistically significant differences between the returns of ethically screened and unscreened universes. More...
22/02/06
Indexes
Jason C. Hsu, Carmen Campollo. Indexing appears to be an easy, inexpensive way of carrying out equity investment. Sharpe’s Capital Asset Pricing Model, by suggesting that a cap-weighted market index is an efficient equity investment, contributed to the popularity of index investing and to the development of exchanged-traded funds. However, capitalisation weighting, which is the weighting most commonly used by market indices, is not the best way for a portfolio to achieve good performance. Previous studies have underlined that cap-weighted indexes underperform non-cap-weighted portfolios with similar risks. More...
22/02/06
SRI Performance
Michael Schröder. With the growth in socially responsible investments in recent decades, many studies have investigated whether SRI funds, which are subject to restrictions in terms of asset choice, can reach equivalent performance levels to those of unrestricted funds. Schröder begins with a recap of the main studies that have been performed on the subject of SRI fund performance, recalling the different markets and periods investigated and the various methodologies used. Most of them have concluded that there is no significant difference between the performance of SRI funds and the performance of traditional funds. More...
06/02/06
SRI Performance
Bert Scholtens. Socially Responsible Investment (SRI) has grown considerably during the past few years, not only in the United States, but also in most developed markets. Scholtens notes that most of the studies performed on SRI fund performance have considered the US markets, while few studies have looked at other markets. He underlines that the Dutch market is an interesting one to study as it is one of the European markets with the highest percentage of SRI in overall investment. More...
30/01/06
Performance
Ammann and Moerth. Ammann and Moerth study the relationship between fund size and performance. The conclusions could be useful in constructing an explicit micro-factor model, where fund characteristics are selected as return factors. A significant relationship between fund size and performance can lead to fund size being included in an explicit micro-factor model. More...
09/11/05
Performance
Lars Jaeger. Jaeger argues that modelling returns of hedge fund indices can give reliable results, in spite of the shortcomings of the indices. This is due to the fact that the shortcomings only impact absolute performance measurement, and not the risk characteristics.
To model each hedge fund strategy, a macro explicit factor model is used, including linear and non-linear factors. For each strategy, the dependent variable is the corresponding return of the hedge fund index, provided by Hedge Fund Research. Returns are regressed from January 1994 to December 2004. An autocorrelation factor is added to take into account persistent price lags in the valuation of hedge funds. The regressions result in a wide range of R². More...
29/10/05
Funds of Hedge Funds
Emily Denvir, Elaine Hutson. Despite the recent phenomenal growth in funds of hedge funds, there has been only a limited amount of research on their performance – most of the academics seem to focus on individual hedge funds. In this paper, Emily Denvir and Elaine Hutson are filling the gap by analyzing the performance and diversification potential of a sample of 332 funds of hedge funds (FOHFs) for the period from January 1990 to May 2003. Consistent with prior studies, the authors find that over the considered period, funds of hedge funds appear to underperform a hedge fund index on a risk-adjusted basis. These sorts of findings are usually explained by the ‘double fee’ structure inherent in funds of hedge funds. More...
30/08/05
Performance
R.G. Ibbotson and P. Chen. Chen and Ibbotson propose a study on two subjects that are now well-documented in the hedge fund area, survivorship and backfill biases on the one hand, and the sources of returns on the other. The database, provided by TASS, covers January 1994 to March 2004. Funds of funds are excluded. The sample contains 2,054 live funds and 1,484 dead funds. In order to estimate the survivorship and backfill biases, six sub-samples are formed: live funds only with backfill data, live funds only without backfill data, live and dead funds with backfill data, live and dead funds without backfill data, dead funds only with backfill data and dead funds only without backfill data. More...
17/08/05
Performance
C. Alexander and A. Dimitriu. Alexander and Dimitriu study switching hedge fund strategies. This involves the fact that return distributions and/or exposures to risk factors and/or alphas depend on the regime, which could be the market environment. The following example of switching is given: a long/short equity strategy is long during bull markets and short during bear markets. According to the authors, linear models cannot take switching strategies into account. They propose the use of a Markov switching model. Two types of models are used: a single factor model and a two-factor model. More...
10/08/05
Performance
Greg N. Gregoriou. Survivorship bias is one of the potential biases that affect databases. Survivorship bias occurs if the database only contains information on “surviving” funds. Since this bias has a positive impact on returns, it is interesting to analyse the mortality of funds as part of performance measurement. In this paper, Gregoriou conducts a survival analysis that focuses on the market neutral and event driven strategies. The data used, provided by Zurich Capital Markets, covers the period from January 1990 to December 2001. It contains 325 live and 205 defunct market neutral funds and 142 live and 71 defunct event driven funds. The effects on survival time of several predictor variables are examined. These covariates are average monthly return, average millions managed, age, performance fees, management fees, leverage, redemption period and minimum purchase. More...
30/06/05
Performance
Craig L. Israelsen. Two simple performance indicators are often used to rank funds. The first one, the Sharpe ratio, was introduced by Sharpe (1966). It estimates the fund's excess return with regard to the risk-free rate divided by its standard deviation. The second one, the information ratio, is defined in a similar way by replacing the risk-free rate with a benchmark portfolio. The denominator of this ratio is therefore the fund's tracking-error. Israelsen points out that these two indicators may lead to spurious fund rankings when excess returns become negative. In that case, the fund with the higher ratio is not always the best one. The author illustrates this assertion with an example. As the issue is the same for the Sharpe ratio and the information ratio, numerical examples are presented for the information ratio only. More...
24/06/05
Performance
Arun S. Muralidhar. The development of risk-adjusted performance measures is a major research theme. In this article, Muralidhar first gives an overview of the various existing measures. The first two measures developed were the Sharpe ratio and the information ratio. These measures were criticised by Modigliani and Modigliani (1997) for not putting a figure on the amount of return and not giving any information on how portfolios should be built. By adapting the Sharpe ratio, they proposed an alternative measure called M². Their measure is expressed in basis points of outperformance, which is easier to understand for the average investor, and it adjusts for differences in volatility between the portfolio and its benchmark. However, according to Muralidhar (2000), this measure still lacks some essential qualities. More...
17/06/05
Performance
Kenneth Winston. Constructing an efficient portfolio presupposes considering both its risk and return. In order to make the process simpler, indicators summing up risk and return in one scalar have been developed and proposed to investors. These single scalar measures, which include the Sharpe ratio, the information ratio, the Treynor ratio and Jensen's alpha, serve to evaluate portfolio performance. The fund rating system proposed by Morningstar is also based on a single number to evaluate fund performance. The methodology, introduced in 1985, has since been improved. Nevertheless, the new measure still shows some weaknesses. Winston underlines the fact that single scalar measures are not sufficient to describe portfolio behaviour. More...
10/06/05
Performance
R.J. Surz. Surz examines the application of Monte Carlo Simulation (henceforth MCS) to hedge funds, by testing the hypothesis “Performance is good”. MCS is presented as an alternative to traditional performance measurement approaches. According to the author, traditional peer groups and indexes cannot be used in the hedge fund area. The test is conducted as follows: the actual performance is compared to all the possible outcomes previously evaluated (“what could have happened”). More precisely, the possible outcomes correspond to the possible portfolios that a hedge fund manager could have constituted. These portfolios are created on the basis of the investment parameters followed by the hedge fund manager, for example the investment style, the long and short positions, the fees and the leverage. The author applies the MCS by focusing on the Market Neutral strategy.
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08/06/05
Performance
J. Brunel. The increasing number of hedge funds and the growing amounts invested in this area are sources of debate on the hedge fund market's capacity to continue to generate high yields, in spite of a potential erosion of the various market opportunities. In this study, where the hedge fund universe is separated into three groups (traditional absolute return strategies, semi-directional strategies and managed futures), the author conducts a polynomial trend analysis of the alphas, on periods from December 1990 to June 2004 and from January 1993 to July 2003. He recognizes the possible limitations of his study due to the fact that the alpha is calculated in a “unidimensional” way, by subtracting the return of an “asset class benchmark”. More...
13/05/05
Performance
V. Karavas, H. Kazemi, G. Martin and T. Schneeweis. In this paper, Karavas, Kazemi, Martin and Schneeweis study the impact of leverage on risk and return in the hedge fund universe. They examine 6 strategies, namely Convertible Arbitrage, Equity Hedge, Event Driven, Distressed Securities, Merger Arbitrage and Equity Market Neutral, on the basis of CISDM and TASS databases, from January 2000 to March 2003 (39 monthly observations). After dividing the sample into two equal-weighted indexes that represent respectively funds with reported leverage information and funds which do not report leverage information, the Welch t-test and the Kolmogorov-Smirnov test exhibit that for the six strategies the distributional characteristics do not differ between the two indexes. More...
06/05/05
Performance
Arturo Rodriguez Castellanos, Belén Vallejo Alonso. This article deals with the problem of fund classification. It is usual to group funds according to the asset classes in which they are invested or according to their investment style. The resulting groups serve in particular to compare fund performance and to perform a ranking of the funds. These groups are supposed to be made up of funds exhibiting similar characteristics and risk. Meanwhile, several studies have identified evidence of fund misclassifications. It appears that funds are often subjected to a level of risk that is higher than that declared by managers. This subject of misclassification is quite important as investors often rely on fund categories to select the funds in which they want to invest. They are in particular greatly influenced in their choice by the ranking of funds according to performance within the categories. More...
15/04/05
Hedge Fund Allocation
Ivilina Popova, David Morton, Elmira Popova. It is now well documented that several hedge fund strategies tend to have non-normal return distributions and exhibit significant positive or negative skewness and a high level of kurtosis. Portfolio optimization and asset allocation models based on the mean variance framework ignore this. Consequently, they are unable to provide an accurate view of how hedge funds effectively behave within a portfolio. In particular, most of the time, they suggest overoptimistic hedge fund allocations, with great mean variance characteristics, but unacceptable levels of skewness and kurtosis. In this paper, the authors provide an effective means of dealing with this problem. The general problem of maximizing an investor’s utility of wealth function over one period and a set of asset classes with known return distributions is hard to solve exactly, because it involves both non-normal distributions and a continuous range of potential returns. More...
04/04/05
Indexes
Jacobson Fund Managers. This paper examines several strategies for investing in investable hedge fund indices. The investing strategies studied involve equally weighted buy and hold portfolios, portfolios formed on the basis of cumulative returns (with the use of a simple momentum and contra/reversal models), and portfolios formed on the basis of the Rachev ratio (with the use of simple momentum and contra/reversal models). For each strategy the authors observe heterogeneity in the returns displayed by the different indices provided by FTSE, HFR, MSCI Lyxor and Standard and Poor’s, with a calculation period from January 1998 to September 2004.
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16/03/05
Asset Allocation
L. Favre, J.A. Galeano In this paper the authors analyze the impact of hedge funds on a “typical” Swiss pension fund portfolio satisfying the regulation established in the “Loi sur la prévoyance professionnelle” (LPP). As stressed by the authors, mean-variance analysis has largely been utilized in the literature to assess the diversification properties of hedge fund strategies. However, this approach relies on two assumptions that are violated in the case of hedge funds, namely, investors have quadratic utility and asset returns are normally distributed. First, investors care about higher moments, and second, hedge fund returns are skewed and leptokurtic (i.e. fat-tailed). More...
20/02/05
Asset Allocation
J.-H. Cremers, M. Kritzman, S. Page It has widely been shown in the literature that hedge fund strategies generate non-normal returns. The authors investigate the extent to which the efficacy of mean-variance optimization is compromised in the presence of significantly negative skewness and positive kurtosis. They thus construct portfolios focusing on specific strategies (i.e. equity hedge, convertible arbitrage, event driven and merger arbitrage) as well as diversified portfolios (i.e. across all of the aforementioned strategies), with funds taken from the CISDM database from January 1994 through December 2003. They then compare the results obtained through mean-variance and full-scale optimization, for investors with, alternatively, log wealth utility functions and bilinear or S-shaped value functions. More...
20/02/05
Alternative Investments
A. Passow Hedge fund strategies may be classified into two broad categories: low volatility and high volatility strategies. Obviously, when using the traditional mean-variance optimization procedure, strategies falling into the first category receive the largest allocation. However, this does not account for the interaction between the first four order moments of the return distribution (i.e. mean, standard deviation, skewness and kurtosis). To address this issue the authors suggest modeling higher order moments while applying the Johnson cumulated densities, and propose a new framework based on the Johnson-Omega. More...
20/02/05
Alternative Investments
L. Favre, J.A. Galeano In this paper, the authors build on Huisman, Koedjik, and Pownall’s (1999) work on asset allocation in a VaR framework, and propose using the Cornish Fisher (1937) expansion to take account of the third and fourth order moments of the return distribution (i.e. skewness and kurtosis). The rationale behind this approach is that risk is underestimated if the portfolio has negative skewness and/or positive excess kurtosis. As stressed by the authors, as long as the underlying assets present normal return distributions, portfolios constructed in a mean-variance and mean-VaR framework are identical (see Arzac and Bawa (1977)). More...
20/02/05
Asset Allocation
S. Chung, M. Rosenberg, J.F. Tomeo The efficiency of the asset allocation process strongly relies on the stability of the parameters. It is thus extremely important, at a preliminary stage, to identify groups of assets presenting similar characteristics and behaviours through time. Due to the considerable diversity of investment styles in the alternative arena, and to the lack of consensus regarding the definition of hedge fund strategies, this task is particularly challenging. More...
20/02/05
Alternative Investments
P.A. Barès, R. Gibson and S. Gyger There is ample evidence in the literature that the attrition rate for hedge funds is significantly higher than that observed for mutual funds. Measuring the consequences of the survival uncertainty of hedge funds is thus an acute issue when it comes to measuring hedge fund performance or constructing portfolios of hedge funds. To investigate the latter issue, the authors suggest using a framework that allows the risks associated with hedge fund’s survival uncertainty to be accounted for. In an initial step, the authors calculate the survival probabilities associated with the different funds contained in the sample. To this end, they use three determinants, namely, the size of the assets under management, the style consistency of the manager, More...
17/02/05
Alternative Investments
F.S. Lhabitant, M. Learned.. Studies on alternative diversification have long focused on the impact of the introduction of hedge fund strategies into traditional portfolios. The originality of this paper is to tackle the diversification issue from a different perspective. What is the behavior in terms of risk and return of a focused fund of hedge funds when the number of its constituents increases? In an attempt to avoid over-exposure to one specific fund, fund of hedge fund managers invest in several funds. They thus diversify specific risks. Unfortunately this does not come as a free lunch. Increasing the number of funds lead to a dilution of the contribution of each fund to the return and risk profile of the fund of hedge funds. As a result, fund of hedge fund managers have to determine a reasonable trade-off between under- and over-diversification. More...
16/02/05
Alternative Investments
R.J. Davies, H.M. Kat, S. Lu The authors introduce a Polynomial Goal Programming (PGP) optimisation model to account for third and fourth order moments of the return distribution (i.e. skewness and kurtosis) in portfolio construction. This approach incorporates investor preferences for high moments and is aimed to construct portfolios presenting an optimal balance between multiple conflicting objectives such |
