Financial Education

When investing or considering investments in International assets, investors should consider the following special issues:

Currency risk: This affects both return and volatility. Investors must decide whether to hedge this risk.

Correlations with other assets: Although international assets frequently have low correlations with domestic assets, the correlations increase during times of stress. Times of stress are exactly the times in which a low correlation (higher diversification benefit) is most needed.

Emerging markets: Emerging markets tend to be less liquid and less transparent than developed markets. Their investment return distributions tend to be non-normal, which is significant for investors employing mean-variance optimization strategies.

Cash

Cash managers can earn higher returns by accepting longer-dated maturities or credit risk. The yield curve reflects the consensus expectation for future interest rates. Managers must distinguish between future events that are reflected in the yield curve adn those that will surprise the market.

Nominal Default Free Bonds

Conventional government bonds of developed countries have little or no default risk. Return can be disaggregated into real return and an inflation premium. The investor must compare his own forecast for inflation with that imbedded in the yield. If the investor believes inflation will be lower than expected, the bonds are a good buy.

Defaultable Debt

Default risk in commercial bonds is reflected in a premium yield relative to Treasuries. This spread tends to widen in recessions as economic stresses increase the likelihood of default. Understanding when a bond is pricing in greater default risk than is necessary can help determine whether securities are attractively priced.

Emerging Market Bonds

The sovereign debt of non-developed countries is often priced in foreign currencies. Since the issuer cannot print the money needed to cover repayment such bonds are subject to default risk, similar to corporate debt of similar ratings. A country risk analysis often involves an understanding of local politics.

Inflation Indexed Bonds

Inflation indexed bonds allow investors to directly observe the consensus inflation forecast by comparison with the yield of conventional bonds. The yield curve will still vary with the real economy and according to supply and demand. However, higher volatility of inflation will increase their hedging value and can result in lower real yields.

Common Stock

The economy affects earnings (cash flows) and interest rates in opposite directions. Trend growth depends on labor growth, investment and productivity while the business cycle affects profitability. In emerging economies, ex-post risk premia have been higher and more volatile than in developed countries.

Real Estate

Returns are affected by growth in consumption, real interest rates, the term structure of interest rates and unexpected inflation. Economic cycles can also affect the cost of building materials and construction labor, but the net effect of lower interest rates is positive for real estate valuations.

Currencies

Exchange rates reflect the balance between supply and demand. Imports increase currency supply, usually reducing its value. Capital flows for investment purposes, however, may outweigh the effect of trade imbalances. Differences between local interest rates can also affect exchange rates, as the higher yielding currencies attract capital and thus the currency value.

Historical averages incorporate many different types of economic environments, only some of which may be relevant to current conditions. One of the most important areas for investors to apply subjective judgment and insights is in “conditioning” historical data or choosing the periods that best reflect current conditions.

Even when using conditioned data, it is important for the analysis to incorporate any new facts that may be relevant to the decisions being made.

A Monte Carlo approach takes the probability distribution to generate multiple “paths” of possible return outcomes over time. It is superior to steady-state (deterministic) approaches to forecasting because it incorporates variability over long time horizons and illustrates how the resulting paths affect ending wealth.

Monte Carlo simulations generate probability estimates of ending wealth rather than a single point estimate. As a result, they more closely approximate likely investment outcomes.  They also provide insight as to the trade-off between short term risks and long-term potential of failing to meet the investment objective. The simulations can also incorporate multiple tax scenarios.

Behavioral finance theory has pointed to research that shows short-term momentum and long-term reversals in pricing as signs that markets are not fully efficient. In the December 2007 Journal of Finance George and Hwang show that the trends may be at least partially attributable to the differential tax rates applied to short-term and long-term capital gains.

The authors first note an asymmetry between the reversals of stocks with capital gains and stocks with capital losses. In the latter case, there is no tax incentive for holding over longer periods. They then test the capital gains hypothesis by comparing U.S. results to Hong Kong, where there are no capital gains taxes. They find no evidence of reversals in Hong Kong, supporting the thesis that short term momentum may be a means of compensating holders for additional taxes, while long-term reversals result as the tax effects subside.

The study is reminiscent of Harti’s study showing underperformance around the anniversary dates of large price swings, which would also appear to be tax-driven.

Investment managers often have a fiduciary duty to their clients, which means their investment actions must consider the portfolio’s appropriateness in terms of:

1. the needs and circumstances of the client
2. the basic characteristics of an investment
3. the basic characteristics of the overall portfolio

Since each of these factors can change over time, fiduciary duty requires actively monitoring each using a systematic process.

Liquidity requirements are any need for cash in excess of the amount being saved (or contributed in the case of endowments or pension plans) in a given year. Liquidity requirements usually stem from liquidity events.

Liquidity events may be planned for, such as a child’s education. They may also be unplanned, such as a medical emergency. In either case they require a portfolio allocation to assets that can be readily converted into cash without impacting their value.

In some cases, liquidity requirements can also be met by using derivatives or insurance products.

Assets should be considered for portfolio addition if their inclusion would improve the portfolio’s mean-variance efficient frontier. This occurs when the asset class’s Sharpe ratio is higher than the product of the existing portfolio’s Sharpe ratio and the correlation between the asset class return and the portfolio return.

For example, a manager may be considering whether to add an asset class with a Sharpe ratio of 0.18 to a portfolio with a Sharpe ratio of 0.20. The correlation between the asset class and the portfolio is 0.5. Since 0.18 > 0.20 * 0.5 = 0.10, the asset class should be added.

The methods analysts use to estimate future returns tend to be influenced by data mining and time period biases.

Data mining refers to the fact that given enough data, certain relationships may appear due to randomness yet have no real relationship that will apply in future periods. Such relationships are not meaningful. One way to identify potential spurious correlations is to question why such a relationship would exist. “No story, no future.”

Time period bias reflects the fact that many research findings are sensitive to the start and end dates of the period measured. If a certain asset had fifty poor years followed by two very good ones, the inclusion or exclusion of those two years could have a significant impact on the results of the study.

Selecting the most appropriate asset allocation for a given investor consists of four steps.

1. Determine all possible asset allocations that meet the investor’s return requirement on the basis of total return after tax.
2. Eliminate any allocations that fail to meet the investor’s risk objective, whether through quantitative risk factors or inconsistency with subjective measures of risk tolerance.
3. Eliminate any allocations that fail to meet the investor’s other constraints (liquidity, legal, tax, unique circumstances).
4. Select, from allocations that remain, that which offers the best risk-adjusted performance and diversification.