Archive for the 'Research' Category

High Yield Bond Returns: Downgrades versus Original Issues

Bonds may either be issued as speculative grade bonds (original issue)or become so following a rating downgrade (fallen angels). In either case, their risk-adjusted returns should be similar. However, in an article published in the Fall 2007Journal of Portfolio Management Fridson and Sterling point out that fallen angels have historically delivered far higher risk-adjusted returns, and discuss several explanations for an apparent market inefficiency.

The authors find the correlation between fallen angels and original-issue speculative grade debt to be lower than that between Treasuries and investment-grade corporate bonds, suggesting dissimilar attributes and below the threshold normally used to classify securities as part of the same asset class.

Possible reasons for the disparity include:

  • Lack of investor awareness, given that the primary high-yield index only recently began breaking out the performance of the two categories
  • Emphasis on security selection and possible overconfidence among managers that they can pick the superior original-issue bonds
  • Investability – fallen angels account for just 30% of available speculative-grade debt and trade infrequently
  • Lottery-like returns for specific original issue bonds
  • Yield appeal due to higher yields typically found with original issue bonds

Posted on 6th October 2008
Under: Active Management, Investing in Distressed Securities, Investing in bonds, Investment Returns, Performance Measurement, Research, Risk Management | No Comments »

Why Do Hedge Funds Stop Reporting Performance?

Hedge funds are not required to report their performance, and those who voluntarily report can opt out of reporting at any time. There are at least two possible reasons a hedge fund might choose to stop reporting results:

  • Poor performance, possibly including fund closure
  • Very good performance has eliminated the need to attract capital

In the Fall 2007 Journal of Portfolio Management, Grecu Malkiel and Saha examine both hypotheses, and find a pattern of declining performance in the months leading up to cessation of reporting. Further the probability that a fund will stop reporting increases rapidly during the first five years of a fund’s life and then gradually declines from the peak. Funds with high Sharpe ratios, more assets and peer-beating performance are less likely to stop reporting.

The authors conclude that hedge funds stop reporting results due to poor performance, rather than strong performance.

Posted on 6th September 2008
Under: Active Management, Alternative Assets, Hedge Funds, Investment Returns, Performance Measurement, Portfolio Management, Research | No Comments »

Patterns in Analysts’ Long-term Earnings Forecasts

It is generally accepted that more accurate earnings forecasts by analysts should result in superior investment performance. In the Winter 2007 Journal of Investing Fortin, Gilkeson and Michelson examine three hypotheses to determine what factors may be advance indicators of superior forecast accuracy.

Hypothesis 1 is that more frequent forecast updates represent greater analyst effort and indicate greater accuracy. No support is found for this hypothesis.

Hypothesis 2 is that (a) greater changes in successive estimates result in more accurate forecasts and (b) given a tendency toward optimism, a decrease in estimates is a stronger indicator than a similar-size increase. Tests of this hypothesis find no support and even that larger changes suggest greater error and may be a signal of higher uncertainty, regardless of direction.

Hypothesis 3 is that (a) the magnitude of the change in earnings relative to last year’s earnings indicates greater accuracy and (b) a decrease is a stronger indicator than a similar magnitude increase. They find that larger changes lead to less accuracy, but that forecast declines lead to greater accuracy.

The authors conclude that investors should avoid following recommendations of analysts who frequently revise estimates and who change forecasts by significant amounts. However, they suggest that analysts forecasting earnings declines are worth noting.

Posted on 8th August 2008
Under: Fundamental Analysis, Investing in Stocks, Research | No Comments »

Do Market Timing Hedge Funds Time the Market?

Many studies have questioned the ability of mutual funds and pension funds to time the market. In an article published in the December 2007 Journal of Financial and Quantitative Analysis, Chen and Liang examine the returns of 221 hedge funds self-identified as market timers. They find that, for the 1994-2005 period, evidence supports timing ability – especially in volatile or bear markets.

The results are robust to model specification and volatility timing. They do not appear to result primarily from option-like trading or luck.

The authors conclude that the flexible strategies associated with hedge funds are useful for professional market timers, and that funds promising market-timing results are likely to deliver them.

Posted on 6th August 2008
Under: Active Management, Alternative Assets, Hedge Funds, Investment Returns, Performance Measurement, Research | No Comments »

Equity Returns at the Turn of the Month

Various studies have documented that the four-day period starting with the last trading day of a month and ending on the third trading day of the subsequent month accounts for the bulk of stock market returns. In the March/April 2008 Financial Analysts Journal McConnell and Xu show that this effect has persisted, and is not confined to small capitalization or low priced stocks. It occurs in 31 of the 35 countries they examined and does not appear to be caused by month-end buying pressure as measured by trading volume or equity fund money flows.

Posted on 5th August 2008
Under: Active Management, Investing in Stocks, Investment Returns, Research, Risk Management, Technical Analysis | No Comments »

Guidelines for Withdrawal Rates and Portfolio Safety During Retirement

For individuals drawing on retirement funds, a 4% withdrawal rate is generally recommended to result in only a small chance of the portfolio running out of money. In the October 2007 Journal of Financial Planning Spitzer, Strieter and Singh simulate thousands of 30-year periods to assess the overall probability of running out of funds.

They find that a standard 50/50 split between stocks and bonds can allow for a 4.4% withdrawal rate with just a 10% chance of depleting funds. Withdrawal rates of up to 6% can be supported with stock allocations of 75% or more.

Posted on 10th July 2008
Under: Asset Allocation, FInancial Planning, Investing in Stocks, Investing in bonds, Investment Returns, Personal Finance, Portfolio Management, Research, Risk Management | No Comments »

How Many Stocks are Needed for Diversification?

Portfolio management theory asserts, based on the variance between a given asset and the rest of the portfolio, that as few as 8-20 stocks are sufficient to provide most of the benefits of diversification.

In the November 2007 Financial Review Domian, Louton and Racine challenge this assumption by proposing that long-term investors are likely to be more concerned with shortfall risk (failure to reach a target ending wealth) than with return variance.

Based on the returns of 1,000 stocks and a safety first criterion, they find that at least 164 stocks are necessary to reduce shortfall risk to no more than a 1% chance of underperforming Treasury bonds. Although smaller portfolios can be enhanced by diversifying across industries, the benefit is not as powerful as that provided by simply adding more stocks to the portfolio.

Posted on 9th July 2008
Under: Active Management, Asset Allocation, FInancial Planning, Institutional Investing, Investing in Stocks, Investment Returns, Passive Management, Performance Measurement, Portfolio Management, Research, Risk Management, Security Selection | No Comments »

Market Timing by Mutual Funds

Previous studies based on returns-based analysis have found no evidence of market-timing ability by mutual funds. In the December 2007 Journal of Financial Economics, Jiang Yao and Yu conduct a holdings-based analysis of 2,300 equity mutual funds and conclude that mutual fund managers have positive and statistically significant market timing ability for three- and six-month periods.

Mutual fund characteristics associated with positive market timing ability include high industry concentrations, large size, and small-capitalization orientations. The authors also find that stronger market timing results are associated with shifting between industries than by adjusting allocations within an industry.

Posted on 8th July 2008
Under: Investing in Stocks, Performance Measurement, Research | No Comments »

Asset Fire Sales in Equity Markets

When mutual funds experience large investor outflows, they must often quickly reduce their holdings to return funds to investors. Such forced liquidation can lead to asset sales at “fire sale” prices. In the November 2007 Journal of Financial Economics, Coval and Stafford show that mutual funds do not allow for the risk of such events, and that such flows are predictable – resulting in an incentive to front run the funds.

Funds in the highest and lowest deciles ranked by performance and prior outflows predictably face large inflows and outflows in subsequent periods. Investors can anticipate such flows by buying or selling the largest fund holdings ahead of the cash flows and reversing the position afterward.

Posted on 7th July 2008
Under: Active Management, Fundamental Analysis, Institutional Investing, Investing in Stocks, Investment Returns, Research | No Comments »

Are Hedge Fund Strategies Just About Leverage?

The growth in the hedge fund industry has increased the importance of measuring how hedge funds achieve their returns. Since many funds either explicitly or implicitly use leverage, a useful question is whether hedge funds merely represent an expensive way to use leverage.

In an article published in the Winter 2007 Journal of Wealth Management, Jean Brunel finds that simple leverage does not appear to be the primary determinant of market-neutral or long-short hedge fund returns. Instead, three broad themes emerge:

  • Beta leverage is not a strong element of long-short or market neutral returns
  • Hedge fund return replication requires dynamic management of leverage
  • When hedge fund managers use leverage, they tend to lever their value added skills rather than generic risk exposures

Posted on 6th July 2008
Under: Active Management, Alternative Assets, Hedge Funds, Investment Returns, Performance Measurement, Research, Risk Management | No Comments »