Is Portfolio Theory Harming Your Portfolio?

Abstract:
Modern Portfolio Theory (MPT) teaches us that active equity managers who use judgment to make investment decisions won’t be able to match the returns (after fees and expenses) of blindly-invested, passively-managed index funds. Data on returns supports the theory, so it’s no surprise that investors are leaving actively managed funds in droves for the better average returns of super-diversified index strategies. Yet the reality is much murkier than we’ve been led to believe.

It turns out that the portfolio theories which inspired the creation and popularity of index funds and top-down, quantitatively-driven index-like strategies, are both flawed and impractical. There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes. However, this important fact has been lost because we allow MPT to define the debate in its own misleading terms, tilting the field in its favor and hiding the reality about active manager performance in a complex game of circular arguments.

MPT relies on a number of unrealistic assumptions including an inaccurate definition of risk. Yet this characterization of risk sets the rules for comparing active vs. passive strategies, often causing active strategies to appear more risky and less efficient than their index counterparts. The same flawed logic is used to risk-adjust returns, biasing them downward for more active, concentrated managers, and rendering this highly important measure highly suspect. Furthermore, reliance on MPT’s measure of risk pressures active managers to super-diversify. The average active fund is thus disfigured to the point where the typical "active" manager is not very active at all, casting the fund in an unfavorable light in a beauty contest versus super-efficient index funds.

Stripping away the influence of portfolio theory involves isolating and evaluating the relatively small group of equity managers who rely heavily on judgment to build concentrated equity portfolios. Empirical data from multiple studies show that these concentrated managers, in fact, persistently outperform indexes. The implications of this statement are enormous. Concentrated manager returns present the best test of whether human judgment can add value in allocating capital, and they win, convincingly. Yet while judgment has prevailed over passive investing, few have taken notice. Most investors continue to look at average active manager returns, not recognizing that these returns are minimally influenced by judgment.

Regardless of MPT’s shortcomings on both a theoretical and empirical level, its dominating influence will not easily be dislodged. MPT is deeply woven into the fabric of our financial system, its mathematical grounding and precise answers inspire confidence. Further, its application is crucial in bringing increased scale and profitability to the financial services industry. Few want to see change. As such, common sense and judgment will continue to diminish in importance as top-down, quantitative strategies and blind diversification gain investment dollars.

An informed investor should welcome this shift. As highly-diversified strategies gain assets, inefficiencies become more prevalent because share prices are increasingly driven by factors other than fundamentals. Individual investors, seeking to exploit these inefficiencies and outperform indexes, should invest in several concentrated funds with strong track records. Managers of these funds have proven themselves adept at turning inefficiencies into strong returns for their investors, and persistence data demonstrates that past performance can indicate which managers are likely to continue to outperform. Concentrated fund returns may exhibit more volatility than indexes, but we now have proof that over the long-term, good judgment will be rewarded.

Vincent, Scott, Is Portfolio Theory Harming Your Portfolio? (April 29, 2011). Available at SSRN: http://ssrn.com/abstract=1840734

What if 8% is Really 0%? Pension Funds Investing with Fingers-Crossed and Eyes Closed

Two views of pension funds; prospectively and current status:

Abstract:
It is well known that pension funds in the United States are underfunded even if they achieve their projected 8% rate of return. The scope of pension underfunding increases to an astonishing level when more probable future rates are employed. A reduction in the future rate of return from 8% to the more reasonable risk-free rate of approximately 4% causes the liabilities to explode by trillions of dollars. As bond yields declined over the past twenty years, pension funds moved toward more aggressive equity-based portfolios in an attempt to reach for this 8% return. By investing in a portfolio with uncertain outcomes, pension funds could experience increasingly volatile and even negative returns. Paradoxically, in an effort to chase the universal 8% rate, pension funds may be laying the groundwork for returns even lower than the risk free rate. In an effort to offer an empirical basis for this possibility, we conclude the paper with a relevant comparison - the return of a hypothetical Japanese pension for the past two decades. We believe that pension funds need to at least prepare for the unfathomable: 0% returns for 20 years. Most pension funds, regrettably, have not adequately stress tested their portfolios for these scenarios.

Faber, Mebane T., What if 8% is Really 0%? Pension Funds Investing with Fingers-Crossed and Eyes Closed (June 10, 2011). Cambria Quantitative Research Monthly, Issue 2, June 2011. Available at SSRN: http://ssrn.com/abstract=1862355



The Funding of State and Local Pensions in 2010

Introduction

The financial crisis of 2008-09 was a major setback for state and local pension plans, as plummeting asset values caused their funded ratios to drop significantly. The initial impact of the crisis on plan health was covered in a brief published last year. Since that time, several new developments have had a mixed effect on the current and future health of public plans. On the positive side, the stock market has risen significantly from the 2009 trough. And many states have introduced reforms to increase pension contributions and reduce future costs. On the negative side, recent growth in liabilities has outpaced growth in actuarial assets (because these values smooth market gains and losses over a five-year period). Moreover, the recession that accompanied the financial crisis has made it more difficult for states and localities to contribute the full amount of their required pension contribution. This brief explores how all of these developments affected the funded status of state and local plans in 2010..

by Alicia H. Munnell, Jean-Pierre Aubry, Josh Hurwitz, Madeline Medenica, and Laura Quinby, May 2011; SLP#17

Standard & Poor's Indices Versus Active Funds Scorecard, Midyear 2009

Standard & Poor's Indices Versus Active Funds Scorecard, Midyear 2009

Abstract:
The S&P Indices Versus Active Funds (SPIVA) Scorecard reports performance comparisons corrected for survivorship bias, shows equal- and assetweighted peer averages, and provides measures of style consistency for actively managed U.S. equity, international equity, and fixed income mutual funds. The CRSP Survivor-Bias-Free U.S. Mutual Fund Database provides the underlying data. To accommodate CRSP release schedules, SPIVA is now published semi-annually with a 6 to 8 week lag. As a result of the market volatility over the past year, domestic and international equity funds have performed in line or marginally ahead of benchmarks. However, both taxable and tax exempt fixed income funds’ assetweighted returns trail benchmarks by large margins. The latest five-year SPIVA data for equity funds can be interpreted favorably by proponents of both active and passive management. Passive management believers can point out that indices have outperformed a majority of active managers across all major domestic and international equity categories, with real estate being the lone exception. Proponents of active management can point to asset-weighted averages suggesting a more level playing field, with active managers level or ahead of benchmarks in most categories, with the exception of midcaps and emerging markets. The five-year data is unequivocal for fixed income funds. Across all categories except emerging market debt, more than three-fourths of active managers have failed to beat fixed income benchmarks. Similarly, five-year assetweighted average returns are lower for active funds in all but two categories. The turmoil of the past year saw 9% of domestic equity funds, 5% of international equity funds and 6% of fixed income funds merge or liquidate.

Standard & Poor's, Index and Portfolio Services, ,Standard & Poor's Indices Versus Active Funds Scorecard, Midyear 2009(August 27, 2009). Available at SSRN: http://ssrn.com/abstract=1462712

Who Should Save in a Roth 401(K)? (It’s Not Just About Tax Rates)

Hu, Wei-Yin, Who Should Save in a Roth 401(K)? (It’s Not Just About Tax Rates) (May 27, 2009). Available at SSRN: http://ssrn.com/abstract=1410821

Abstract:
The advent of the Roth 401(k) significantly expanded opportunities for tax-preferred retirement saving, but at the same time it created much confusion for individual savers regarding whether to save in the form of pre-tax or Roth dollars. The financial community’s conventional wisdom is based on comparing current and future tax rates. We show how relying solely on the conventional wisdom can be wrong. We first show that comparing different saving strategies requires making an apples-to-apples comparison, which can be achieved by keeping take-home pay constant. An individual currently saving pre-tax can maintain the same take-home pay by switching to a lower amount of Roth saving. However, some important rules imposed by either 401(k) plans or the IRS encourage “tax illusion” by treating pre-tax and Roth dollars as if they were equivalent. First, moderate savers need to take care to understand how switching to Roth saving could lose them free money through employer matching contributions. Second, the IRS limit on annual 401(k) contributions means that aggressive savers who save Roth dollars can save more in a tax-advantaged way than those who save pre-tax dollars. For both of these groups, the conventional wisdom can be completely reversed under fairly normal circumstances

The Microstructure of a U.S. Treasury ECN: The Brokertec Platform

Fleming, Michael J. and Mizrach, Bruce, The Microstructure of a U.S. Treasury ECN: The Brokertec Platform (July 13, 2009). Available at SSRN: http://ssrn.com/abstract=1433488

Abstract:

This paper assesses the microstructure of the U.S. Treasury securities market using tick data from the BrokerTec electronic trading platform. We examine trading activity, bid-ask spreads, and depth for the on-the-run 2-, 3-, 5-, 10- and 30-year securities and find that liquidity is markedly greater than that reported by earlier studies using data from GovPX. We analyze the price impact of trades and find that the effects are overstated if order book changes are ignored, and that order book changes affect prices by themselves. We also explore a novel feature of this platform, the ability to enter 'iceberg' orders, and find that such orders are more common when price volatility is higher, as'predicted by theory.

The Case for Tips: An Examination of the Costs and Benefits

Dudley, William, Roush, Jennifer E. and Steinberg, Michelle, The Case for Tips: An Examination of the Costs and Benefits (July 1, 2009). Economic Policy Review, Vol. 15, No. 1, July 2009. Available at SSRN: http://ssrn.com/abstract=1434111

Abstract:
Slightly more than a decade has passed since the introduction of the Treasury Inflation-Protected Securities (TIPS) program, through which the U.S. Treasury Department issues inflation-indexed debt. Several studies have suggested that the program has been a financial disappointment for the Treasury and by extension U.S. taxpayers. Relying on ex post analysis, the studies argue that a more cost effective strategy remains the issuance of nominal Treasury securities. This article proposes that evaluations of the TIPS program be more comprehensive, and instead focus on the ex ante costs of TIPS issuance compared with nominal Treasury issuance. The authors contend that ex ante analysis is a more effective way to assess the costs of TIPS over the long run. Furthermore, relative cost calculations, whether ex post or ex ante, are just one aspect of a comprehensive analysis of the costs and benefits of the TIPS program. TIPS issuance provides other benefits that should be taken into account when evaluating the program, especially when TIPS are only marginally more expensive or about as expensive to issue as nominal Treasury securities.

Standard & Poor's Indices Versus Active Funds Scorecard, Mid Year 2008

Standard & Poor's Indices Versus Active Funds Scorecard, Mid Year 2008

�� The S&P Indices Versus Active Funds (SPIVA) Scorecard report performance comparisons corrected for survivorship bias, shows equal- and asset-weighted peer averages, and provides measures of style consistency covering actively managed U.S. equity, international equity and fixed income mutual funds.
�� Starting with this report, we reintroduce an enhanced SPIVA with broader asset class coverage. Data for enhanced SPIVA is from the CRSP Survivor-Bias-Free U.S. Mutual Fund Database. To accommodate CRSP release schedules, the new SPIVA will be published semi-annually with a fourteen week lag.
�� Over five years ending June 2008, S&P 500 outperformed 68.6% of actively managed large cap funds, S&P MidCap 400 outperformed 75.9% of mid cap funds and S&P SmallCap 600 outperformed 77.8% of small cap funds.
�� Among global equity funds, five-year results show S&P Global 1200 outperforming 70.1% of global equity funds, S&P 700 outperforming 86.5% of international equity funds, and S&P IFCI
Composite outperforming 73.9% of emerging market funds.
�� Among fixed income funds, indices outperformed twelve of thirteen categories over a five-year horizon. Only emerging market bond funds outperformed their benchmark index.
�� Funds disappear at a meaningful rate. Over five years, 26.8% of U.S. equity funds, 22.5% of global equity funds and 24.7% of fixed income funds have been merged or liquidated. This highlights the importance of addressing survivorship bias in mutual fund analysis.

ARE RETIREMENT SAVINGS TOO EXPOSED TO MARKET RISK?

ARE RETIREMENT SAVINGS TOO EXPOSED TO MARKET RISK?

by Alicia H. Munnell and Dan Muldoon

IB#8-16

Introduction

The stock market, as measured by the broad-based Wilshire 5000, declined by 42 percent between its peak in October 9, 2007 and October 9, 2008. Over that one-year period, the value of equities in pension plans and household portfolios fell by $7.4 trillion. Of that $7.4 trillion decline, $2.0 trillion occurred in 401(k)s and Individual Retirement Accounts (IRAs), $1.9 trillion in public and private defined benefit plans, and $3.6 trillion in household non-pension assets.

This brief documents where the declines occurred. This information is interesting and important in its own right. But the declines also highlight the fragility of our emerging pension arrangements. Today the declines were divided equally between defined benefit and defined contribution plans, but in the future individuals will bear the full brunt of market turmoil as the shift to 401(k)s continues. Much of the reform discussion regarding private sector employer-sponsored pensions has focused on extending coverage. But the current financial tsunami also underlines the need to construct arrangements where the full market risk does not fall on pension participants.

The Hewitt 401(k) Index™ Observations

The Hewitt 401(k) Index™ Observations

• Amid the market turmoil, 401(k) participant activity was high and transfers were significant out of equities during September, according to the results of the Hewitt 401(k) Index™. A total of $921 million moved out of equities and into fixed income investments during the month. The directions of the transfers were fixed income oriented during 76% of the total days, and nearly all of the days in the second half of the month.


• While activity was relatively high, the vast majority of 401(k) participants stayed calm. The overall transfer activity level in September was only slightly higher than the average transfers of the trailing 12 months — 0.06% of balances were transferred on a net daily basis in September versus 0.05% of balances transferred during the past year.


• Five days of the month had above normal* level of transfers, with four out of the five days showing up in the latter half of the month. All four days were strongly fixed income oriented and followed significant market drops. On September 16th, the day following the news of the collapse of Lehman Brothers and the credit-rating downgrade of AIG, the index transfer activity was nearly three times as high as the usual level — with 0.13% of balances transferred. On September 29th, the financial rescue plan was defeated on Capitol Hill and the markets broadly dropped, and participant transfers were 2 to 3 times the normal levels on the following two days.


• The three fixed income asset classes received nearly the entire inflows (96%) in September. Approximately $733 million moved into GIC/stable value funds, representing 68% of the net transfers in September. Bond and money market funds also received $178 million (16% of net transfers) and $133 million (12% of net transfers), respectively.


• As the MSCI EAFE Index declined over 14% in September, international funds experienced the largest outflows, with nearly $330 million transferring out of this asset class. Large U.S. equities also experienced $234 million in outflows, followed by lifestyle funds ($141 million) and balanced funds ($137 million).


• For the third quarter, a total of $1.9 billion moved from equities to fixed income investments, mainly from international funds ($700 million) and U.S. equities ($478 million) into stable value funds ($1.7 billion).


• Due to both participant transfers and market decline, participants' overall equity exposure has dropped to its lowest level since April 2003, at 58.8%. It was down by 3.7% for the quarter.


• Employee equity contributions (participant discretionary contribution) also declined 2.9% during the quarter to 62.4% by the end of September.

*A "normal" level of relative transfer activity is when the net daily movement of participants' balances as a percent of total 401(k) balances within the Hewitt 401(k) Index equals between 0.3 times and 1.5 times the average daily net activity of the preceding 12 months. A "high" relative transfer activity day is when the net daily movement exceeds two times the average daily net activity. A "moderate" relative transfer activity day is when the net daily movement is between 1.5 and two times the average daily net activity of the preceding 12 months.