Saturday, October 26, 2013

Emerging Equity Markets in a Globalizing World


Given the dramatic globalization over the past twenty years, does it make sense to segregate global equities into “developed” and “emerging” market buckets? We argue that the answer is still yes. While correlations between developed and emerging markets have increased, the process of integration of these markets into world markets is incomplete. To some degree, this accounts for the disparity between emerging equity market capitalization in investable world equity market benchmarks versus emerging market economies in the world economy. Currently, emerging markets account for more than 30% of world GDP. However, they only account for 12.6% of world equity capitalization. Interestingly, this incomplete integration along with the relatively small equity market capitalization creates potentially attractive investment opportunities. Our research has important policy implications for institutional fund management.

Bekaert, Geert and Harvey, Campbell R., Emerging Equity Markets in a Globalizing World (October 24, 2013). Available at SSRN:

Sunday, February 10, 2013

Low Risk Stocks Outperform within All Observable Markets of the World

This article provides global evidence supporting the Low Volatility Anomaly: that low risk stocks consistently provide higher returns than high risk stocks. This study covers 33 different markets during the time period from 1990-2011. (Two previous studies by Haugen & Heins (1972) and Haugen & Baker (1991) show the same negative payoff to risk in time periods 1926-1970 and 1970-1990.) The procedure for our study is intentionally simple, transparent and easily replicable. Our samples include non-survivors.

We look at an international universe of stocks beginning with the first month of 1990 until December 2011; we compute the volatility of total return for each company in each country over the previous 24 months. Stocks in each country are ranked by volatility and formed into deciles. In the total universe and in each individual country low risk stocks outperform, the relationship with respect to Sharpe ratios is even more impressive.

We believe this anomaly is caused primarily by agency issues, namely the compensation structures and internal stock selection processes at asset management firms which lead institutional investors on average to hold more volatile stocks. The article also addresses the implications for how corporate finance managers make capital investment decision in light of this evidence. The evidence presented here dethrones both CAPM and the Efficient Market Hypothesis. 

Baker, Nardin L. and Haugen , Robert A., Low Risk Stocks Outperform within All Observable Markets of the World (April 27, 2012). Available at or

See also : Low Volatility Index returns - Bogleheads

Saturday, January 12, 2013

How Do Employers’ 401(k) Mutual Fund Selections Affect Performance?

The brief’s key findings are:
  • 401(k) performance is affected by the decisions of plan administrators as well as participant choices.
  • Administrators choose mutual funds that perform worse than comparable indexes but better than comparable, randomly selected funds.
  • When making changes to a plan’s fund offerings, administrators chase returns and do not improve performance.
  • Participants also tend to chase returns through contribution changes and asset transfers, and their investment strategies add no value.

Edwin J. Elton,Martin J. Gruber and Christopher R. Blake, How Do Employers’ 401(k) Mutual Fund Selections Affect Performance?  IB#13-1

Value and Momentum Everywhere

We study the returns to value and momentum strategies jointly across eight diverse markets and asset classes. Finding consistent value and momentum premia in every asset class, we further find strong common factor structure among their returns. Value and momentum are more positively correlated across asset classes than passive exposures to the asset classes themselves. However, value and momentum are negatively correlated both within and across asset classes. Our results indicate the presence of common global risks that we characterize with a three factor model. Global funding liquidity risk is a partial source of these patterns, which are identifiable only when examining value and momentum simultaneously across markets. Our findings present a challenge to existing behavioral, institutional, and rational asset pricing theories that largely focus on U.S. equities.

Asness, Clifford S., Moskowitz, Tobias J. and Pedersen, Lasse Heje, Value and Momentum Everywhere (June 1, 2012). Chicago Booth Research Paper No. 12-53. Available at SSRN: or

See also:  Momentum index returns - Bogleheads

Saturday, July 09, 2011

Is Portfolio Theory Harming Your Portfolio?

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:

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

Two views of pension funds; prospectively and current status:

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:

The Funding of State and Local Pensions in 2010

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

Thursday, August 27, 2009

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

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:

Wednesday, July 22, 2009

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:

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

Sunday, July 19, 2009

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:

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.